Recent Bond Defaults will not Lead to Systemic Concern, China Likely to Tackle the Risk of Excessive Liquidity Tightening

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Recently, risk appetite continued to be dampened as the market became concerned over increasing bond defaults, in addition to external factors such as trade disputes and turmoil in emerging markets on the back of rising US interest rates and stronger US dollar. The rising bond market volatility has widened credit spreads and depressed corporate bond issuance.

Specifically, this round of credit default events was somehow triggered by the initiation of a set of new asset management policy guidelines which is an important part of the government’s de-leveraging initiatives for the financial sector. The new asset management industry rules have pushed up the funding cost for local Government projects and private enterprises. In addition, macro policies have tightened on multiple fronts under the general guideline of “deleveraging and risk-prevention”, which in turn lead to a notable slowdown of shadow banking and Total Social Financing (TSF) growth.

We do not expect these defaults to lead to systemic concerns as the total defaulted amount is a very small proportion of total outstanding corporate bond liabilities (less than 0.2%1) and policymakers, from our observations, have a firm grip on the market conditions and at the same time, the People’s Bank of China (PBoC) has been quite responsive in providing liquidity relief to the system. The recent moves by the PBoC, including cutting the reserve requirement ratio (RRR) in April and targetted RRR cut to be effective in July and the expansion of collateral acceptances for Medium-term Lending facilities (MLF) with banks, are good evidences of the government’s pro-active approach in managing the risks of excessive liquidity tightening. To further iterate PBoC’s preparedness to act, it issued a statement on June 19 saying that it has placed a high priority to manage the impact of external shocks and may pre-emptively use policy tools to ensure stable domestic liquidity and manage the pace of deleveraging. We believe that its tool kit includes  RRR cuts and open market injections, increasing loan quota, accelerating government bond issuance, and fiscal easing as the ultimate support of the economy.

We have noticed that both the PBoC and the top regulators were more willing to take feedback and advice from market participants and experts before making policy decisions in the last 1-2 years. We hold the view that the quality of policy decisions made by the Chinese government has shown a remarkable improvement, admittedly after a number of tough and costly lessons learnt in the last few years. This string of credit defaults may have a negative impact on near-term sentiment as stock market investors are worried about potential domino effects and the shrinkage in financing channels for corporates. We also like to note that there is a potential relaxation of corporate bond issuance approvals from the regulators in the near-term as the issuance had been put on hold on regulators’ window guidance earlier on, which would imply that the government is keen to diligently manage the risks to the broader economy arising from the deleveraging initiatives.

Corporate bond defaults have been taking place in industries such as environmental protection and other urban infrastructure sectors which typically have aggressive private-enterprises embracing high leverage and liability duration mismatch involved. The defaults effectively freeze the new-issuance market of corporate bonds. Moreover, with a stronger risk-conscientiousness in mind, the central government has been eyeing the excessive local infrastructure investments disguised as Private-Public-Partnership (PPP) projects. Around 12% (or Rmb 1.53 trillion) of the planned PPP investment has been revoked from the project inventory between November 2017 and April 20182. This certainly has hamstrung the fixed asset investment impetus to overall GDP growth. Given this, we believe it would be wise to invest in companies with either a very strong operating cash flow to cover their financing needs or well-supported by banks given the robustness of their businesses.

In the short term, the rising defaults may increase bearish sentiments, but these developments will likely contribute to the normalization and resilience of the bond market in China over the long run. Furthermore, tightening credit conditions will likely accelerate industry consolidation as it is becoming more difficult for weaker companies to get funded. Liquidity pressure for Hong Kong listed companies will likely be manageable as they have multiple channels for funding, compared to their onshore peers. Overall, we believe that volatility and uncertainties will dominate in the short term, but economic resilience, thanks to a robust synchronized global recovery and Chinese Government backstop, should offer a more benign and constructive backdrop for the economy in the latter part of the year.

[1] Source: CICC Research as of June 2018
[2] Source: CICC Research as of May 2018

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Why are economic activities in China weaker than expected in the first few months of 2018?

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Economic indicators fell short of market expectation in previous months. The manufacturing Purchasing Managers’ Index (PMI) in April was 51.4%, which experienced a 0.1% fallback from March1. Indeed, the figure was recorded at 50.3% in February, which was the lowest in the past 19 months1. The anxiety of investors on the potential slowdown of industrial economy has suppressed market sentiments in a certain extent, whereas cyclical stocks have been plagued in particular.

Our observation on the ground leads us to think that there has been a mini-destocking cycle happening in China, which led to the marginally weaker economic data-points. On the supply side, as 2017 was a great year for China corporates, they were expecting strong domestic demand in 2018 and decided to stock up on inventories starting in in late 2017 before the prices of raw materials and commodity rose further. However, the start of 2018 was met with weaker demand caused by the mild slowdown in production and investment, and in some cases, over stringent enforcement of environmental directives. A few “one-off” factors have contributed to softer production and investment growth in March, such as a late Chinese New Year which affected the number of effective working days in March and the longest “Two Sessions” – the annual meetings of the national legislature and the top political advisory body – in history (traditionally economic activities soften during these major meetings because of policy uncertainty and environmental considerations), and colder weather in the north also dampened construction in March. The above resulted in an imbalance of supply and demand in some sectors, which were expressed through weaker economic figures.

However, we have noticed that the destocking cycle of some industries is nearing the end. For instance, the total rebar stock and hot-rolled steel coil stock have been declining since late-March2. We expect that the stocks stacked up last year are likely to be fully digested around June to July this year. As a matter of fact, our viewpoint that the mini-destocking cycle is coming to an end has been supported by the economic data in May. May NBS manufacturing PMI recovered to 51.9% from 51.4 in April, slightly higher than the market consensus3. New Orders Index picked up to 53.8% from 52.9%3. Meanwhile, high-frequency data showed stronger price momentum in raw material prices such as coal and oil in May3.

Finally, a transformation in the nature of cyclical industries has been taking place in recent years. In the past, corporates tend to increase capacity in good times. Excess capacity then caused raw materials prices to drop, leading to constant and vigorous fluctuations in corporate profits. Since the implementation of supply-side reform, the phenomenon of unconstrained capacity expansion has rarely occurred. Up-stream prices have been stabilized in general, whereas profits have been steadily improving. Corporates in cyclical industries will not spend excessively on capital expenditure. Hence, profits for these corporates will no longer fluctuate as wildly as before, and it is expected that their balance sheets will show improvements in two years’ time, accompanying a higher chance of dividend payout and higher dividend yield. We believe cyclical stocks will likely undergo a re-rating in the near future.

[1] Source: The Wall Street Journal, as of May 2018
[2] Source: Bloomberg, as of May 2018
[3] Source: CICC Research, as of May 2018

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.