The Chinese government’s aggressive regulatory crackdown on the country’s private technology companies (most recently, the online education sector) has shaken investor sentiment toward a range of Chinese assets, causing China’s equity and bond markets alike to swoon in recent days. The crackdown comes as Chinese policymakers embark on the delicate balancing act of redefining the role of private enterprise in China, versus the often-competing objectives of the nation’s common prosperity and social responsibility.
Here’s a distillation of our global fixed income and emerging markets debt teams’ latest views on some of the potential investment implications.
Fixed income investment implications
China equities and sovereign bonds, along with the Chinese currency, abruptly sold off in unison following the government’s latest regulatory actions during the week of July 26. But most Chinese household wealth is still mainly invested in fixed-rate deposits, wealth management products, and real estate assets. This should help limit the broader fallout of the recent equity market selloff, beyond the obvious impact on risk sentiment. As of this writing, we do not expect any commensurate regulatory actions that might heavily influence financing flows in Chinese interest-rate, currency, or credit markets.
The domestic bond market rout was triggered by a liquidity squeeze from massive fund redemptions and margin calls by investors in response to the equity market correction. For the near future, we suspect China’s bond market is likely to be caught between the ongoing liquidity stress and flurries of risk-off moves by global investors. Over the medium term, we believe bond market sell-offs like this latest episode could provide favorable entry points for investors, given Chinese sovereign bonds’ continued appeal as a domestic and global “safe-haven” type of duration asset.
Given the prevailing risk-off mood in global currency markets, we are cautious on the Chinese yuan (CNY) for now, as the traditional safe-haven currencies — developed markets like the US dollar, the Japanese yen, and the Swiss franc — may experience a broad rally driven by “flight-to-quality” asset flows in the period ahead. At this time, relative to the CNY, we see more attractive value in some other Asian currencies, particularly those where the country’s policymakers look more likely to tighten monetary policy in the near term.
As for the credit market, we think the regulations imposed on China’s education and technology sectors will impact these companies’ business models to one degree or another. In our view, this “fairness over efficiency” is an emerging theme in China’s regulatory environment and would inevitably increase companies’ operating expenses. Their regulatory burden may mount, profits could be reduced, and industry competition will likely intensify from here.
However, our base case is that large industry players with diversified businesses and strong balance sheets should be able to withstand the near-term regulatory hit with minimal damage. Many of these companies will pass some of the incremental costs along to their end customers. This could be “credit constructive” longer term, as companies are forced to scale back bold expansion plans and refocus on core business strength.
In contrast, we expect credit-rating sensitivity to be higher over the next 12 – 18 months for companies with less diversified business models and less robust balance sheets. One of the key credit metrics we will be watching closely is the operational performance of these companies’ core business segments, including whether there will be disruptions or lasting market-share losses as further details of these regulations become available.
Final high-level thoughts
The drumbeat of calls for US policymakers to take the drastic step of banning or restricting US investments in China-linked assets has been echoed across recent US administrations, so the heightened concern around that possibility is nothing “new” among market participants. We have not seen any substantive evidence so far to support the theory of a definitive investment restriction by US policymakers. At the very least, we think US regulatory agencies will be prompted to reconsider domestic investor protection provisions with respect to US-listed securities of Chinese issuers/entities.
However, the recent market turmoil does suggest that US and other overseas investors’ confidence in China has dropped to a point of seriously questioning the investible nature of Chinese assets in general and beginning to reassess China’s overall investment climate. It will clearly take some time to rebuild that confidence to prior levels. In the meantime, markets could encounter more bouts of volatility related to this issue, precipitated by both domestic and foreign investors, even in the absence of further US and Chinese regulatory measures.
Chinese policymakers will likely step up penalties for business misconduct, yet they will also seek to maintain a delicate balance by not causing a systemic shock to the Chinese economy. As a result, judicious top-down macroeconomic , geopolitical, and regulatory analysis, combined with rigorous bottom-up security selection, will be increasingly critical going forward.