The case for China bonds: A potential hedge against rising inflation

2. US inflation may not be transitory

We believe higher US inflation may not be transitory in nature that only reflects temporary supply shocks. Rather, higher inflation is likely a consequence of stronger US demand and goods consumption. Higher consumption and imports in the US are positive contributors to China’s trade surplus which is positive for the CNY.

3. US inflation is outpacing that of China

With US inflation currently outpacing China inflation, the value of the CNY (in real terms) is likely to be closer to fair value compared with the US dollar. The latter is more likely to be overvalued due to its higher inflation based on the real effective exchange rate (REER). The REER is a measure of a currency’s value against those of its major trading partners after adjusting for inflation.

4. The market is in a “risk-on” mode

A market environment with higher breakeven rates and low-to-negative real yields is generally associated with a “risk-on” mode, i.e., global investors are more likely to allocate away from US Treasuries to higher-risk asset classes in this environment. Hence, on this basis, a greater allocation to CNY assets can be expected.

As inflation has ramped up in the last 12 months, we have seen US Treasury inflation-linked bonds outperform US Treasuries over this time. Similarly, China bonds (unhedged) have performed strongly and kept pace with the performance of US Treasury Inflation-linked bonds over the same period, giving support to our thesis that China bonds can provide investors with a hedge against US inflation.

Chart 3: 5-year returns of China bonds (unhedged) vs. US Treasury inflation-linked bonds

Bloomberg, data as of 30 November 2021.

Conclusion

We have highlighted some of our key observations and explained why we think China government bonds and the CNY Chinese renminbi have the potential to act as hedges against US inflation. China bonds are already an attractive asset class, given their higher nominal and real yields and diversification benefits due to a lower correlation with other assets. However, the potential for China bonds to be a positive-yielding asset that also hedges against rising global inflation further enhances their appeal. We believe there is now an even stronger case for considering China bonds as a key part of global investors’ portfolios.

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Certain sub-funds may invest directly in certain China A shares via Stock Connect, which may involve in risk related to Investments via Stock Connect and Mainland China investment.
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Certain sub-funds with significant exposure to Renminbi (“RMB”) bonds/equity/assets or emerging markets, may involve debt instrument, credit/counterparty, concentration, liquidity, volatility, currency, tax, economic, foreign exchange/multi-currency conversion, down-grading, regulatory and political risks and these risks could be substantially higher than the risks normally associated with the world's more established markets.
A bond sub-fund may hold a significant portion of assets in deposits if there are not sufficient RMB instruments for it to invest in. This may adversely affect its return and performance.
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