Why China is a better bet for investors, even as US Fed raises interest rates

  • Given the high US inflation rate, whatever the Fed does in the coming months, the reality is that investors in US Treasuries will be earning a negative real return
  • With China, however, investors can be sure that fiscal and monetary policy will remain stimulatory to support the economy

The Federal Reserve will raise interest rates, the only question being how far it will go as it seeks to curb US consumer price inflation. Higher nominal US interest rates will entice many investors but, from an overall investment perspective, China may still prove the more attractive proposition.

First, with US interest rates at the zero bound now but the consumer price index at 7.5 per cent year on year in January, whatever the Fed does in the coming months, the reality is that investors in US Treasuries are still going to be earning a negative real return for some time to come.

The yield on the benchmark 10-year Treasury was 1.93 per cent at last week’s close.

In China, where the official consumer price index rose by only 0.9 per cent in January on an annualised basis, down from 1.5 per cent in December, but the yield on the 10-year Chinese government bond was at 2.8 per cent at last Friday’s close, investors are still getting a positive inflation-adjusted return on their money.

Even allowing for the fact that Beijing is focused on supporting the pace of Chinese economic growth rather than curbing inflation, and the People’s Bank of China’s monetary policy settings are consequently steady, the nominal yield differential still favours Chinese government bonds over US Treasuries – and dramatically so when viewed on an inflation-adjusted basis.

Indeed, overseas investors continued to pile into China’s bond market in January.

Foreign holdings of interbank bonds hit 4.07 trillion yuan (US$640 billion) at the end of last month, according to PBOC data released on February 14, a figure that represents 3.5 per cent of the market total.

Admittedly, the net increase of 70 billion yuan in January was lower than the 78.7 billion yuan and 80 billion yuan recorded in December and November respectively, but this is likely to reflect the impact of a recalibration of market expectations of front-loaded US interest rate hikes that are now fully incorporated in the US yield curve.

If the focus is on the quest for yield, it’s perhaps noteworthy that there have still been continuing incremental increases in overseas investments in Chinese bonds despite market awareness that the nominal US-China yield differential seems set to be less skewed in China’s favour.

Additionally, as data from China’s Ministry of Commerce showed on January 13, overall foreign direct investment (FDI) inflows spiked 20.2 per cent year on year in 2021 in dollar terms to US$173.5 billion.

Indeed, French bank BNP Paribas argued last week that “despite US-China political tension, China remains a magnet for global business communities due to its large and growing markets, and its tried and tested supply chains” and said it expected “FDI inflows to remain robust, although the pace may slow”.

Robust FDI inflows, combined with the likelihood that China’s export sales will remain healthy as post-pandemic global consumer demand rebounds, should provide two forms of support for the yuan anyway.

But there is also the very real possibility Beijing will recognise that, in a period of rising prices for US dollar-denominated raw material imports, a stable-to-stronger renminbi might be best for the Chinese economy.

Then there’s the issue of relative equity prices. It remains to be seen how much of an impact higher US interest rates will have on US equity markets which, if not priced for perfection, are arguably fully priced.

Nor can investors yet know the impact that the impending halt of Fed asset purchases will have on US equity valuations.

And there is certainly no clarity on what would happen to US equity values if the Fed ultimately concludes that a smaller US central bank balance sheet is justified and so initiates some degree of quantitative tightening.

But what investors can be sure of is that Chinese fiscal and monetary policy is going to remain stimulatory because Beijing’s primary economic objective is getting China’s economy back on track.

On a comparative basis, and underpinned by the argument that the yuan will be stable to stronger, a plausible case might be made that renminbi-denominated equities offer an attractively priced alternative to US stocks.

Markets know that the United States has a problem with inflation, which requires tighter monetary policy, and that China has an issue around economic growth that requires supportive fiscal and monetary policy settings.

These circumstances could favour capital flows into the US in pursuit of higher Treasury yields but that seems a narrow view. The better bet for investors may yet be China.

Author: Neal Kimberley is a commentator on macroeconomics and financial markets, SCMP

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