Asset Management

China purges bond sector amid strong post-pandemic and renewable energy growth

Market Update

As China celebrates the New Year, investment professionals from three of our investment boutiques share their views on the economic powerhouse.

  • The macro view by Sven Schubert, Senior Investment Strategist, Multi Asset Boutique
    The growth gap between the West and China will continue to widen and the US-China trade conflict will continue as a low-intensity tech war. Meanwhile, the US and China will continue to vie for supremacy in their regions through existing and potentially future inter-state economic partnerships.
  • The micro view by Cosmo Zhang, Research Analyst, Fixed Income Boutique
    Bond defaults in China have increased which is the result of the Chinese government's intention to improve the quality of the local credit market. Any volatility experienced represents an opportunity for active bond investors to generate alpha.
  • The ESG view by Pascal Dudle, Head of Listed Impact, Sustainable Equities Boutique
    Becoming carbon-neutral by 2060 accelerates growth in the renewable energy sector which is likely to attract investment flows to China. Xinyi Solar, a leading solar glass manufacturer, has already rewarded investors with strong returns whereas Jiangsu Zhongtian Technology stands to benefit from a massive expansion in Offshore Wind.

The Macro view: Gap with the West will widen

Sven Schubert, Senior Investment Strategist, Multi Asset Boutique

Even if the global synchronized recovery will continue this year thanks to the COVID-19 vaccine, the growth gap between China and the US as well as Europe is likely to increase in the first quarter of this year due to renewed lockdowns in the Western world and delays in the vaccine rollout. Later this year, the divergence in economic growth could lessen, as the vaccine proves effective against the virus. However, the US and Europe will be slow in catching up, while China powers on.

China did impose regional restrictions again recently to stem local virus flare-ups, but a renewed nationwide lockdown is unlikely. Thanks to swift action, the COVID-variant in Beijing seems to have been reigned in and infection rates, which spiked in January, are again under control. This reduces the pressure on the government to correct for the slow pace of the vaccine rollout. In addition, hope is in sight with Chinese companies like Sinovac, CanSino and Sinophram making progress on vaccines. Sinovac alone says it could provide 600 million doses this year.

Low intensity trade/tech war to continue but US-China relationship to become more predictable

Now that Biden has taken office, Chinese economic growth is likely to see less of a threat from a belligerent America. Even if the Democrats align with the Republicans in a rare bi-partisan agreement that China represents a clear threat to US technological, economic and military dominance, they will take a different approach to dealing with it. Donald Trump preferred a “shoot-first-and-then-talk” strategy of pushing through tariff hikes and export bans on China and even on some of its own allies. Conversely, the Biden administration is more likely to seek a consensus with its allies before approaching China.

Moreover, the Biden administration seems to have a better understanding of the economic costs of the trade war. The dependency of the US corporate sector on Asia and China in particular in terms of earnings is significant. Apple’s recent quarterly earnings revealed that sales growth was strongest in China. Therefore, the risk of a further escalation of the trade war is low as it could inflict significant harm on the US economy.

China and the US aim for increased economic integration in their regions

The US will continue to watch China like a hawk on matters of digital supremacy. Jared Cohen and Richard Fontaine, two former members of the US State Department have called for a T-12, a group of 12 techno-democracies, to coordinate their response to the digital threats posed by autocratic regimes like Russia and China. The purpose of such an alliance between like-minded countries would be to define standards on the use of private data by digital platforms, to start joint venture research projects in areas of new technologies and to secure supply chains of goods critical for their economies more efficiently. Therefore, a coordinated answer may lead to more information-sharing, more investments in new technologies and possibly stronger growth.
China's Belt and Road Initiative and the recently announced Regional Comprehensive Economic Partnership (RCEP) are the expression of a similar intention in Eurasia as China strives to increase the dependencies of other economies on the Chinese economy. The RCEP is likely to spur growth in the region with positive consequences for Asian markets. Therefore, the relationship between the two countries and regions is likely to become more competitive. Assertive foreign Chinese policy, for example in the South Asian Sea, remains a risk however. The Biden administration emphasized already – contrary to Trump – that the US would stand by its Asian allies on geopolitical security issues.

The micro view: Increased bond defaults in China is testimony to increased market efficiency

Cosmo Zhang, Research Analyst, Fixed Income Boutique

Due to the pandemic, China’s corporate sector has been seeing an increased number of defaults since early November last year, which has triggered some selloffs in November in both onshore and offshore markets. As a result, total defaults in 2020 could be higher than in 2019, and drive the 2020 onshore corporate bond default ratio up to over 1.0% from 0.62% in 2019. However, this is still lower than the global average. In addition, the risk is manageable and poses no systemic threat thanks to Chinese policymakers’ abundant resources.

The fact that such defaults now occur rather earlier than later is testimony to the Chinese government's efforts to increase market efficiency and transparency for the benefit of the overall economy. Therefore, rather than being due to deteriorating credit fundamentals, these defaults have been prompted by the Chinese government's decision not to bail out isolated cases of weak state-owned enterprises (SOEs) as the country recovers rapidly from the pandemic. This strategy is in line with policymakers’ deleveraging plan, which was launched in 2018 to mitigate “moral hazards” and promote credit differentiation as well as pricing. By letting markets run more freely, investors will learn to price default risks correctly – a long overdue development that should help create a healthier and more efficient credit market. As context, the central bank acted quickly and decisively in 2019 after the failure of Baoshang Bank, a regional lender based in Inner Mongolia, when it became clear that this rare occurrence had spooked the market. The lender was taken over by authorities and swiftly restructured, with large institutional depositors suffering a moderate 10% haircut. This shows the government’s determination to avoid systemic risk as it seeks to build a stronger, more efficient economy. While this may be bad news for the weakest SOEs, it is an improvement for investors and the Chinese credit market as a whole. A more accurate pricing of risk gives buyers of bonds greater transparency in a relatively opaque economy. That would boost the allure of Chinese debt, drawing more inflows, which in turn would help reduce the reliance of the nation’s capital markets on the government.

This is positive progress in the long-run for China’s development of a healthy credit market, albeit with some short-term pain. From an investor perspective, volatility created by higher defaults presents attractive buy-dip opportunities to acquire bonds from strong issuers at cheap valuations during the selloff in past weeks.

The ESG view: Strong growth in Chinese renewable energy

Pascal Dudle, Head of Listed Impact, Sustainable Equities Boutique

China has committed to carbon neutrality by 2060. Assumptions are that the country will accelerate two of its main goals, limiting the share of coal in the primary energy mix to 52 percent and pushing non-fossil fuels to 20%, by bringing them forward to 2025 from 2030, which the government initially committed to. This implies 90% growth in renewable energy over the coming 5 years. Therefore, many companies in the sector are set to benefit from this growth harboring strong alpha potential for investors. Two examples are Xinyi Solar and Jiangsu Zhongtian Technology (ZTT).

Xinyi Solar is a leading global solar glass manufacturer producing various products such as ultra-clear patterned glass, AR photovoltaic glass, backplane glass for thin-film, and ultra-clear float glass.

Glass has an attractive position in the solar value chain and Xinyi is a key provider to the industry. With approximately 30% market share, the company is one of the two major players in the market that has seen recent consolidation. As a specialty glass manufacturer, the company is also likely to benefit from rising demand for bifacial modules, which are increasingly used to generate a higher energy yield and make solar cells more durable. The company recently experienced a strong rally and has generated generous returns for investors, who recognized its potential.

ZTT primarily manufactures power transmission cables for utilities and grid operators, whether for high-voltage connections between grids or for the integration of renewable energy generation. A major growth area will be the connection of large offshore wind farms, where ZTT is one of the few suppliers in Asia thanks to its many years of experience in installing deep-water cables. In addition, the company manufactures optical cables and communications equipment for the telecommunications and IT industries. The company also offers solar and wind power equipment and, increasingly, maintenance services in all its fields.

One of the most important sectors ZTT services with power transmission cables is Offshore Wind. This sector will expand massively in the coming years, and China could become the world's Number 1 offshore wind power production country.

ZTT supplies across the entire value chain, i.e. submarine cables, seabed survey and submarine cable laying, and wind turbine construction. It is expected that the offshore engineering and submarine cable business contributed more than 20% of earnings in 2020 and will grow to around 35% this year. In addition, ZTT's power transmission business is expected to continue to receive orders from onshore renewable energy projects and the rapid deployment of electric car charging stations.

Currently, ZTT's share price implies falling cash flow returns on investments (CFROI). However, the company has already invested well in growth and should therefore continue to generate solid cash flows from its businesses.