China and u.s. Take opposing monetary policy stances
Currently, an unprecedented decoupling of monetary policy between China and the U.S. is emerging, according to Vontobel. Emerging market corporate bonds post high initial yields. Opportunities come from highly diversified global emerging market portfolios in China and India, as well as Latin America.
"With vaccination programs in place across the board and Omikron apparently posing less of a threat than thought, interest rates, foreign exchange, inflation rates and monetary policy risks could be responsible for market volatility to a greater extent than the pandemic this year", says Cosmo Zhang, Research Analyst, Vontobel.
The market consensus expects interest rate hikes in most countries in 2022 due to a strong increase in inflation in the USA and most industrialized countries. Short-term volatility (with a three-month time horizon) could be higher than in the past, he says, due in part to the Fed's change in policy and ongoing supply chain disruptions caused by the situation at U.S. West Coast ports. This will continue to have an impact on the consumer price index (CPI), he added.
Monetary policy China and U.S. decoupled for first time
"In addition, we see an unprecedented decoupling of monetary policy between China and the U.S. China is currently facing the onset of disinflation and a slowdown in GDP growth, which could be around 5% in 2022, the lowest level since 1991", according to Zhang. As a result, the People's Bank of China (PBOC) is loosening the reins and has adopted an expansionary monetary policy stance. Since early 2022, it has been lowering the reserve requirement ratio (RRR) and interest rates while the Fed announces tapering and rate hikes. The PBoC will inject liquidity into the Chinese onshore market through the medium-term lending facility (MLF) rate, on-lending rates, rediscounting, the special CO2 emission reduction lending instrument and foreign exchange purchases, he said.
"For the first time, the two largest economies are pursuing opposing monetary policies, which we believe will have a very big impact on the market. There will be a reduction in Chinese onshore interest rates and a depreciation of the renminbi against the U.S. dollar. This will have a direct impact on investors' asset allocation and capital flows. Against the backdrop of intensified geopolitical conflicts, market volatility will increase significantly over the next twelve months", emphasizes the research analyst.
Emerging market corporate bonds at an advantage
The persistently high inflation figures are bad news for fixed-income investors, Zhang says. Fixed-income investments, however, would have the advantage that the returns are fixed: Unless an issuer defaults, investors get back the agreed amount, provided inflation does not erode the real value of the cash flows.
"Emerging market bonds represent attractive opportunities for investors with a medium to long-term investment horizon. In our view, corporate bonds from emerging markets in particular have a clear advantage. Unlike developed countries, they post relatively high initial returns. With higher yields, the likelihood of positive real returns increases even as inflation rises. EM corporate bonds also have the advantage of a rather short maturity compared to many other fixed income asset classes. This gives investors the opportunity to reinvest the proceeds at maturity with higher yields", Zhang explains.
He cites three reasons why he believes emerging market corporate bonds are an attractive asset class in the current environment:
- Short duration: Short duration makes them much less sensitive to further increases in yields on US Treasuries.
- Diversification: EM corporate bonds represent a very broad range of companies located in a wide variety of industries and countries.
Attractive risk premiums: "We believe EM corporate bonds are the lowest risk asset class as they are broadly diversified with low interest rate risk. Even though EM corporate bonds are often considered risky, the risk premiums are extremely attractive", stresses the research analyst at Vontobel.
Where opportunities arise in 2022?
Zhang says investors often underestimate the benefits of emerging market stocks globally. For example, more diversified global EM portfolios offer more attractive risk-adjusted returns than Asian bond markets, especially over cycles, due to their volatility and cyclicality, he says. On a regional level, Vontobel expects Latin America to offer investors attractive opportunities. These include, for example, selected companies in countries such as Brazil, Colombia and Mexico.
"In Asia, Chinese real estate companies can offer attractive returns in the high-yield space. In the investment-grade space, we believe short-dated Chinese local government financing vehicles (LGFVs) and bank hybrid bonds (Tier 2/AT1) are good options. Moreover, in China, sectors with high fixed investment, z. B. The building materials and engineering industries, benefiting from government investment in infrastructure. Indian and Chinese renewable energy companies also offer attractive investment options", says Zhang.