China Led The Recovery Trade; Now Almost Everyone Is Cautious

(Bloomberg) - Regardless of the asset class, the outlook for China's financial markets is bleak.
The country's stocks, bonds, and currencies are losing their luster after an impressive start to the year, overshadowed by a stronger dollar, higher US Treasury bond yields, and a domestic campaign to reduce financial risk.
China's benchmark index remains 13% below its 13-year high in early February after a brutal sell-off wiped out more than $ 1.3 trillion in market value. The yuan just suffered its worst month in a year in March, wiping out all of its 2021 gains against the greenback. In the case of Chinese government bonds, which have been a haven during the recent global crisis, foreign investors reduced their holdings for the first time in more than two years last month.
The sharp turnaround in wealth came as confidence grew in a strong rebound in the US economy, regaining the appeal of dollar assets around the world. The recent underperformance in Chinese markets also resulted from Beijing's decision to resume a debt war that was interrupted by the trade war with Washington and the pandemic.
Concerns over inflation and tightening monetary conditions are likely to dampen appetite for Chinese stocks as the country's sovereign debt market faces a supply glut test later this year, investors and analysts say. The yuan could weaken further if the dollar extends its global resurgence.
"China's bull run is being tested," said Adrian Zuercher, head of global asset allocation for UBS's Chief Investment Office. "The volatility will remain elevated in the near future."
Subdued trading
After the world's best rally earlier in the year, Chinese stocks have reversed their course since February, when it became increasingly clear that policymakers were shifting their priorities to taming asset bubbles and reducing financial leverage.
The broader risk reduction campaign also includes cracking down on the internet and the country's fintech giants. In the latest such measures, the authorities imposed a record $ 2.8 billion fine on Alibaba Group Holding Ltd. over the weekend. imposed after an anti-monopoly investigation found it abused its dominance.
While the penalty sparked a relief rally of up to 9% in Alibaba's shares in Hong Kong, those of its peers like Tencent, JD.com and Baidu fell by at least 2.7% amid fears they might be one of Beijing's next target clampdowns .
The onshore benchmark index CSI 300 fell 1.4% during Monday's lunch break, bringing its year-to-date loss to 4.7% and 14.5% from its February high.
The world's second largest stock market is $ 838 billion smaller than its February peak, and trading interest has subsided. Average daily revenue on the two Chinese stock exchanges so far this month was 670 billion yuan ($ 102 billion), the lowest since May, according to data compiled by Bloomberg.
UBS 'Zuercher expects rising government bond yields to be a major source of short-term volatility in China's equity market as it continues to put pressure on valuations of the country's growth stocks and trigger a rotation.
Herald van Der Linde, head of equity strategy for Asia Pacific at HSBC Holdings Plc, reiterated the view, saying that there is still downside risk to Asian equities in the short term and "China is no exception".
Domestically, a central bank unwilling to keep funding terms too loose has also disappointed equity investors unlike its peers in other major economies. Aside from its debt relief campaign, signs of inflationary pressures, as evidenced by the cross-consensus increase in Chinese producer prices of 4.4% in March, could lead Beijing to further reduce its pandemic-fueled economic stimulus.
"We believe monetary policy could be tightened," Hanfeng Wang, strategist at China International Capital Corp., wrote in a note this week, adding that investors are taking the political signals from the next meeting of the Politburo, the head of the Communist Party, Should pay attention to the decision-making body.
Bonds put under pressure
While Chinese government bonds outperformed their peers in the first quarter as they stood out as a bulwark in the global slump due to their port status, they face a number of challenges in the months ahead.
In addition to a longer-than-expected phase-in-phase for inclusion in the FTSE Russell World Government Bond Index, an increase in the supply of bonds from local governments and a tightening of the US in the US. Interest gaps also threaten to make Chinese debt less attractive.
China's 10-year government bond yields are projected to rise to 3.5% by the end of this quarter, according to Becky Liu, head of China's macro strategy at Standard Chartered Plc.
As China's yield premium over government bonds declined, global investors reduced their holdings of Chinese government bonds last month for the first time since February 2019, a trend that is expected to continue for some time. The yield gap fell to 144.8 basis points on March 31, the narrowest since February 24, 2020 when it was 144.2 basis points.
Weaker yuan
The renewed strength of the dollar, the tighter interest rate gap and Beijing's latest move to increase capital outflows have led analysts, including INGs, to lower their forecasts for the Chinese currency.
After rising nearly 7% against the dollar last year and further gains earlier this year, the yuan suffered its worst sell-off in a year last month and has seen steady gains since May.
Read: Yuan Wipes Out Annual Gains Against Dollar If PBOC Stands Aside
The yuan is also weighed down by the slowed pace of capital inflows: cross-border currency flows tracked by Goldman Sachs totaled $ 1.5 billion for the week ending April 7, compared to about $ 3 billion the previous week.
"It's about how views on the US dollar have changed quickly," said Zhou Hao, an economist at Commerzbank AG. "People believe the US economy will rebound strongly over the next two years, and that's exactly what stocks and bonds have priced in."
Zhou said he expected the yuan to fall from around 6.56 on Friday to 6.83 per dollar by the end of this year.
(Updates with the performance of broader stock market and technology stocks in the ninth and tenth paragraph)
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