South Africa looking brighter
February 21, 2018

Jan Dehn, head of research at Ashmore, discusses the outlook for South Africa after Zuma's resignation, which he insists is now significantly brighter. He also explains why investing in Chinese government bonds is a good bet, given they have performed far better than developed market bonds even during bouts of negative sentiment towards China.

Zuma's resignation: the outlook for South Africa is now significantly brighter

Jacob Zuma resigned and Cyril Ramaphosa was sworn in as South Africa's President in his place. South Africa's institutions worked as they should and a peaceful transition of power took place. Ramaphosa's ascent to power is not just a change of President; it represents a marked shift in policy away from corruption and discretion towards transparency and reforms. Ramaphosa will also lead the ANC into the next general election, which he is likely to win. So the outlook for South Africa is now significantly brighter, not just for now but over the medium term. South Africa desperately needs this change. The country needs reforms, new ideas, less corruption and a boost to business confidence. Ramaphosa has the potential to deliver all this. Ramaphosa's rise to power in South Africa also illustrates another ‘truth' about politics in EM countries, namely that EM presidents generally do not survive politically for very long if they start to mess with the economy. This is because the vast majority of people in EM countries are poor with no inflation hedges or unemployment benefits, that is, no means of protecting themselves against macroeconomic volatility. Therefore, they have a strong preference for stability and growth. The only governments in EM where presidents are able to hang on despite bad policies tend to be countries, where presidents are backed by the resources from other countries, usually one of the super powers, or where presidents control vast oil wealth. 

The case for EM local bonds

As yields rise in the US treasury market, other developed bond markets will come under pressure and investors who are exclusively invested in developed market fixed income will struggle due to high correlations between all these markets. Government bonds in EM offer an obvious solution. Yields on EM local currency government bonds are currently trading a mere 65 basis points (a basis point is one-hundredth of a percentage point) lower than at the end of 2006, when the Fed funds rate was 5.25 percent (6.07 percent today versus 6.72 percent in 2006). In other words, EM local bonds are in effect pricing a Fed funds rate of 4.60 percent (5.25 percent minus 65bps), while the actual Fed funds rate is currently only 1.5 percent. By contrast, US five-year government bonds are currently trading at 2.63 percent, which is 206 bps lower than in 2006. German five-year bonds trade 384 bps lower than in 2006. Clearly, EM local currency bonds have a comfortable yield cushion, while developed market bonds do not. EM currencies are also providing an important tail wind, while the absolute higher yields provide income.

Despite the obvious attractions of EM bonds compared to developed markets bonds, many fixed income investors still pay heed to an Apartheid-like regime, which still permeates the financial industry, whereby government issuers are divided into arbitrarily defined ‘risky' and ‘risk-free' countries. Due to this distinction many investors, including central banks, will simply not consider the EM option. This is a shame, especially for underlying stakeholders. Nevertheless, there is one way to obtain EM exposure, while remaining within the cushion confines of the world of global reserves currencies: namely, by increasing exposure to Chinese bonds.

The case for Chinese bonds

Granted, China's vast bond market is still not part of the JP Morgan GBI EM GD benchmark index, but China's currency has already been admitted to the Special Drawings Rights (SDR) club of reserve currencies and there are reasonable expectations that Chinese bonds will be included in the main fixed income indices in the not-so-distant future (see below). As it turns out, Chinese government bonds have performed far better than developed market bonds, even during a period of exceptionally negative sentiment towards China.

During the period from April 2013 to today, that is, a period of extreme bearishness towards both China and EM, Chinese bonds have:

·         Strongly outperformed government bonds in all the other SDR markets. Chinese bonds have outperformed US bonds in Dollar terms by 12.3 percent, German bonds by 15.4 percent in EUR terms, British bonds by 23 percent in GBP terms and Japanese bonds by 18.1 percent in JPY terms. This translates into annualized outperformance of Chinese bonds between 2.5 percent and 4.8 percent against other SDR bond markets, mainly due to much higher yields.

·         Made FX gains versus EUR, GBP and JPY. The modest FX loss (-2.8 percent) suffered against the USD only cancels a fraction of the positive return from yields.

It is difficult to escape the conclusion that Chinese bonds have been an excellent place to invest as an alternative to developed market bonds, even during EM and China bear markets. This means that Chinese bonds also have an important role to play within an EM local currency bond strategy. Since Chinese bonds have outperformed developed markets bonds during EM bear markets they have also outperformed EM bonds during such periods. On the other hand, non-Chinese local EM markets have outperformed Chinese bonds during EM bull markets. In short, Chinese bonds offer a ‘within-EM safe haven' destination for EM fixed income investors, who can do better by seeking refuge in China than in developed markets during bouts of risk aversion. 

To take advantage of these attractive features of Chinese bonds, investors will need to be prepared to go off-benchmark because, remarkably, Chinese government bonds have still not been included in the JP Morgan GBI EM GD index. However, the signs all point to the conclusion that China's bonds will soon be included. For example, PBOC announced last week that it has appointed JP Morgan as the clearing bank for CNY-denominated securities in the US, which makes JP Morgan the first non-Chinese bank to be appointed as clearing bank for CNY-denominated assets outside of China. This arrangement will clearly improve the internationalization of renminbi, which we expect to accelerate as the dollar declines, but we also think that the deepening relationship between China and JP Morgan will be positive for index inclusion at the margin. Last year JP Morgan won approval to underwrite corporate bond sales in China's interbank market.





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Jan Dehn, head of research at Ashmore, discusses the outlook for South Africa after Zuma's resignation, which he insists is now significantly brighter. He also explains why investing in Chinese government bonds is a good bet, given they have performed far better than developed market bonds even during bouts of negative sentiment towards China.

Zuma's resignation: the outlook for South Africa is now significantly brighter

Jacob Zuma resigned and Cyril Ramaphosa was sworn in as South Africa's President in his place. South Africa's institutions worked as they should and a peaceful transition of power took place. Ramaphosa's ascent to power is not just a change of President; it represents a marked shift in policy away from corruption and discretion towards transparency and reforms. Ramaphosa will also lead the ANC into the next general election, which he is likely to win. So the outlook for South Africa is now significantly brighter, not just for now but over the medium term. South Africa desperately needs this change. The country needs reforms, new ideas, less corruption and a boost to business confidence. Ramaphosa has the potential to deliver all this. Ramaphosa's rise to power in South Africa also illustrates another ‘truth' about politics in EM countries, namely that EM presidents generally do not survive politically for very long if they start to mess with the economy. This is because the vast majority of people in EM countries are poor with no inflation hedges or unemployment benefits, that is, no means of protecting themselves against macroeconomic volatility. Therefore, they have a strong preference for stability and growth. The only governments in EM where presidents are able to hang on despite bad policies tend to be countries, where presidents are backed by the resources from other countries, usually one of the super powers, or where presidents control vast oil wealth. 

The case for EM local bonds

As yields rise in the US treasury market, other developed bond markets will come under pressure and investors who are exclusively invested in developed market fixed income will struggle due to high correlations between all these markets. Government bonds in EM offer an obvious solution. Yields on EM local currency government bonds are currently trading a mere 65 basis points (a basis point is one-hundredth of a percentage point) lower than at the end of 2006, when the Fed funds rate was 5.25 percent (6.07 percent today versus 6.72 percent in 2006). In other words, EM local bonds are in effect pricing a Fed funds rate of 4.60 percent (5.25 percent minus 65bps), while the actual Fed funds rate is currently only 1.5 percent. By contrast, US five-year government bonds are currently trading at 2.63 percent, which is 206 bps lower than in 2006. German five-year bonds trade 384 bps lower than in 2006. Clearly, EM local currency bonds have a comfortable yield cushion, while developed market bonds do not. EM currencies are also providing an important tail wind, while the absolute higher yields provide income.

Despite the obvious attractions of EM bonds compared to developed markets bonds, many fixed income investors still pay heed to an Apartheid-like regime, which still permeates the financial industry, whereby government issuers are divided into arbitrarily defined ‘risky' and ‘risk-free' countries. Due to this distinction many investors, including central banks, will simply not consider the EM option. This is a shame, especially for underlying stakeholders. Nevertheless, there is one way to obtain EM exposure, while remaining within the cushion confines of the world of global reserves currencies: namely, by increasing exposure to Chinese bonds.

The case for Chinese bonds

Granted, China's vast bond market is still not part of the JP Morgan GBI EM GD benchmark index, but China's currency has already been admitted to the Special Drawings Rights (SDR) club of reserve currencies and there are reasonable expectations that Chinese bonds will be included in the main fixed income indices in the not-so-distant future (see below). As it turns out, Chinese government bonds have performed far better than developed market bonds, even during a period of exceptionally negative sentiment towards China.

During the period from April 2013 to today, that is, a period of extreme bearishness towards both China and EM, Chinese bonds have:

·         Strongly outperformed government bonds in all the other SDR markets. Chinese bonds have outperformed US bonds in Dollar terms by 12.3 percent, German bonds by 15.4 percent in EUR terms, British bonds by 23 percent in GBP terms and Japanese bonds by 18.1 percent in JPY terms. This translates into annualized outperformance of Chinese bonds between 2.5 percent and 4.8 percent against other SDR bond markets, mainly due to much higher yields.

·         Made FX gains versus EUR, GBP and JPY. The modest FX loss (-2.8 percent) suffered against the USD only cancels a fraction of the positive return from yields.

It is difficult to escape the conclusion that Chinese bonds have been an excellent place to invest as an alternative to developed market bonds, even during EM and China bear markets. This means that Chinese bonds also have an important role to play within an EM local currency bond strategy. Since Chinese bonds have outperformed developed markets bonds during EM bear markets they have also outperformed EM bonds during such periods. On the other hand, non-Chinese local EM markets have outperformed Chinese bonds during EM bull markets. In short, Chinese bonds offer a ‘within-EM safe haven' destination for EM fixed income investors, who can do better by seeking refuge in China than in developed markets during bouts of risk aversion. 

To take advantage of these attractive features of Chinese bonds, investors will need to be prepared to go off-benchmark because, remarkably, Chinese government bonds have still not been included in the JP Morgan GBI EM GD index. However, the signs all point to the conclusion that China's bonds will soon be included. For example, PBOC announced last week that it has appointed JP Morgan as the clearing bank for CNY-denominated securities in the US, which makes JP Morgan the first non-Chinese bank to be appointed as clearing bank for CNY-denominated assets outside of China. This arrangement will clearly improve the internationalization of renminbi, which we expect to accelerate as the dollar declines, but we also think that the deepening relationship between China and JP Morgan will be positive for index inclusion at the margin. Last year JP Morgan won approval to underwrite corporate bond sales in China's interbank market.



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