DR.CHENJIAZI ZHONG

In Brief

• Investing with a long-time horizon and through a diversified portfolio are the best ways to batten down the hatches against volatility and avoid emotional investing errors.
• How should investors dampen portfolio volatility in the later stages of the business cycle?
• In the bond market, an inverted yield curve has often predicted a recession in developed economies, but what does the recent inversion of the yield curve in China say about the country’s economic outlook?
• China’s stimulus-led rebound has had widespread benefits but has made the risks from a tightening in credit in the country a global concern.

Is China’s Yield Curve Signaling a Further Economic Slowdown?

Since 2005, the yield on the 10-year Chinese government bond (CGB) has exceeded the one-year CGB yield by an average of 100 bps. An upward-sloping yield curve of this sort is normal in the $3.5 trillion CGB market and as in most countries, reflects expectations for future policy rates, a term premium and healthy market supply-demand dynamics. But on June 7, the 10-year CGB yield sank below the one-year yield. This yield curve inversion has occurred only once before, in June 2013, amid a severe liquidity crunch in the interbank market. What is causing the current yield-curve inversion?

• The People’s Bank of China (PBOC) has tightened monetary policy since the fourth quarter of 2016 to curb an asset bubble, mitigating financial leverage and supporting the yuan. Since the end of the third quarter of 2016, the 10-year CGB yield has risen 85 bps to 3.59%, and the one-year yield has risen 145 bps to 3.62%.
• The PBOC hiked the seven-day reverse repo rate twice – by a total of 20 bps, from 2.25% to 2.45% since the fourth quarter of last year. The PBOC’s liquidity-draining operation lowered the system’s excess reserve ratio from 2.4% at the end of 2016 to only 1.3% by the first quarter of this year, the second-lowest on record.
• Wholesale funding, which accounts for a quarter of banks’ liabilities, has tightened sharply, and benchmark three-month negotiable certificate of deposit (NCD) rates have surged 220 bps to 5.1% since PBOC tightening began late last year. NCDs are the main interbank money market instruments and account for 3% of banks’ liabilities, thus setting most banks’ marginal funding costs.
• There has been renewed regulatory pressure on banks to unwind their leveraged bond portfolios both on and off their balance sheets, which partly explains the severity of the sell-off.

The PBOC has clearly tightened monetary conditions, pressuring banks to curb corporate and mortgage lending while passing through higher lending rates to borrowers. Chinese growth, particularly nominal growth, clearly peaked. Historically, a flattening and inverted yield curve has indicated weakening industrial production with a lag of five months. China’s reflation momentum is also turning. The surge in producer prices from upstream commodities faded during the second quarter, and tight liquidity is expected to weaken construction demand and create some destocking pressure, particularly in commodities such as iron ore. On the margin, China’s monetary tightening and financial deleveraging will be a headwind to a rebound in global manufacturing and reflation in commodities.

Focus on the Destination: Investors with a Long Time Horizon Experience Less Volatile Returns

While volatility can cause major deviations in the near term for equity markets, investors should focus on their destination. Examining rolling returns for equities, while historic annual returns have varied from -38% to +47% in a single year, rolling annualized returns, over a 20-year period, have been positive for the past 60 years. Unfortunately, short-term investors are much more likely to realize the waves of volatility that occur over the one-year investment horizon. Investors with long-term goals, who are able to shift their focus to the long-term return potential of equity investments, have the luxury of realizing infrequent negative equity market returns.

We live in a headline-driven world, where media often impacts equity prices in the near term. But an investment portfolio should not be a dinghy tossed and turned by market churn; it is possible to gain portfolio stability through diversification. While equities tend to perform better with economic growth and moderate levels of inflation, rate-sensitive fixed income is important to portfolios when economic growth falters. Although most investors have a positive outlook on U.S. equities in the coming year, other developed market equities can give both exposures to risk factors outside the U.S. economy and to faster-growing emerging market economies that may help boost portfolio returns. Small cap stocks provide a pro-cyclical tilt to a portfolio compared to large cap stocks, though they can also be more sensitive to growth scares. While a combination of various asset classes should improve portfolio returns, diversification is most valuable for keeping a portfolio on an even keel.