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Special report: Outlook 2019

Rebound expected for stocks, bonds as China emerges

Hayden Briscoe believes the inclusion of China in global bond indexes will be a seismic event.

Stock and bond markets in the Asia-Pacific region should rebound in 2019 from hefty declines over the past year, as an anticipated slowing of the buoyant U.S. economy opens the region's doors to bargain hunters.

Together with those cyclical opportunities, the region will stage the opening act of a seismic structural change in April with the Barclays Bloomberg Global Aggregate Bond index's inclusion of an initial weighting for China's $12 trillion bond market. That move will mark the start of what Hayden Briscoe, UBS Asset Management's Hong Kong-based head of fixed income, Asia-Pacific, called "the biggest change" bond market veterans will experience in their lifetimes.

The U.S. economy, meanwhile, won't be easing in isolation. Market veterans expect the Chinese economy to decelerate as well in 2019, with the past year's estimated growth in excess of 6.5% likely to push toward 6% in 2019.

Companies, not GDP growth

Much ink has been spilled on the prospect of China's growth slowing a few tenths of a percentage point below 6.5% but investors invest in companies, not GDP growth, noted Andy Rothman, San Francisco-based investment strategist with Matthews International Capital Management LLC, in an interview. And 6% growth at the Chinese economy's current scale provides more opportunities for investors than 10% growth for a much smaller economy a decade ago, he said.

While the global economy's "two engines of growth" — as HSBC Global Asset Management described the U.S. and China in a Dec. 13 report — are likely to slip into a lower gear, for the most part analysts expect both economies to remain relatively robust.

That confidence should survive the lump of coal investors received from tech behemoth Apple Inc. on the first trading day of the new year in the form of a Jan. 2 cut in the company's earnings estimates, attributed to weak Chinese demand for the company's flagship iPhone products, said Mr. Rothman.

In that slower but still healthy environment, stocks and bonds in the Asia-Pacific region should attract greater attention from value hunters, reversing some of the flows into U.S. markets prompted by the past year's turbocharged, tax-cut-fueled growth over the first three quarters of 2018.

For the year ended Dec. 31, benchmark equity indexes in Hong Kong, Tokyo, Seoul and Manila all dropped by more than 10%.

Shanghai and Shenzhen's A-shares markets — with the added distraction of President Donald Trump's focus on China in his quest to tilt global trade toward the U.S. — fell by 25% and 34%, respectively.

"A number of growth-sensitive asset classes have become significantly cheaper over 2018, and we think they now offer good value — especially Asian equities and emerging market equities," said Bill Maldonado, HSBC Global Asset Management's global CIO equities and CIO, Asia-Pacific, in the firm's report.

Some asset owners in the region share that sentiment, even as the recent uptick in global market volatility has left them looking for more reassuring economic data for the moment.

The big gap now between emerging market and developed market equities could spell a good investment opportunity, but the potential fallout from the recent spike in global market volatility bears watching, said Jang Dong-Hun, chief investment officer of the 11.8 trillion won ($10.4 billion) Seoul-based Public Officials Benefit Association.

Further clarity on Chinese policymakers' success in stabilizing that country's economy in the face of headwinds now could set the stage for shifting to an overweight from a neutral emerging markets weighting vs. an MSCI All Country World index benchmark, Mr. Jang said.

Asian bond markets, meanwhile, suffered as well in 2018 — a year where credit spreads, currencies and interest rate differentials all moved against regional paper — and some babies got thrown out with the bathwater, said Teresa Kong, a San Francisco portfolio manager with Matthews International.

Chief among them were Asian and Chinese high-yield bonds. Ms. Kong noted that the spread of Asian high-yield bonds over U.S. Treasuries has widened to 590 basis points now from 440 basis points at the start of the year, a level that implies a 7% default rate for issuers — more than triple the current rate of 2%. While the default rate is likely to pick up over the coming year, the current spread is discounting a considerably ugly market environment, making this a "very good time" to invest, she said in an interview.

That's even more true for investors taking an active approach, said Ms. Kong, noting that in two decades of managing emerging market and high-yield bonds not one of her portfolio companies has suffered a default.

Turnaround for Asian bonds

Luc Froehlich, Fidelity International's Hong Kong-based Asia-Pacific head of investment directors, fixed income, said technical factors, including a rush of new issuers and a temporary dearth of demand, more than a U.S. economy vacuuming up global investment flows, helped make the past year the worst for Asian bonds since the global financial crisis. That famine should give way to a "bright year for Asian fixed income" in 2019, as a big swath of outstanding bonds matures, depressing supply, while investors pursuing the fatter spreads on offer now from Asian bonds boost demand, he said.

UBS' Mr. Briscoe, in a Dec. 18 interview, likewise called Asia's $200 billion high-yield market, half of it in Chinese paper, a compelling opportunity now, with the potential to offer yields of 10% over the coming year, with perhaps another 2 percentage points of gains from spread compression.

Even so, Mr. Briscoe said the addition of Chinese bonds to the Barclays Bloomberg Global Aggregate Bond index in April will prove the more far-reaching and momentous development in 2019 — or any year, for that matter. There's never been a $12 trillion bond market that wasn't part of benchmark indexes, and for fixed-income veterans, the start of that market's inclusion during the coming year will prove "the biggest change in anybody's lifetime," he said.

Mr. Briscoe said institutional investors still appear to be coming up to speed with what they'll need to do to take advantage of that opportunity.

It's a "Sputnik moment," when investors and money managers globally will have to come to grips with the fact that "while we were sleeping, China's bond market became the third-largest bond market in the world, just behind the U.S. and Japan," Matthews International's Ms. Kong said.

Foreign investors' share of China's bond market has surged to 8% from basically nothing over the last couple of years, so big institutional pools such as sovereign wealth funds have clearly started moving, Ms. Kong said. But with April's inclusion every investor will have to form an opinion about a market that has morphed from a "tactical alpha opportunity to a beta market opportunity," she said.

When all major index providers add Chinese government bonds to their benchmarks, their weightings will be around 6%, bringing in between $300 billion and $500 billion in institutional flows, Mr. Briscoe said.

Ms. Kong said over the coming five years, allocations to Chinese bonds could come to $1 trillion, as other global benchmark indexes add weightings for Chinese bonds.

Foreign ratings agencies, meanwhile, are poised to win regulatory approval in China to publish their ratings there, which will allow Chinese credit to be included in global bond benchmarks, noted Mr. Briscoe. That, in turn, will lift the weight of Chinese paper in those benchmarks to 12%, he said.

Fly in the ointment?

Trade, meanwhile, remains a potential fly in the ointment for investors looking at Asia-Pacific stocks and bonds now, with Mr. Trump seemingly ready to declare a trade war by tweet should the spirit move him. But for the most part, market veterans say they're betting sanity will prevail.

With the U.S. stock market looking increasingly fragile and the president's counselors apparently impressing on him the hit to U.S. growth that a trade war would exact, both the U.S. and China are likely to be careful not to let things get out of hand, Matthews' Mr. Rothman said.

Even so, analysts say the potential for global supply chains to give way to more domestically oriented approaches to building economies bears watching.

Mercer, in the consulting giant's December report on trends and opportunities for institutional investors in 2019, noted that any reversal of the process of globalization could lead to a dispersion of investment trends in different regions, and that in turn could boost interest in regional mandates at the expense of global mandates.

Mr. Briscoe said that trend may be underway, with China's efforts to use its local currency for major commodity purchases such as oil already reducing the transmission mechanisms of U.S. monetary policy decisions on Asia. If that continues, eventually, "I would only care about the People's Bank of China," rather than what the U.S. Federal Reserve is doing, he said.