In this report:
- 2024 Overview
- Our 2025 outlook for Chinese assets
- Policies to continue to lead economic fundamentals Still robust growth potential that only Beijing could suppress
- A wide arc of a policy turn began in 2023 and will likely continue in 2025
- New protectionist measures by the US may lead to more remedial domestic policies
- An equities-led turn in the markets
- Why the strange correlations between bonds and equities in Q4 2024?
- Risks to our outlook
2024 Overview
RMB bonds were the best-performing major bond market in the world in 2024; please see the chart below. While this superior performance was due to China’s much lower inflation (0.1 percent in 2024 and 3.1 percent cumulatively since 2020, compared to 2.5 percent and 22 percent in the US, respectively), China’s troubled economics also played a role. In any case, investors buy bonds for various reasons, including holding bonds to guard against bad economic news. In this sense, the strategy of long RMB bonds worked very well in 2024.
The bad news about China’s economy has translated into strong performances in Chinese bonds. Since the summer of 2021, when Beijing adopted a harshly hawkish regulatory stance, RMB bonds have rallied by a cumulative 22 percent (total return). While in most EM markets, bad economic news often leads to poor equity, bond, and currency performances, in China, the negative correlation between equities and bonds has been largely preserved. A positive way to view this strong bond performance is that much of the on-shore institutional money has shifted from equities (and property) markets to bonds without fleeing the Chinese market. The negative way to view this is that capital controls have trapped capital onshore, resulting in the bond market rally being exaggerated relative to the economic fundamentals because investors in China have been unable to shift their assets to alternative investments outside China.
In any case, the annual return of 8.9 pecent on central government bonds (CGBs) in China marks the highest single-year return since 2014.
Not only have Chinese RMB bonds thrived in 2024, they have continued to be the best safe haven asset in the world in the past two decades. We have been tracking the performances of a wide range of assets during difficult times – either significant economic setbacks or financial fractures anywhere in the world. The chart below shows that Chinese RMB bonds consistently outperform most other assets across various negative scenarios. Cumulatively, over the eight episodes we have identified over the past two decades, Chinese RMB bonds have been the top performer by a significant margin. Chinese bonds, thus, remain the best safe haven ballast for risk asset exposures.
Chinese equities have struggled under the weight of the poor economic fundamentals, which were mostly policy-induced, in our opinion. While the macroeconomic misalignments that had existed in China before the regulatory tightening that began in mid-2021 were substantial, Beijing’s policies in correcting these imbalances were less than perfect. Many outside China might agree, even if few inside China would openly admit this. Privately owned enterprises (POEs) fought macroeconomic headwinds centred on a collapsing property market and a general perception that the government no longer trusted POEs. Not only was headline GDP and company revenues growth slower than in previous years, but the bottom line corporate earnings contracted in 2024.
In 2024, while equity markets, at one time, had a maximum drawdown of 14 percent (as of September 2024), policy interventions triggered a rally from then that flattered the CY2024 performance to +25 percent towards the end of the year. The chart below shows how the China A Shares responded to the news.
Our 2025 outlook for Chinese assets
Based on a few important assumptions, below is our baseline forecast for Chinese assets in 2025.
The economy's real growth is assumed to hover at around 4.5-5.0 percent in 2025, with no inflation or deflation. Consumer and producer confidence is expected to be incrementally nursed back into health by instalments of fiscal stimulus and regulatory easing on the POEs. Corporate earnings should finally start to recover.
Back in November 2024, the government finally announced large-sized fiscal transfers from the central government to help discharge some of the local government debt. To us, these measures are similar to the bailouts during the European Debt Crisis of 2011-12, with the key difference being that a communist regime is averse to acknowledging any write-off on the local government debt obligations. In contrast, in Europe, the size of the transfers and loans to the crisis-hit member countries were ‘real’ instead of ‘notional.’
In any case, the point is that Beijing’s tolerance threshold was breached last fall, provoking an acute but essentially defensive response to truncate the left tails for the financial markets and the economy. Because of what we witnessed in China last year, we assume that Beijing will continue to do what it takes to keep China growing above the ‘stall speed’ or just above 4.5 percent.
Having said this, we also expect Beijing to continue to be parsimonious with its stimuli to minimise moral hazard problems that the super-sized 2009 bailout created. Our assumption is that the cumulative fiscal stimulus will ultimately be around 10-15 percent of GDP. For an economy with a nominal 2024 GDP of around RMB 130 trillion, this would be RMB13-20 trillion. The announcements so far suggest that we may only be at the halfway point in terms of the fiscal transfers needed. The additional stimulus will likely be announced in instalments.
For sovereign bonds, the current 10Y CGB yield of around 1.6 percent is already too low, in our view, but will likely only rise very gradually. There is a debate on whether China is inevitably heading toward Japan’s debt-deflation spiral. Our position, for what it is worth, is that China won’t be a Japan. We will discuss this below. The equilibrium long-term interest rates might not be too far below China’s nominal GDP growth rate, which might be around 3.5-4.0 percent. For 2025, our target for the 10Y CGB yield is 1.75-2.00 percent.
The yield spreads between the 10Y UST and the 10Y CGBs are important for investors to monitor. Capital controls in China have prevented the two biggest bond markets in the world from converging, as arbitrage opportunities are limited, and the two economies have been out of sync for several years now. Nevertheless, the two largest economies in the world that trade intensively – directly and indirectly – should not be out of sync with each other for so long unless the policies in the two countries are polar opposites. For context, until early-2024, the 15-year range of the spread between the 10Y sovereign yields of the US and China is +245 to -224 bps. We are, thus, at a fairly extreme level of spread. Currently, the spread is around -300 bps. A narrowing of the spread seems likely in the quarters ahead, i.e., the UST yields to fall while the CGB yields to rise. The speed with which this prospective yield convergence might occur will be a function of disinflation in the US and the PBOC’s monetary stance to support the Chinese economy. The equilibrium 10Y CGB yield of 3.5-4.0 percent, thus, implies a 0 bp spread between the US and China in the long run.
The credit spreads of policy banks relative to the CGBs have been compressed to only 5 bps now, from 38 bps in the summer of 2021 to an average of 65 bps over the five years ending in 2019. This is also abnormal, reflecting very large institutions' frantic search for yield. It may be premature to position in 2025 for normalisation in this credit spread, but the risks are clearly biased to the upside. For 2025, we expect the policy banks’ credit spread to widen modestly as the sovereign bond yield drifts higher.
As mentioned above, we expect further defensive stimulative programs from Beijing. Without these prospective stimuli, Chinese equities might sag further because general investor sentiment remains poor. Countering this downward trend is the risk of more government interventions. Our judgment call is that bad news (lower equities and a weaker economy) will lead to good news (policy interventions). The left tails for companies and equities are effectively truncated, but the mean of the distribution of possible outcomes may not rise much. At 15x, China’s broad market PE is still relatively low, compared to 25 and 22 in the US and India, though it is not far from its long-term average of around 14-15x in the years before the Pandemic. As investors become more convinced that Beijing will not allow China to collapse, we believe China’s earnings growth should rise further in 2025.
The diagram above shows earnings growth (horizontal axis) versus the PE ratio (vertical axis). Most markets spread along a positively-sloped line: the higher the future earnings growth, the higher the PE ratio because the NPV (net present value of the discounted future stream of earnings) should be higher the fatter the earnings in the out-years. The red bubbles are the Chinese high-growth, the Chinese broad market, and the HK stock exchange. As shown in the diagram, they all trade at a discount from the rest of the world, i.e., below the hashed upward-sloping line. This risk premium, we are guessing, has a higher probability of shrinking further in 2025 than expanding. In 2025, we could see China’s PE rise to 15-17x. With some further recovery in earnings growth, this could mean a 10-20% percent upside in broad Chinese equities. This prospective rally will not be monotonic for the reasons explained above.
Trade-in subsidies may be broadened to entice consumers to spend on staples and, hopefully, some discretionary products. Buy-backs and SOE reforms could also boost the equity prices of certain sectors and companies. But we believe it would be prudent to remain defensive with high-yield names.
As mentioned above, better economic growth should flatter corporate earnings, which have slowed to -8% in 2024, down from a 10-year average of 4%. By sector, similar to what we wrote for 2024, we retain a barbell strategy into the new year. Defensive sectors, like SOE banks, utilities, and energy, will continue to outperform before there are clear signals of improvement in economic fundamentals, like property, CPI and consumption, although we change the order of preference. We prefer SOE banks as their valuations are still very low, and they will benefit if the economy really improves in 2025. At the other end of the barbell, we still like the IT sector. In 2025, the adoption of AI will probably lead to significant changes in consumer electronics, like smartphones, PCs, AI glasses and earphones, and therefore, there may be a new round of consumer upgrades of their devices. The trade-in policies of China will expand to include smartphones, tablets, and smartwatches. Chinese companies play an important role in consumer electronics, so they will benefit from the new round of upgrades. In an optimistic scenario, if the Chinese economy improves and the property market stabilised, blue-chip large growth sectors, like consumption-related sectors and real-estate related sectors, could outperform as risk sentiment returns and expectations improve.
For the Chinese RMB, we were not correct last year in expecting USDCNY to trade lower due to disinflation in the US, lower interest rates in the US, and the heavy weight of an overhang of dollars held by Chinese exporters. Even though we were wrong on this market call, we believe that the dollar is grossly over-valued and the key fundamentals supporting the dollar were flattered by both the oversized fiscal posture and inflation – both of which need to reverse further in the coming years. For 2025, we are not making a strong call on USDCNY because getting the timing right on this prospective turn lower in this cross has proven difficult for us. Investors know our thinking; that’s what's important.
In sum, for 2025, we are positive on Chinese equities, cautious on Chinese bonds, and agnostic on the currency with the view that a stronger CNY would make more sense to us than a weaker CNY. (More on this topic below.)
Policies to continue to lead economic fundamentals
Policies are usually important for every country but are not always the dominant factor to consider. In China, however, policies have absolutely dominated its economic trend in recent years. What Beijing has done since mid-2021 is highly unusual compared to its history over the past quarter of a century. In the pursuit of ‘equality’ or ‘equity’, Beijing has chosen to impose regulations to severely restrict the ability of certain sectors to thrive. The property market arguably could have been slowed through property taxes instead of the draconian sudden-stop mandates that severely disrupted the entire property ecosystem overnight.
What happens to China in 2025 and beyond will likely continue to be dictated by policies out of Beijing.
Still robust growth potential that only Beijing could suppress
We still believe China has huge potential to achieve outsized economic growth if only its private sector could be allowed by Beijing to do so. Much of the foreign commentaries suggest that China's economic plight reflects its inability to grow. In contrast, we believe it is more of an ‘unwillingness’ question, or a question about the policy orientation of Beijing, whether it genuinely believes in maximising the overall prosperity of the nation as the primary goal and whether the government trusts that the private sector could be allowed to be the main propellant for such growth.
The potential growth rate of any nation tends to decline with the level of per capita income. As income rises with the development of an economy, the low-hanging fruits will have been picked, making it increasingly difficult to eke out incremental growth. This is witnessed in virtually every single country, a point we have made for the past decade about China’s inevitable growth deceleration. Having said this, we do not share the view that such a growth deceleration will need to be sharp and abrupt in China, like what Japan has experienced since the 1980s. Unless Beijing insists on yielding such an inferior outcome in exchange for equality or other objectives, we believe the private sector and the citizens in China remain sufficiently hungry for growth, wealth, and progress that China would not be content with what it now has. This hunger for more will help propel investment, risk-taking, hard work, and a virtuous circle of economic progress and confidence.
China’s demographics are indeed hostile. But we do not believe they will prove to be debilitating. Even Japan managed to ‘bend its demographic curve’ by a decade. China’s mandatory retirement age is 60 for men and 55 for women. The scope for China to tweak its policies to counter the demographic trend is significant.
A large educated class, trained and disciplined manufacturing workers, a docile populace, good infrastructure, and ample finances are assets China still has, just as it did before the Pandemic.
China will thrive if it is permitted by Beijing to do so, we continue to believe, and the only country that can prevent China’s economic rise is China itself.
A wide arc of a policy turn began in 2023 and will likely continue in 2025
It is difficult to turn around a super-tanker; it is especially difficult to do so against the captain’s prior declarations. This has happened in China in slow motion: the consequences of the regulatory tightening have proven so debilitating for the economy that many of these policies need to be reversed. However, this policy turn has been grudging and gradual to avoid openly admitting policy errors. Nevertheless, to avert a severe crisis, we believe Beijing will likely continue to trace out a wide arc of a policy turn that began in 2023 but will likely continue in 2025.
We will likely see new supportive measures for the property sector. Without underpinning this sector, it would be very difficult to restore consumer confidence and establish ‘Dual Circulation’ to shield the Chinese economy from external shocks.
New protectionist measures by the US may lead to more remedial domestic policies
Investors are familiar with the adversarial economic policies the US has adopted against China, including the high import tariffs (close to 20 percent across the board now but will likely rise further under Trump 2.0) on Chinese goods and sanctions on higher technology parts and products that China could import from the US or its allies. These policies have been somewhat effective. However, China has partially circumvented some of these obstacles by diverting exports through Asian countries and Mexico that would re-export to the US and re-double China’s domestic efforts in developing its own technological advances.
Indeed, total Chinese exports are extremely strong, registering some USD3.5 trillion in 2024, compared to an average of USD3.1 trillion over the prior five years and USD2.3 trillion over the five years ending in 2019. Even though China’s export market share in the US has slipped to number three, it has significantly increased its market shares in the rest of the world. The total trade surplus in China rose to an estimated USD969 billion in 2024, compared to USD421 billion in 2019 and an average USD678 billion in the prior five years.
The Chinese economy may have struggled, but not in manufacturing or its exports.
At this point, it is unclear how President Trump will prosecute its trade policy against China, and Beijing’s response is equally unclear. What we could state with a certain level of confidence is that (i) the sector in question happens to be China’s strongest sector and (ii) any external shock will likely be met by stimulative policies from Beijing to further support domestic demand, with logical consequences for China’s domestic assets.
In sum, we may very well have entered the zone whereby bad news is good news. And new bad news on China’s exports may lead to good news on the weakest sectors in China.
An equities-led turn in the markets
Last year, we expected equities to lead a prospective turn in the Chinese financial markets. In 2024, while we saw a bounce in equities, no meaningful positive impact has been detected in Chinese bond yields or the RMB. 2025 might be a bit different: we may see a delayed response in the bond and currency markets if Chinese equities rise further in 2025.
Chinese equities may be the most truthful barometer of the overall state of the economy; they are still quite cheap, with a trailing PE ratio of 15x for the CSI300 (up from a cycle-low of 12 in December 2023 and below the cycle-high of 22x in early-2021). Chinese companies in the CSI300 index had a CAGR of 5.9% in the decade before the Pandemic, compared to 5.7% and 2.4% in the US (S&P 500) and Germany (DAX), respectively. With such a high earnings growth rate, Chinese PE ought to be closer to that of the US (with a PE ratio of 25x now) and ahead of Germany (with a PE ratio of 14x now – the same as China’s). If China’s PE ratio recovers halfway to its cycle peak, it would mean a 40% rally in equity prices; a full recovery to its cycle peak would mean an 80% rally. These are obviously not our targets, but upside risks seem substantial.
Further, both foreign and domestic investors are still so bearish on and underweight in China as a country and Chinese companies that the risks to equity prices, we think, are heavily biased to the upside from here. All that’s needed is a policy excuse for such a prospective rally to materialise. How could the second-largest economy in the world remain uninvestible forever?
While in the US, bonds will probably be the dominant asset that will drive other assets, in China, equities will likely dictate the trajectories of bond yields and the RMB, if not immediately, eventually. As argued above, much of this will be driven by Beijing’s policies. A more effective policy turn in support of the economy would mean much higher equity prices, marginally higher bond yields, and a stronger RMB.
Why the strange correlations between bonds and equities in Q4 2024?
We mentioned above that, historically, Chinese bonds and equities have mostly been negatively correlated – uncharacteristic of EM markets. However, in Q4 2024, bond yields failed to rise with the bounce in equities. Why?
We have a few thoughts. One guess is that the property sector, which used to be the single-largest repository of household savings, is no longer an attractive asset to hold. Precautionary and other types of savings have flooded bank deposits, compelling banks to search for yield further down the yield curve. This tsunami of excess savings is so large, and the net flows into equities in H2 2024 were relatively modest that the correlation between bonds and equities was not perfectly negative. This line of argument, if correct, implies that bond yields would rise in earnest when the property market is again seen as a legitimate and viable investment option for households. This may take some time, which is also why we believe the prospective rise in the bond yields will likely be very gradual, being more of a function of the property market than the equity markets. In sum, in China, the arbitrage is between equities, properties, and bonds; investors need to think in terms of this triangular relationship.
A second hypothesis is that China still suffers from the ‘problem’ of excess savings, which allows such capital to be misappropriated, particularly into investments by the SOEs, which have had a lower return on capital than POEs. If a significant part of the investment in China is directed by the government and does not reflect investment returns, the sovereign bond yields should drift toward the actual return on capital rather than the overall nominal GDP growth rate, as is the case in the developed West.
A third hypothesis is heavy bond purchases by the PBOC. This may or may not be considered as QE, but it is a fact that, after warning the market of a ‘bond bubble,’ the PBOC began buying long-term bonds in order to enhance the availability of liquidity in China. This has had a depressive effect on long bond yields in China, which are far below where they should be, given the economic growth rate. If bond yields are low because of the PBOC’s purchases, the correlation between bonds and equities should be disturbed, much like the period of the Fed’s QE driving up US equities while the US bond yields remained low.
A fourth hypothesis is that the reported GDP growth rate may have somehow exaggerated the true state of the economy.
All of these hypotheses point to bond yields staying below China’s nominal GDP growth rate. This is why we are assuming that China's long-term equilibrium 10Y sovereign bond yield may be similar to that of the 10Y UST yield, even though China should have a higher potential growth rate than the US.
Risks to our outlook
In 2022, 2023, and 2024, the number one risk to our China market calls was sticky inflation and a resilient US economy, keeping US yields and the dollar high. That risk indeed materialised three years in a row. Given the likely disinflation trend, the 10Y UST yield at around 4.5 percent seems high to us. Historically, inflation has been more global than local, i.e., when the global inflation trend is clear, it is unlikely for any country to have sustained inflation exhibiting a different trend. With Asian inflation remaining low and inflation in Europe continuing to drift lower, it seems unlikely that inflation in the US does not fall further. The wildcard here is, of course, the US’ fiscal policy: if fiscal stimulus persists, it might make it difficult for services inflation to recede. Stubbornly high US services inflation may thwart the Fed’s rate cut program and help support the dollar relative to the RMB. High US interest rates remain our biggest risk for the new year, sapping the total return of our RMB strategy.
The second risk is that Beijing will fail to rekindle risk-taking in China and restore a recovery in general confidence. After the recent stimulus programs, we believe this is not a particularly high risk in terms of the probability of it happening. However, the consequences of this risk materialising are very significant. The cyclical operation that will likely be necessary in 2025 is more than ‘mechanical’ because all the multipliers require synergy from the private sector, which acts on how confident they feel about spending and investing. Further, beyond the immediate challenge of restoring confidence, China faces a mixture of cyclical, structural (including demographic), and geopolitical headwinds, even more daunting than those confronting the UK after Brexit. Beijing should heed the example of the UK policymakers’ failure to address the multitude of issues. Having said this, the incremental U-turns in policies bode well for Beijing, halting harmful policies to its economy, social harmony, and international standing. More proactive policies are needed, and we believe they are coming.
The third risk is new tariffs from the US and possibly Europe. This is our third risk because we think it is largely priced-in, and Beijing likely has a strategy to deal with this policy risk. In fact, the remedial policies may include further stimulus packages to support domestic demand, which we stated above would be positive for China and Chinese equities and currency.
Bottom line
2024 indeed turned out to be a ‘glass-is-half-full’ year, thanks to the fiscal interventions by Beijing. We maintain a cautiously optimistic expectation of stronger policies from Beijing in 2025. In terms of pre-positioning, we will be restrained. New and powerful measures will need to be announced before we would contemplate adjusting our portfolios to align with such a scenario. However, we continue to believe that the logical outcome in 2025 remains a stronger economy, partially restored confidence, higher equities, modestly higher bond yields, and a stronger RMB.
Disclosure
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