China’s Reopening Is a Mixed Blessing for Emerging Market Assets

(Bloomberg) — The story of China’s reopening is quickly becoming the most important trading topic in emerging markets, so studying its potential impact across asset classes is critical for global investors.

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For stocks, this is a boost as it promises to boost consumer demand, improve corporate cash flow and revive trading volumes. However, for currencies, it could be a drag, reducing real incomes through inflation, putting pressure on China’s current account and delaying Federal Reserve policy. For bonds, it’s a mixed proposition.

The country’s easing of its Covid Zero policy and stimulus to revive growth sent Hong Kong-listed Chinese shares to their best start since 2006, the yuan to a six-month high and bonds to a third-month rally. It also led to gains in emerging markets, from the Thai baht to the South African rand and Brazilian stocks. Forecasts show that the second-largest economy could grow by 4.8% in 2023, compared with 0.4% expansion in the US and 0.1% in the European Union.

“The story of China’s reopening will be a key driver of emerging market sentiment, with positive effects particularly on regional economies and global commodity suppliers,” said Galvin Chia, currency strategist at NatWest Markets in Singapore. “While the US and Eurozone are on the upswing, China is definitely a source of optimism as it will partially offset the slowdown in demand.”

Emerging-market stocks and currencies had their strongest start to a year since the 1990s, and bonds posted their best gains in more than a decade as investors shut out during China’s fight against the pandemic returned. GAMA Asset Management was bullish on emerging markets last month. Fidelity International, which was bearish for most of last year, is now overweight its assets, favoring China and Latin America.

“China’s pro-growth policies were the last driver I expected,” said Rajeev De Mello, global macro portfolio manager at GAMA. “Taiwan, South Korea and Malaysia will be the biggest beneficiaries of China’s greater demand for goods, while Chile, Brazil, Indonesia and South Africa offer exposure to China through commodity exports. “The opening of international travel will primarily benefit the closest destinations for Chinese tourists, such as Thailand.”

Moreover, a narrowing of China’s factory-gate deflation signaled a return to activity, while a small increase in consumer inflation still leaves room for the central bank to add stimulus. Morgan Stanley expects the yuan’s gains to continue, and its quantitative strategists say hedge funds and long-only money managers are beginning to look for A-pay ideas. BNP Paribas SA raised the target for the MSCI Emerging Markets Index, saying policy support will keep China’s growth above 5% this year.

Morgan Stanley sees more yuan gains as China nears Covid peak

Stagflation risk

But the run of optimism is beginning to attract its critics. As Chinese factories rebound, investors are discussing the risk that inflationary pressures will increase long before growth impulses take root. UBS Group AG says the yuan is expensive and China’s reopening theme is better played through stocks and interest-payers. When analyzed through a balance of payments lens, strategists led by Manik Narain, the currency has more to lose before it reopens.

Some analysts go a step further and raise the specter of stagflation—a period of high inflation coinciding with little growth. Concerns that the Fed will rely on inflationary pressures from China to remain hawkish are also weighing on the outlook.

“The reopening will put pressure on Chinese export prices and complicate the Fed outlook,” said Aninda Mitra, macro and investment strategist at BNY Mellon Investment Management in Singapore. “Although the prospect is distant, investors should consider the risk of stagflation. This will prevent the Fed from cutting rates even as the economy weakens and rates may remain higher for longer.”

Policy Impact

China’s currency has risen 9% in the past week since early November, when reopening talks began making the rounds in markets. Money managers are now betting that it is overvalued. JPMorgan Chase & Co. said that carrying the yuan was no longer attractive and would look to restore some short positions in offshore markets as it received a price that “reopened China euphoria”.

“Given the pace at which the reopening has taken place, it is inevitable that inflationary pressures will emerge in China,” said Eugenia Victorino, head of Asia strategy at SEB AB in Singapore. “China’s pro-growth policies typically drive up energy prices at a time when global supply is constrained. This can prevent central banks from quickly switching to a dove position.”

For now, most investors are happy about the rebound and its spread to emerging markets. Emerging market stocks rose on Monday, with the average sovereign risk premium falling 9 basis points to 453, according to JPMorgan data.

“There is no doubt that China’s reopening is improving growth expectations for emerging markets, which supports broader market sentiment across the asset class,” said Paul Greer, money manager at Fidelity International in London.

What to look at

  • GDP, retail sales and industrial production will give investors an update on the Chinese economy as the nation moves away from Covid Zero.

  • Indonesia, Malaysia and Turkey are expected to raise the exchange rate by 25 basis points with the two Southeast Asian countries, while politicians in Ankara are expected to keep rates unchanged.

  • Russia and Thailand will report foreign reserves, while South Africa and Russia will update consumer price increases

  • Taiwan GDP data is expected to show a sharp slowdown in the last quarter of 2022

–With assistance from Ronojoy Mazumdar.

(Adds market action in penultimate paragraph)

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