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Retirement Week: Bonds that may thrive regardless of larger international inflation and rates of interest

Retirees and near-retirees may not need to reduce or abandon their fixed income exposure out of concerns about higher global inflation and higher interest rates.

I'm not saying this because they mistakenly believe that higher inflation and interest rates on bonds in general would be bearish. But retirees could overlook the bond market of a global economic powerhouse for which interest rate, currency and inflation trends will be favorable over the coming decades.

That's the provocative claim made by Vincent Deluard, head of global macro strategy at investment firm StoneX. I dedicate this column to his reasoning because I have not seen it discussed at length by the other advisory services I watch.

Deluard argues that a unique combination of demographic, economic, monetary and political forces in China will keep Chinese interest rates low and the Chinese currency stable for decades to come. That, in turn, is good news for Chinese government bonds, as they already offer one of the highest inflation-adjusted returns in the world.

In an interview, Deluard said at the heart of his case is that China is facing a "demographic collapse" that will have huge deflationary effects in the long term, which in turn will be very optimistic about Chinese government bonds. I mentioned the long-term demographic trends in China in a recent column, and noted that some demographers predict that China's population will decline by 48% by 2100.

It is difficult to overestimate the economic importance of this “demographic collapse”. The number of people in employment in a country is one of the most important determinants of a country's prosperity. "The slowdown in [economic] growth will be massive," said Deluard.

While productivity growth can at least somewhat mitigate the deflationary effects of population decline, it won't be much more than a drop in the ocean, according to Deluard. "With the exception of the destruction of pre-Columbian civilizations, humankind has never seen the demographic collapse that East Asia will face over the next 20 years."

Deluard admits that US investors will find it difficult to accept his forecast as they assume that politicians and the Federal Reserve will not allow deflation. Instead, those in power will always choose to blow their way out of any deflationary threat – causing bonds to suffer mightily.

However, Deluard emphasizes that the situation in China is very different. One of his overarching long-term policy goals is to make his currency, the renminbi, one of the world's reserve currencies. And for this to happen, the government must prefer deflationary policies to inflation.

One of the prerequisites for the renminbi as a reserve currency is that the market for Chinese government bonds must grow significantly both in size and in liquidity. That won't happen if Chinese inflation or interest rates are allowed to rise significantly, so the government will prevent it.

The lack of political forces in China to sustain inflation

Such a geopolitical and economic goal could not be pursued in the US because there are too many powerful political interests that stand in the way of deflation. One such group is stock investors, and Deluard reminds us that 72% of the US stock market is owned by large, politically connected institutional investors. As a result, a stock bear market becomes a political problem.

In China, on the other hand, only 9% of the stock market is owned by institutional investors, according to Deluard. A Chinese bear market is therefore not a political problem. “China's stock market is dominated by gambling-addicted private investors. Asking the government for bailouts is seen as absurd, like asking the house for a refund after a bad night in Macau. "

A telltale sign that the Chinese government is ready to ditch its stock market is its latest 5-year plan. Deluard points out that it was the first in the country's history that did not include an economic growth target.

As Deluard characterizes this contrast, the US “euthanizes” its bondholders, while China “flatters” them.

How to invest in Chinese government bonds

Of course, Deluard's bet on Chinese government bonds is long-term. Even if you want to take his advice, do so only as part of the fixed income allocation of a long-term financial plan.

As is so often the case, exchange traded funds are the easiest way to invest in Chinese government bonds. Unfortunately, none of the obvious candidates are trading in the US, so you'll need to ask your broker to sort out the logistics of buying one of them.

Here are three exchange-traded funds that provide exposure to the Chinese government bond market:

GaveKal China Fixed Income UCITS Fund A USD trading in Ireland with USD 1.5 billion in assets under management. This ETF has an expense ratio of 0.5%.

ICBC CSOP FTSE Chinese Government Bond Index ETF
CYC,
+ 0.07%,
which is traded at $ 1.4 billion in Singapore. The average term is 6 years with an expense ratio of 0.25%.

NIKKOAM-ICBCSG China Bond ETF
ZHS,
-0.10%,
which also trades in Singapore. Assets under management are USD 209 million, an average term of 4.1 years and an expense ratio of 0.30%.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert ratings track investment newsletters that pay a flat fee for testing. He can be reached at mark@hulbertratings.com

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