Sino-US tensions remain a significant short-term risk for the CNY.

SYNTHESIS

• The US dollar has been under pressure since the end of March, especially against currencies in other developed markets, and less against those in emerging markets, but this has recently changed with regard to the Chinese renminbi (CNY).
• The CNY has recently appreciated against the USD, due to China's large current account surplus, regular and substantial capital flows into Chinese onshore market assets (notably passive flows) and an interest rate differential favorable to the Chinese currency.
• We have a positive view on the CNY and believe that a stronger renminbi could push other emerging currencies higher against the dollar, which reinforces our positive view on emerging equities. Overall, we maintain a bias towards risky assets in our multi-asset portfolios, with an overweight to equities and credit.

A FAVORABLE CONTEXT FOR THE CHINESE CURRENCY

In recent months, the US dollar has weakened against other currencies, but not uniformly: the depreciation of the USD has been more pronounced against currencies in developed markets than against those in emerging markets. Since its recent peak at the end of March, the dollar has weakened by around 10% against the benchmark index of developed market currencies (the DXY) and only 3% against the index of emerging currencies. (the MSCI EMFX). Over the same period, the CNY (which alone accounts for more than 40% of the EMFX basket) appreciated by around 4% against the dollar, lagging behind the rate of appreciation at two Euro, British Pound and Australian Dollar figures against US currency.

Can the CNY catch up? Can it drive the EMFX higher? We believe that the outlook for the Chinese currency is favorable against the dollar, due in particular to fundamentals that are playing in its favour.

A FAVORABLE CONTEXT FOR THE CHINESE CURRENCY
In recent months, the US dollar has weakened against other currencies, but not uniformly: the depreciation of the USD has been more pronounced against currencies in developed markets than against those in emerging markets. Since its recent peak at the end of March, the dollar has weakened by around 10% against the benchmark index of developed market currencies (the DXY) and only 3% against the index of emerging currencies. (the MSCI EMFX). Over the same period, the CNY (which alone accounts for more than 40% of the EMFX basket) appreciated by around 4% against the dollar, lagging behind the rate of appreciation at two Euro, British Pound and Australian Dollar figures against US currency.

Can the CNY catch up? Can it drive the EMFX higher? We believe that the outlook for the Chinese currency is favorable against the dollar, due in particular to fundamentals that are playing in its favour.

Fundamentals favorable to the CNY: exports and capital flows

There are signs that the pace of CNY appreciation has accelerated in recent weeks. On September 1, the CNY hit its highest level in a year against the dollar. We believe that several fundamental factors could continue to work in favor of the CNY in the short term.

The first is the strength of trade-related demand. China's current account surplus is likely to remain elevated for the rest of the year, supporting CNY demand. Despite weak and slowing global demand during the COVID-19 crisis, Chinese exports have held up remarkably well, beating market expectations for five consecutive months since March. In July, China's export growth jumped to 7.2% year-on-year, from an average growth of 0.5% in 2019.

We believe that China will continue to show strong export performance until the end of the year. As long as the risk of a resurgence of COVID-19 persists, demand for medical supplies and technology products for working from home will remain strong until a vaccine or more effective treatments arrive. The ongoing economic recovery in developed countries should also fuel a broader rebound in global demand, which should also support Chinese exports. On the other hand, foreign exchange outflows linked to imports are likely to remain limited, given the low oil prices and the sharp decline in foreign exchange demand for Chinese tourism abroad.

The second reason why we might see CNY appreciation in the short term is the inflow of investment capital into onshore Chinese assets, which is putting upward pressure on the CNY.

Purchases of Chinese stocks and bonds by foreign investors have accelerated in recent months. In July, the net amount of these purchases amounted to 165 billion RMB for Chinese bonds, a figure not reached since the opening of the Chinese bond market to foreign investors in 2010.

Passively managed funds have been a major driver of these capital flows. China has been added to two major international bond indices (the Bloomberg Barclays Aggregate and the JPMGBI-EM Global Diversified), channeling capital from the passive tracking strategies of these indices into the Chinese bond market. If Chinese bonds were added to the FTSE Russel World Government Bond Index (WGBI) at its annual review at the end of the month, these passive flows could gain further momentum.

ATTRACTIVE INTEREST RATES

At the same time, the higher interest rates offered by Chinese bonds compared to other major markets are attracting capital flows from international investors in search of yield. The yield of around 3% on 10-year Chinese government bonds offers a substantial yield advantage over the sovereign bonds of the main developed countries (graph 1). In particular, the interest rate differential with US Treasuries widened to its highest level in over ten years.

We believe that this differential will remain high and will continue to attract flows of foreign investors in search of yield. Contrary to the Federal Reserve's pledge to maintain a dovish long-term stance, China has likely already passed the peak of its monetary easing, as its economic recovery appears to be on track. Chinese monetary policy has been less accommodating since the end of May and Chinese leaders seem reluctant to implement large-scale easing measures. We further believe that the issuance of a significant amount of government bonds should continue for the rest of the year to finance the government's fiscal stimulus, which will put upward pressure on bond yields.

Another important factor, apart from these favorable fundamentals: although the Sino-American tensions persist, they have not had a major adverse impact on the CNY. Despite tightening US restrictions on a number of Chinese tech companies and several bouts of diplomatic and geopolitical tension, China has failed to respond with aggressive retaliation, which has encouraged investors. Recent events on the trade front have also been positive. In a statement released Aug. 24, the U.S. Trade Representative said both sides were seeing progress on the Phase I agreement and noted China's progress in areas such as intellectual property protection.

Sino-US tensions nevertheless remain a major risk for the CNY in the short term. The risk of further escalation will increase ahead of the US election in November, and if confirmed, it could dampen FX sentiment towards the Chinese currency.

IMPLICATIONS FOR ASSET CLASSES

We have a positive opinion on the outlook for the CNY against the USD. The appreciation of the Chinese currency could also open the door to the appreciation of other major Asian currencies against the dollar, such as the Korean won or the Taiwanese dollar.

We therefore expect a further weakening of the dollar against emerging currencies, under the effect of the appreciation of the CNY, which would confirm our preference for emerging equities. Historically, emerging market equities have tended to do well during periods when the dollar declines against emerging currencies (Chart 2). More generally, we maintain a favorable bias towards risky assets in our multi-asset portfolios, with an overweight in equities and credit in a context of continued economic recovery and continued monetary easing measures. In addition to our preference for emerging markets, we also favor US and European equities among equities. In bonds, we are slightly underweight duration.