Bridgewater ®

Daily Observations
March 27, 2018 ©2018 Bridgewater Associates, LP

(203) 226-3030 Greg Jensen

Paul Podolsky
Sean Macrae
Nicholas Bernold

Inclusion of China in Bloomberg’s Global Aggregate Bond Index

Boosts Pressure on Investors to Figure Out How They Will Deal with the
Opening of Chinese Markets
Most global investors have very small allocations to China that do not appropriately reflect the size and
importance of the Chinese economy or its assets. We expect that will change significantly over the next few
years, and Bloomberg’s inclusion of the Chinese bond market at a bit over 5% weight is the first material shift by
one of the major indices to boost exposure to Chinese onshore financial assets. Many more moves like this are
coming and will reshape global portfolios, and we would encourage investors to think proactively about the
exposure they want to China now.

The availability of Chinese assets provides a meaningful opportunity for diversification. Chinese assets have a
fairly low correlation to global assets because the Chinese economy is largely driven by domestic demand, which
in turn has its own idiosyncratic drivers. The motivations for China to open up their markets are equally clear.
China wants foreign capital to deepen their capital markets, help further develop their economy, and bring in
flows that will allow them, over time, to relax capital controls and create a two-way currency market. The launch
Monday of an RMB-denominated oil future open to international investors is another step in the same direction.
The oil exchange reflects a desire to harness financial markets to more efficiently allocate capital, and doing so
will improve global commodity liquidity. While the bond inclusion is the bigger deal, both of these developments
highlight the fact that going forward Chinese assets will play a significant role in most investor portfolios. While
today foreigners have a tiny share of their portfolios invested in Chinese assets, particularly relative to the size of
the Chinese financial markets and economy, we expect this to change dramatically in coming years.

China Onshore Assets, Share of

China Share of Global Output China Share of Global Assets
Foreign Portfolios
20% 20% 20%

15% 15% 15%

10% 10% 10%

5% 5% 5%

0% 0% 0%
00 10 00 10 00 10

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Bridgewater® Daily Observations 3/27/2018
Chinese Bonds to Enter the Index Next Year and Be Phased In to Full Weight

Beginning in April 2019, China will be included in the Bloomberg Global Aggregate. By 2021, Chinese bonds will
make up about 5.5% of the aggregate. This is a big deal for global capital allocation, as trillions of dollars track
this index explicitly and trillions more use it as an important reference for their allocation. Given that investors
already hold some government bonds, this means hundreds of billions of dollars will likely move into the bond
market. In a statement, Bloomberg said Chinese bonds now meet inclusion criteria that the bonds be investment
grade, freely tradable, allowed to be currency hedged, and “free of capital controls.” If other flagship indices
follow suit, we estimate that very roughly something like $1.2 trillion will flow into the bond market, as we show
in the red bar below.

China RMB Debt Held by Foreign Investors (USD, Bln)

1,400

1,200

1,000

800

600

400

200

0
2011 2012 2013 2014 2015 2016 2017 With All Indices:
World-Agg Full
Inclusion Inclusion
(Est) (Est)

If China Continues on Its Current Path, Chinese Assets Are Likely to Represent Roughly One-Third of Investor
Portfolios

An even bigger flow will occur as Chinese stocks also gain inclusion to equity indices. To illustrate the point, if
Chinese bonds and stocks are given a market weight in global indices, we will move from the chart on the left to
the chart on the right. As of June, onshore Chinese stocks will join the major MSCI indices (the offshore H-
shares are already in the index). Though the inclusion weight will initially be very low, we expect onshore
equities to eventually be included at their full weight (about 17% of global market cap). This would represent a
staggering shift in the source of global returns.

Developed World & China 60/40 Developed World & China 60/40
Using Current Index Weights Using Future Index Weights (Est)
USA China Europe Japan USA China Europe Japan

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Bridgewater® Daily Observations 3/27/2018
Opening China’s Markets Makes Sense for China…

Chinese policy makers have been working assiduously toward opening their markets for years. The stock and
bond connects, working with outside investors to deal with issues like currency hedging and intervention, fit into
a chain of reform that stretches back to 1978, an evolution we have described elsewhere. The key thing for
foreigners to recognize is that opening their markets serves China’s interests. To continue to reform and reach
their own growth targets (becoming a “moderately prosperous society”), China needs to deepen their capital
markets and transform them into a source of capital for increasingly private-sector-driven savings (i.e., insurance
and pension funds) and investment by households and innovative private sector businesses.

…and for Foreign Investors

China represents an almost unprecedented opportunity for investors to diversify their portfolios. While China has a
large influence on other major economies and vice versa, growth is primarily driven by the domestic economy and
domestic drivers. For starters, China’s short-term and long-term debt cycles are at different points relative to most
of the developed world. Japan, Europe, and the US all have debt levels over 300% of GDP, interest rates close to
zero, large central bank balance sheets, and growth well below 5%—none of which is true in China. Of course, as a
consequence of global capital flowing more freely, in the future the correlation between Chinese and foreign assets
will likely rise somewhat as ebbs and flows in global liquidity begin to have more impact in China. Still, we expect
the fundamentally diversifying effects of Chinese assets will persist. All of these factors mean that conditions in
China look different than in the countries that dominate institutional portfolios, as shown in the charts below.

Growth: Correlation to Rest of World (Since the Inflation: Correlation to Rest of World (Since
Start of CHN Data in 1991) the Start of CHN Data in 1985)
100% 100%
90% 90%
80% 80%
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20% 20%
10% 10%
0% 0%
USA EUR JPN CHN EUR USA JPN CHN

Given that conditions are lowly related, it isn’t surprising that asset class returns have been lowly related as well.
This means that adding these assets to a portfolio is significantly diversifying.

Equity Returns: Correlation to Rest of World Sov Bond Returns: Correlation to Rest of World
100% 100%

80% 80%

60% 60%

40% 40%

20% 20%

0% 0%
GBR EUR USA CAN AUS JPN CHN GBR EUR USA CAN AUS JPN CHN

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Bridgewater® Daily Observations 3/27/2018
We’ve also noted previously that China has “fuel in the tank” to ease, should they need to do so. That question,
which once seemed like a distant consideration, is now suddenly more front of mind, given recent turbulence
around both trade and late-cycle dynamics. While we have our own tactical views on such matters, our core
perspective is that it is best to spread one’s bets. The opening of China’s markets and now the inclusion of
Chinese bonds will increasingly drive many investors to do just that.
Monday’s Launch of an RMB Oil Future Available to Foreign Investors Is Another Opening Up
Given the news over the bonds, it would be easy to miss another important milestone—the Monday opening of
RMB oil futures available to foreigners. China is a huge player in global commodity markets (as illustrated
below), so developing onshore commodity futures markets makes sense. China already allows trading of a gold
future denominated in RMB.

China Share of Global Commodity Consumption

2000 Today
0% 10% 20% 30% 40% 50% 60%

Aluminum

Copper

Zinc

Iron Ore

Nickel

Oil

The parameters of the Shanghai contract are largely similar to crude oil futures currently traded in London and
Chicago, with the notable difference that they are denominated in RMB (though foreigners can post margin and
take profits in dollars) and have a tighter cap on daily price moves (plus or minus 4%).
RMB futures will allow onshore market participants like oil companies, large consumers, and asset managers
(some of whom are currently prohibited from trading commodities, but we expect this will eventually change) to
either hedge or gain portfolio exposure to oil without going through the process of converting their local currency
into dollars. If onshore investors begin to use oil futures in their investment portfolios, China could become an
even more important component of the marginal demand for oil. The chart below on the left shows China’s
increasing share of oil consumption, and the chart below on the right shows that a significant share of the global
shifts in oil demand come from China. Given this, creating a commodities trading hub in China is logical.

China Share of Global Oil Demand Change in Oil Demand (Barrels/Day)

World (Y/Y) China (Y/Y)

15% 3,000K
14%
2,500K
13%
12% 2,000K

11% 1,500K
10%
1,000K
9%
8% 500K
7% 0K
6%
-500K
00 05 10 15 00 05 10 15

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Bridgewater® Daily Observations 3/27/2018
US Durable Goods Report Is the Latest Sign of US Business Investment Reinforcing
the Ongoing Expansion
Matthew Karasz | Brennan Robbins | Rutendo Chigora

US business investment has been picking up for some time, and as we look ahead we expect it to continue to
reinforce the already strong US expansion. So far, it appears that US companies are responding to the normal
cyclical pressures as one would expect: businesses have faced strong demand for some time, they are
increasingly under pressure to expand capacity, and they are flush with cash. In line with this, US business
investment has picked up, and the durable goods report suggests that this trend continued through February.
Looking ahead, we expect these cyclical supports to remain in place, and we think that the recent US tax cut is
likely to provide a further boost now that companies have clarity about it. The likely acceleration in business
spending is one reason why we expect overall US growth to remain well above potential, even as the Fed moves
to reduce stimulation. Of course, one clear and mounting risk to global business spending and the US expansion
more broadly is the threat of a trade war, especially now that tensions with China have been increasing.
However, as we mentioned in Friday’s Observations, the restrictions announced on Thursday so far have been
small, and the bigger threats we’re watching are an escalation by the US or more significant retaliation by its
trading partners.

The first chart below shows a timely read on US business investment. Shipments of core capital goods—a
measure of the items used in businesses investment, excluding volatile shipments of aircraft and defense
equipment—continued to trend up through February, reflecting the strength in the broader economy. This
measure has risen somewhat less quickly in recent months, but other measures of business activity (like the ISM
manufacturing survey) are somewhat stronger.

Core Cap Goods Shipments (3m, Ann) ISM Manufacturing

20% 60.0
57.5 Shipments
10%
55.0 trending up,
and ISM
52.5 survey points
0%
50.0 to further
strength
47.5
-10%
45.0
-20% 42.5
40.0
-30% 37.5
35.0
2000 2005 2010 2015

The durable goods report reflects both domestic investment in equipment and foreign demand for US business
goods exports. The recent strength primarily reflects domestic investment. As the chart below on the left
shows, this has provided nearly a 1% support to growth. Businesses abroad have also hiked investment in
response to strong demand, and this has provided a further marginal support to US growth, since US businesses
export many of the capital goods needed for investment abroad.

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Bridgewater® Daily Observations 3/27/2018
 Contribution to US RGDP (Q/Q)
Real Business Fixed Investment Real Exports Business Durable
of Business Goods
Durable Goods
Coincident Estimate Coincident Estimate
3% 3%
Material support
to growth 2% 2%
Small support
to growth
1% 1%

0% 0%

-1% -1%

-2% -2%

-3% -3%
00 03 06 09 12 15 18 00 03 06 09 12 15 18

Another clear reflection of the pressures on businesses to increase investment is the strength in business capex
surveys. As the charts below show, all of the major surveys of capex plans have surged since the passage of the
tax cut late last year.

Bus Roundtable: Capex Sentiment NFIB: Composite Capex Sentiment Duke CFO Survey: Capex (12m Frcst)

20 15%
Strong Strong Strong
50% 15 10%
10
25% 5%
5

0% 0 0%

-5
-5%
-25%
-10
-10%
05 10 15 05 10 15 05 10 15

The ongoing pickup in domestic business investment makes sense to us when we look at underlying business
conditions in the US. By this point in the expansion, businesses have faced strong demand for some time, they
are increasingly under pressure to expand their capacity, they’re flush with cash, and they now have clarity
around the tax cut. As the charts below show, the demand facing businesses is the strongest it has been in
years, at a time when capacity utilization is roughly normal. Taken together, these conditions are encouraging
businesses to invest in additional capacity to meet new demand, at a time when high levels of cash on balance
sheets and the recent tax windfall have given them ample ability to do so.

Growth Facing Businesses (6m Chg, Ann) Capacity Utilization ex-Mining (Detrended) Non-Fin Corp Cash (% GDP)

All-time highs
6% 5% 11%
Strongest in years
5% 4%

4% 3% 10%
Roughly
normal 2%
3%
1% 9%
2%
0%
1%
-1% 8%
0%
-2%
-1% -3% 7%
-2% -4%
-3% -5% 6%
00 05 10 15 00 05 10 15 00 05 10 15

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Bridgewater® Daily Observations 3/27/2018
Thus far, US business investment has mostly risen in line with the strong demand businesses have faced, but
going forward, we see the possibility of a more material acceleration. One main driver that could cause an
acceleration is the significant support to growth from fiscal easing that is just starting to come online now. As
the chart below shows, the recent tax cut and budget expansion will likely boost the US economy by as much as
1.25% of GDP over the next year, an aggregate fiscal stimulus roughly as big as the one enacted in 2009 during
the most acute phase of the global financial crisis. A big part of this boost is likely to come through additional
corporate spending, as the tax cut provides direct incentives to increase investment (through accelerated
depreciation), and the tax windfall will give corporates more cash to do so.

Government Impact on Growth

Forward Estimate
1.50%
1.25%
Almost as much 1.00%
government support as
0.75%
during the financial crisis
0.50%
0.25%
0.00%
-0.25%
-0.50%
-0.75%
-1.00%
-1.25%
1995 2000 2005 2010 2015 2020

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Bridgewater® Daily Observations 3/27/2018
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Bridgewater® Daily Observations 3/27/2018