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An experimental economist could not have planned events better if she had tried. The world has three leading international financial centres. Two, New York and London, are serving as controls, while the third, Hong Kong, has started chipping away at its independent judiciary, which is the ultimate guarantor of civil liberties including a free press, freedom of expression and an open internet. That will make the semi-autonomous Chinese territory a test of whether civil freedoms, free information flows and the rule-of-law are in fact necessary components of a smoothly functioning global finance hub. Wittingly or unwittingly, the Chinese Communist party has embarked on this experiment in recent weeks as its patience frays with the demonstrations that first erupted in June in opposition to a controversial extradition bill and are now demanding universal suffrage in the former UK colony. It is hard to exaggerate the importance of the outcome, as China and the US square up for a century-defining contest between their diametrically opposed political and economic systems. President Xi Jinping is betting that he can rein in Hong Kong’s stubbornly independent jurists without damaging the city’s role as a crucial fundraising centre for China’s leading state-owned enterprises and private-sector companies. If he is successful, it will reinforce already sky-high levels of confidence among Beijing officials about the superiority of their governance model, especially when they look at the impeachment circus that currently has Washington in thrall. Late last month the Communist party’s Central Committee issued a series of vague threats that suggested Beijing was poised to tighten its grip on Hong Kong. Then, on November 19, a spokesperson for China’s rubber stamp parliament criticised a recent Hong Kong court ruling that invalidated the Emergency Regulations Ordinance enacted last month by the territory’s embattled chief executive, Carrie Lam. Only the National People’s Congress, the spokesperson said, could determine whether Hong Kong laws accord with the territory’s mini-constitution, or Basic Law. How Hong Kong crisis is forcing companies to rethink While the NPC has long been recognised as the ultimate authority on the Basic Law, it had never before suggested that lower courts could not do so as well. Indeed they have been doing just that ever since Hong Kong reverted to Chinese sovereignty in 1997. Ms Lam had used the ordinance to implement a ban on wearing masks supported by hardliners in Beijing, who thought it would help police to identify and arrest people participating in unauthorised assemblies. They also wanted Hong Kong’s chief executive to have the flexibility to take even more draconian measures if needed to restore order. So far, from China’s perspective, so good. The recent tougher signals from Beijing did not dissuade investors from snapping up a $13bn secondary offering in Hong Kong this week from Alibaba, the Chinese tech group whose main listing is in New York. Alibaba’s long-awaited Hong Kong offering came after China’s securities regulator began to urge overseas-listed Chinese tech champions to hui gui, or return home. As one party official puts it, if China’s best companies aren’t listed on local stock exchanges then the country’s capital markets will be “doomed”. Jack Ma, Alibaba’s billionaire founder and recently retired chairman, is a loyal party member. So it is not surprising that his company would push ahead with what was advertised as a “vote of confidence” in Hong Kong even as tear gas wafted through the streets. There have not been destabilising capital outflows from the territory since the protests began. And for all the periodic outbreaks of violence over the past six months, the benchmark Hang Seng index is down just 0.5 per cent since the protest movement erupted in mid-June. But Beijing should not interpret the relative resilience of Hong Kong’s financial sector to date as a sign that it has an opportunity to tighten further its grip over the territory by bringing the judiciary to heel. The Chinese Communist party has crushed plenty of rebellions during its 70 years in charge of the world’s most populous country. However, it has no clue what to do when confronted by a protest movement that, because of the Hong Kong’s unique historical circumstances, enjoys the protections afforded by a free media, open internet and — for now — an independent legal system. For Mr Xi and other party leaders whose careers have been spent in a political system where might makes right, it is inconceivable that their authority could ever be constrained by a mere court, as Ms Lam’s emergency powers were. In the parallel universe that they inhabit, courts and judges exist to aid and abet one-party rule, not to protect people from its excesses. But such institutional checks helped to make Hong Kong, during 151 years of largely prosperous British administration, an attractive destination for millions of hard-working and entrepreneurial Chinese fleeing autocratic mainland regimes, including that of Mr Xi’s political idol, Mao Zedong. Beijing, after ruling the territory for 22 increasingly dysfunctional years, should think twice before gutting them.

Bonds have become the new equities, say fund managers, stirring concerns that dangers are lurking in the supposedly safest corners of financial markets. Historically, investors have for the most part bought government bonds for their security and interest payments, while they have sought out equities in the hope of capitalising on rising prices. There are exceptions, of course, but by and large this relationship has remained constant through the modern era.  Now, though, investors are forced to live with the opposite — bonds that yield nothing but that gain in price, and equities that are relied on for their streams of dividends rather than their rising prices. It is a flip that has unsettled many analysts and money managers. “It’s terrible,” said Con Michalakis, chief investment officer of Statewide Super, an Australian pension fund which manages A$9.7bn ($6.6bn) in assets. “Everyone has become a short-term trader, not buying bonds to hold them. That’s not a good thing,” he said. “And I don’t think people understand the volatility of equities.” Negative-yielding bonds are at the heart of the problem. Prices are so high that investors are certain to get back less than they paid, via interest and principal, if they hold the bond to maturity. Yet investor demand — coupled with central bank buying — has expanded the universe of sub-zero yielding debt to $13.3tn. Although there are several regulatory and technical reasons why investors would buy bonds with negative yields, some are doing so in the expectation that they can later sell them on at an even higher price. Low-yielding bonds are also producing outsized price gains that dwarf their modest coupon payments. The Bloomberg Barclays Global Aggregate bond index has returned over 6 per cent this year and about 8 per cent over the past 12 months, despite yielding just 1.37 per cent. Even with modest gains from here, this year’s performance could mark the second time the index has surpassed 7 per cent since the financial crisis. With the European Central Bank set to restart its quantitative easing programme, the Federal Reserve cutting interest rates and the Bank of Japan continuing to pump money into the global monetary system, it is hard to see an end to the broad market rally. “Some bond buyers are motivated by hopes of capital gains,” said Jeffrey Gundlach, chief executive of DoubleLine Capital, which has $147bn in assets. In some cases, yield-starved investors try to make up the shortfall by buying increasingly risky debt, Mr Gundlach noted. But others are seeking out stocks that pay healthy dividends instead. Leaving aside ultra-long dated 30-year Treasuries, the entire US government bond market now yields less than the average S&P 500 stock (2.1 per cent). “Institutions and individuals need income, but income from bonds and other traditional sources has been diminished,” said Kera Van Valen, a portfolio manager at Epoch Investment Partners, which manages $33bn in assets. “Dividends are always positive contributors to equity market returns and companies that pay consistent and growing dividends have historically provided downside protection in volatile equity market environments.” French bank Société Générale has also advised its clients to seek out steady dividend payers in response to rock-bottom global bond yields. That includes an S&P index of dividend “aristocrats”, which have reliably increased cash payouts over the past 25 years. But the advice comes with a warning: a deep recession would see a sharp sell-off in such stocks. Meanwhile, this shift in portfolio construction represents a long-established market orthodoxy being turned on its head. Through the 19th century and the first half of the 20th, the US stock market’s dividend yield was higher than the average bond yield, simply because investors assumed that riskier assets like equities should pay them more than relatively safe and steady fixed income. But what had seemed an immutable law began to change in the late 1950s, when the 10-year Treasury yield vaulted over the S&P 500 dividend yield. Peter Bernstein, the late financial historian, once recalled how one of the elder partners at his investment firm shrugged off the phenomenon at the time, saying: “Don’t worry, kid. This’ll reverse itself. This is unreal and not to be sustained.” And yet, the 10-year Treasury yield stayed above the US stock market’s dividend yield for the next half-century — until recently. The question is whether this new world will continue, and whether fund managers will come to regret loading up on stocks instead of government bonds if disaster strikes. Mr Michalakis doubts the current environment can last. He is concerned that it will mean that bonds exhibit more equity-like volatility, while becoming more correlated to the stock market — making them less effective as portfolio ballast.  “When it turns it will be really interesting,” he said. “If we have any hint that the party is over, it will reverberate across the system.”

CORBYNMANIA

The UK’s bond market seems to be intensely relaxed about Jeremy Corbyn. On Thursday, the opposition leader unveiled a manifesto laden with promises of huge investment funded by borrowing. But investors are unworried about being asked to pay for it. Yields on government bonds are close to all-time lows, and big fund managers say hundreds of billions could be added to the national debt without an uncomfortable rise in the cost of borrowing. The market calm, of course, partly reflects the low probability investors assign to Mr Corbyn’s Labour party winning next month’s general election. After all, the bond vigilantes have not all suddenly become socialists. Labour’s plans for swingeing nationalisations are certainly cause for worry, even if the sheer size of spending plans is not. But it is also a sign of something bigger: bond markets no longer seem to care very much about deficits. The ruling Conservative party, too, has pledged a spending splurge, and public sector net borrowing has already shot to a five-year high in October. The UK is not even the best example of this new attitude to public finances. In countries with negative sovereign bond yields investors are practically screaming at governments to borrow. This is symptomatic of a post-crisis world where monetary policymakers pulled out all the stops to stimulate the economy while fiscal authorities mostly tightened their belts. Interest rates were slashed and central banks bought up a huge slice of government bond markets. Now, however, the talk among investors is of a “pivot” to fiscal policy, given that monetary policy is widely perceived to be out of ammo. Calls for fiscal restraint are unlikely to feature prominently in next year’s US presidential campaign, particularly if it is a contest between Mr Trump and Elizabeth Warren. Even Germany’s long commitment to maintaining budget surpluses is coming under fire, both at home and abroad. If a global shift is coming, the UK could find itself a test bed. Will bond markets really swallow a borrowing binge at a time when debt levels remain high and Brexit promises an economic upheaval? Recommended Sovereign bonds How bonds became stocks and stocks became bonds The consensus is that yields are likely to rise if and when governments dump a tonne of new issuance on to markets. But that is largely because investors think fiscal expansion will be more effective than monetary policy in boosting growth. They will only worry about getting their money back — or about runaway inflation — in the most extreme of scenarios. For developed markets that have their own currencies and central banks, higher bond yields are typically a sign of economic health, not crisis — a point clearly lost on Donald Trump when he looks at Europe’s negative borrowing costs and says “give me some of that”. In the UK and beyond, as long as any rise is orderly and does not threaten to spiral out of control, higher yields should be cause for celebration, not consternation.

EM YIELD FLEEING

By any standards, this is not a fitting backdrop for a rip-roaring emerging markets (EM) bond rally. A trade war is raging. The US Federal Reserve is cutting rates, US growth is slowing and the Treasury curve recently inverted in a sign of approaching recession. Europe remains stuck with intractable problems in its banking sector and the ECB has run out of ammunition. Germany is probably already in recession and dark Brexit clouds hang over the UK economy. China and India are slowing. The political news is ugly in Latin America. Russia and Turkey are vilified. Commodity prices are depressed. The dollar is near all-time highs. Geopolitical tensions are rising as President Donald Trump shrinks from global leadership. Yet, despite this messy backdrop, EM bonds have staged a formidable rally, which began shortly after the Fed began to raise interest rates in December 2015. beyondbrics Emerging markets guest forum beyondbrics is a forum on emerging markets for contributors from the worlds of business, finance, politics, academia and the third sector. All views expressed are those of the author(s) and should not be taken as reflecting the views of the Financial Times. Over this period, EM local currency government bonds have returned 7.2 per cent annualised in dollar terms compared with just 2.2 per cent for similar duration US government bonds. In the year to date, EM local bonds are up by 9 per cent in dollar terms. EM sovereign and corporate dollar-denominated bonds are not doing badly either. Up by 12.6 per cent and 11.5 per cent a year to date respectively, they are beating the comparable 10-year Treasuries and US high-yield bonds. Over the past four years, they have returned 7.4 per cent and 7.1 per cent annualised, respectively. EM corporate high-yield bonds are up 8.9 per cent annualised since the start of 2016. EM bonds have therefore outperformed US Treasury bonds by a factor of two to three times over the past four years. Why is EM fixed income so healthy, when the world is so sick? One reason is light positioning. Between 2011 and 2015, investors offloaded a third of their EM exposure to chase capital gains in US stocks and eurozone bonds. Very little of this money has yet returned, so there are more buyers than sellers. Valuations also play a part. EM dollar-denominated sovereign bonds pay 330 basis points over Treasuries for exposure to a hugely diverse asset class comprising 73 countries with an average investment grade credit rating. To put this in context, in 2006 investors were only paid 180 bps for the index, which, at the time, had fewer than half the number of countries and a lower average credit rating. Put another way, the yield on EM external debt today is consistent with a fed funds rate about 100-200 bps higher than the current rate, based on the historical relationship between EM yields and the fed funds rate. EM bonds have outperformed developed market peers
Local markets also offer value. Few investors will be aware that EM local currency bonds have narrowly outperformed EM sovereign bonds in dollar terms over the past four years. This is almost entirely due to the steady decline in EM inflation in recent years, so, in spite of nominal yield compression, investors are paid almost exactly the same real yield today as they were 10 years ago. Large flows back to EM local markets have barely begun yet. High yield corporate bonds in EM also look appealing, especially compared with their US counterparts. They pay around 150 bps more in spread than US high-yield bonds, but default rates on EM high-yield bonds are 220 bps lower than their US counterparts (0.7 per cent versus 2.9 per cent, respectively). Meanwhile, the fundamental case for allocating to EM continues to strengthen. EM economies have lived down a plethora of external headwinds since the Taper Tantrum of 2013. Because of declining inflation, cheaper currencies and reforms, many are now highly competitive. By contrast, the US economy suffers from an overvalued real effective exchange rate, while Europe languishes in a structural mess. The IMF is forecasting EM growth rates to rise relative to developed economies every year for the next five years. Granted, two or three EM countries get into trouble every year, but diversification offers great protection against idiosyncratic shocks. Argentina’s bond prices fell 50 per cent this summer. In 2000, this would have pushed down the index by 10 per cent, but this year the impact was a mere 0.9 per cent and the index is up 12.6 per cent for the year. Diversification means that idiosyncratic EM shocks no longer pose the systemic risks they did in the past. What next for EM bonds? At current yields, if the EM bond rally stalls completely, so that investors only get paid coupons, they can expect a compounded return of 29 per cent in dollars for the next five years. However, it is likely that EM currencies will gradually claw back some performance after their 50 per cent fall versus the dollar during the QE years, especially if the US continues to slow and the Fed resumes its cutting cycle. Even a modest 20 per cent recovery in EM FX would lift the five-year return on EM local bonds to 50 per cent in dollar terms, or about 9 per cent annualised. Eurozone investors hedging EURUSD risk can expect about 36 per cent return euro terms. It is difficult to identify investment grade government bonds with five years of duration anywhere else in the world able to beat that.