Outlook 2016: Asian Fixed Income
The coming year will lay the foundation for attractive entry points to add risk in Asian bond markets, particularly once the US Federal Reserve (Fed) signals its trajectory for interest rate hikes.
11 December 2015
China dominates headlines
News in 2015 was, and still is, very much dominated by the growth slowdown in China and the collapse in oil and commodity prices.
The collapse has been driven to a large extent by a combination of oversupply as well as the moderation in Chinese demand.
Furthermore, relatively larger debt loads in certain emerging markets, when compared to developed markets, and mixed signals from the major G3 central banking policymakers, have unsettled investors.
Against this backdrop, market participants have not been able to make up their minds. The uncertainty centres around five positive developments:
1. Chinese reform programmes and policymakers’ concerted push towards economic growth dependence on services rather than manufacturing.
Firstly, China wants to avoid the “middle income trap”, whereby a country does not reform its economy after having grown rapidly, and instead gets stuck in activities that stop it from achieving wealth comparable to an advanced country.
For this reason, Chinese policymakers have engaged in a significant push towards moving the economy away from being the “factory of the world” towards one that focuses on moving up the value chain towards more high-tech, value-added services – in a similar vein to the transition of other Asian countries such as Singapore and South Korea.
Providing services to its increasingly affluent consumer and the rest of the world is the long-term goal and should result in higher revenue generation, further development and enhanced wealth creation.
This ties in neatly to debt.
As most investors are aware, China has a debt problem and, by some counts, has the third-highest debt burden in the emerging world behind Hungary and Malaysia – if you ignore the financial sector – at over 200% of GDP.
Although the desire to avoid the middle income trap can partially explain the willingness to take on debt, Chinese authorities have recognised the drawbacks of excessive borrowing and are engaged in deleveraging through reforms of central and local government finances, dealing with debt in state-owned enterprises (SOEs) and the private sector, and pulling the plug on leveraged activities.
The short-term effect of these two reforms has historically resulted in slowing GDP growth in other countries. China appears to be no different.
What this implies is that the winners in the old economic model will now be the losers, such as basic manufacturing industries, steel companies and firms that consume vast amounts of commodities.
The winners in the new economy are likely to be well-run technology, healthcare and infrastructure firms, amongst others.
For bond investors, a slower/lower growth model is a good thing.
Chinese government bonds become the choice instruments for investors looking for safety and high quality investment grade corporate bonds benefit from investors’ de-risking bias towards safer and less leveraged firms.
In the long run, Chinese deleveraging and a push towards a higher value-added economy point to stability and arguments for a lower risk premium.
2. Beneficiaries of low oil and commodity prices
Lower commodity prices are proving painful for commodity-producing countries and companies, as revenues and profits fall whilst servicing debt burdens rise.
The reverse is true for commodity consumers. The US, eurozone and Asian countries, bar Malaysia and Indonesia, are big consumers of both oil and hard commodities.
Any reduction in the cost of these imports has a positive effect on the current accounts of commodity importers and the wallets of commodity importing nations’ consumers.
In Asia, where growth has slowed, this is a welcome respite for economies and consumers.
It also allows governments and central banks in the region the much-needed wiggle room, in terms of monetary/fiscal policy, to mitigate the slowdown being caused by a lower growth rate in China.
There is also the inflation effect. Lower food, commodity and energy prices translate into lower inflation in Asia.
This implies that central banks in the region have the flexibility to cut interest rates, which should be supportive of bond markets in the region.
3. An increasingly resurgent US economy and a eurozone that appears to be stabilising
Asia is the manufacturing hub of the world. Even though numerous studies have suggested that global trade has reversed, a resurgent US and a stabilising eurozone are both likely to translate into better prospects for Asian companies – particularly those who have good links to these economies. Good quality investment grade companies stand most to benefit from this phenomenon.
4. Japan’s renewed internationalism
For too long the Japanese have been focused on investing their vast savings into the domestic Japanese bond market.
Following the push by the Japanese government to diversify away from Japanese bonds and into overseas bonds and equities, capital from Japan is flooding financial markets and Asian bonds are turning out to be a beneficiary of this trend.
5. The end of easy (destructive) monetary policy
Many can point to historical instances where a period of tightening in US monetary policy is typically accompanied by pain in emerging markets.
This time is no different. Since 2013, the Fed’s intention to disengage from easy monetary policy has been a contributing factor to weak performance in the emerging market complex.
However, if historical precedent is anything to go by, Asian and emerging markets tend to recover once the tightening actually occurs.
So while the anticipation of rising US rates tends to have a negative impact on Asian markets, the actual point at which rates are raised and when clarity around the pace of rate hikes begins to emerge, tends to result in a stabilisation of returns for Asian investors.
Although many expect the US dollar to keep strengthening on the back of rate hikes in 2016, we believe that once the path of Fed hikes is priced into the dollar, the currency may top out.
It is already a crowded trade and a stronger US economy should lead to a greater US trade deficit and therefore, an increase in the supply of dollars.
As a result, we expect there to be some viable opportunities in 2016 to go long Asian currencies versus the greenback.
All of the above imply that good quality Asian government bonds hedged or partially hedged to the US dollar will benefit – given lower inflation and the likelihood of central banks easing monetary policy in the region.
Furthermore, Asian US dollar-denominated investment grade bonds will be in demand on the back of the low growth environment and also as investors de-risk away from the high yield sector amidst rising defaults.
The yield spread between Asian government bonds and other markets continues to be high, especially after the decline in European yields, and we see this trend continuing into 2016 as monetary policy in Europe looks set to be in easing mode for a while yet.
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