Market Views: Fixed Income

Where next for Asian bonds?

The slowdown in China ignores the region’s broader strengths.

25/08/2015

Asia Fixed Income Team

Asia Fixed Income Team

Amidst the noise and volatility in financial markets it is useful to take stock of the situation and consider the data instead of market paranoia and conjecture.  What we know today is:

  • The US economy is growing relatively robustly  when compared to most of the developed world
  • The eurozone economy appears to have turned a corner but is still likely to be on life support for a while
  • Most Asian countries - one could argue are at a later stage of the economic cycle when compared to the US - are slowing down on the back of a mix of slower Chinese growth; weak global trade; policy induced slowdown by Asian policy makers; and in some instances political upheavals.
  • Most commodity prices are at levels seen just after the great financial crisis indicating that it is likely to be a tough time for commodity exporters but a positive one for commodity importers.

The current state of the Asian landscape

Given the most recent drama in global markets, we believe it’s worth revisiting our approach to fixed income in Asia. There are three things we tend to look out for when considering investing our clients’ assets in Asian bonds:

  • What do the fundamentals look like on the ground in Asia?
  • Do valuations compensate investors for risk given the backdrop?
  • Where are markets likely heading to?

China

First of all let us look at the situation in China.  We would disagree with the pessimists that the Chinese economy is heading for a hard landing.  However, we would also disagree with the optimists who portray the situation in China as the proverbial “storm in a tea cup”.  We like to think that we fall within the pragmatists’ camp in that we agree with naysayers that the property market in China had grown substantially, with speculation rife, and that grand buildings and towns were created where demand did not exist and is unlikely to exist in the short- to medium-term.  We also agree that following the extreme reaction – aggressive quantitative easing – by Chinese authorities, in response to the global financial crisis of 2007-2009, Chinese local governments and state owned institutions used the ample liquidity on offer to leverage their balance sheets and are now saddled with a significant amount of debt.

However, our analysis, which includes political, economic and social factors, suggests that China is likely to pull through this challenging phase on a slower growth footing.  Chinese debt owed by local governments and state institutions to state-owned banks is large.  But the central government has significant firepower – large reserves, high real interest rates, regulation – to mitigate a nasty recession.  Secondly, the Chinese property market is beginning to recover with Tier-1 and Tier-2 cities starting to show improvements in property transactions.  

One must remember that the Chinese economic growth slowdown has been engineered by the political establishment in order to reduce the massive growth in debt, rebalance the economy towards a consumer-driven model of growth, reform the gargantuan state-owned firms and curtail the pernicious hold of corruption.  Clearly, this is negative for economic growth in the short- to medium-term for China and its trading partners as traditional export-oriented industries lose the outright support of the state.  Hence, we see the dramatic fall in commodity prices.  There is a lot more we could write about China to help justify our stance; however, this would take up a lot more than the purview of this note.

We now turn our attention to the other Asian countries that have been dominating headlines – India, Indonesia, Malaysia and Thailand. 

  • In India, we continue to remain optimistic that some reform of the bureaucracy, a focus on economic growth policies and efforts to reduce endemic corruption by the Indian government will eventually bear fruit.  
  • Indonesia, on the other hand, has stalled in its leadership’s desire to enact structural reform as the Presidency lacks adequate political support to embark on reform. 
  • Malaysia, albeit with reasonable fundamentals but still commodity dependent, is struggling with a political crisis that is destabilizing the leadership over alleged kickback schemes to which the Prime Minister is being linked. 
  • Meanwhile, Thailand’s leadership, having gone through a coup last year, is not appearing to focus on the economy and instead looks bent on consolidating power and gaining legitimacy locally and internationally.
  • This leaves us with the developed nations of Singapore, Hong Kong, South Korea and Taiwan.  All four economies are also in slowdown phase as weak global trade and a weakening China suggest that their economies are likely to slow into 2016, having enjoyed strong growth through 2013.

Positive signs

However, the weakening of Asian currencies and the dramatic collapse in commodity prices, particularly oil, is a very positive sign for Asian economies – barring Malaysia to a degree.  This is because Asia is the world’s manufacturing hub and so goods and services produced in the region are likely to cost less to produce – as input costs fall – and they are able to sell these goods cheaper into the export market.  This suggests to us that given the slowdown, Asian economies are being given the “wiggle room” to not suffer too much pain as input cost reductions should be positive for the current accounts of these countries.

Valuations

Secondly, in terms of valuations, attractive opportunities are beginning to pop up. However, we anticipate some more weakening for better entry points in the short term and so remain on the side-lines for the time being.

Volatility

Finally, we anticipate some more volatility but feel that the aggressive moves in financial markets over the past few weeks is likely on its last legs and hence the reason why we foresee better entry points in the short term.
In summary, over the medium-term, Asia’s macro-economic fundamentals remain strong. We expect growth to remain stronger than in Europe, the US and Japan. Debt and deficit ratios are stronger than most countries and most Asian countries run current account surpluses generated by competitive manufacturing exports.

What this means for investors

Investors have multiple ways of accessing opportunities in Asia with the easiest being equities, bonds and currencies.  The state of affairs across most of the Asian region suggests to us that in general it is challenging for us to be bullish on growth and growth-related financial assets – equities and currencies.  Whereas bonds, on the other hand, are likely to benefit as policymakers, whether they are politicians or central bankers, or both, look to re-engineer growth in the region through a combination of economic reforms, interest rate cuts and regulatory actions.  This suggests to us that in Asia, countries are likely to become more credit worthy or witness a cut in interest rates.  These are bond positive actions. 

Given that yields in Asia – in general – are substantially higher than in the western world, investors can lock in attractive yields in their portfolios but also face the very likely prospect of capital gains from falling yields in Asia on the back of policy actions within the context of a yield-starved global investment landscape. 

Within the Asian bond space, government bonds offer the best risk-adjusted return prospects while corporate bonds to us are, in general, unattractive and need to experience a correction. Finally, we also believe that there is likely to be a better entry point for investors later in the year and so patience and discipline to “average-in” over the coming months could result in attractive returns in the fixed income space.

 

*At the time of writing, the People's Bank of China announced a 25 basis point cut to its benchmark one-year lending rate (to 4.6%) and a 25 basis point cut to its benchmark one-year savings rate (to 1.75%), both effective immediately. A reserve ratio requirement cut of 50 basis points was also announced, effective from 6 September.