Outlook 2017: Asian bonds
Volatility in bond markets should also open up opportunities in 2017, particularly in Asia.
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- Short-term boost to US growth will mean higher wages and inflation
- Tighter monetary policy in the US will make Asian central bankers more hesitant to cut rates
- Winners and losers in Asia will depend on how they fit in global supply chains and their trade relationship with the US
It has been an eventful 2016 where a host of events, including Brexit and the election of Mr Trump as US president, have confounded market expectations. What does this all mean for Asian bonds? The new incoming US administration’s policies should lead to stronger US fiscal spending, along with deregulation in the energy and financial sectors, which will be positive for growth in the world’s largest economy.
The US and its global impact
Stronger US growth will have a worldwide impact which should benefit emerging markets but to a lesser degree than in the past. Countries which have the largest trade surpluses with the US, especially in value added goods, could be under pressure while countries exporting commodities and commoditised products could be less affected.
At current levels of unemployment, wages and inflation will rise. The US economy is operating close to its potential growth rate as indicated by tightening labour conditions (with the unemployment rate at 4.6%). A boost to short-term growth could easily translate into higher wages and higher inflation.
Taken together, this should see the Federal Reserve (Fed) shift to a more hawkish bias. Two Federal Open Market Committee (FOMC) seats are vacant and will be nominated by the incoming president. We expect a further two FOMC members to be replaced and the seats of Chair Janet Yellen and vice-Chair Stanley Fischer will need to be replaced when their terms end in 2018. The Fed’s new nominations will change the central bank, influencing the sequencing of rate hikes versus balance sheet reduction.
Fiscal spending will help the Fed reduce the risk of impotent monetary policy when policy rates are close to zero or the effective lower bound. This will mean an increase in short-term growth and inflation, thereby allowing the Fed to normalise monetary policy. Higher nominal rates will give policy makers greater leeway to cut rates in the event of an adverse shock.
Following the election of Mr Trump, protectionist measures will likely increase, which are a direct source of higher inflation. Even if threats of trade barriers are eventually negotiated down, they will create significant uncertainty for investors.
Emerging markets have benefited tremendously from globalisation so we expect that a reversal of this trend would negatively impact large exporters of manufactured products. Additionally, there is the bigger risk of misunderstandings with China – as has been already illustrated by President-elect Trump’s campaign speeches and tweets since the election.
We expect greater policy uncertainty in fiscal, monetary, regulatory and trade policies since the president-elect is not clearly aligned with the past policies of the Republican Party.
In Europe, a series of important elections will create concerns about the strength of popular support for the European Union as an institution. The Netherlands’ legislative elections and the French presidential elections in 2017 could repeat the unexpected popular votes already seen this year.
Regional outlook and market implications
In Asia, China will be cautious about maintaining relatively strong growth due to its leadership transition. A stronger US dollar could unsettle the relative calm in the Chinese currency markets and Asian currencies could be affected during periods of external outflows. In such an environment where the Fed is tightening, Asian policy makers will be more hesitant about cutting policy rates.
Stronger US growth and higher inflation should lead to gradually higher global yields, with greater policy uncertainty helping to steepen the yield curves. Overall, higher yields will compete with those Asian bond markets which depend more on foreign financing, such as Malaysia and Indonesia. Corporate bond yields will be pushed up by higher government yields and more business spending propelled by stronger business confidence. The US dollar should rise in an initial phase as fiscal policy is loosened and monetary policy is tightened relative to the rest of the world.
Positioning in a new world
As always, selectivity in emerging countries will be critical: winners and losers will depend on how they fit in global supply chains, the extent of their trade surpluses with the US and the degree to which they compete with it as well.
While we expect some periods of a rising US dollar, we will look for relative value opportunities between Asian currencies. We expect the opportunities to exploit market movements around the various policy announcements and upcoming European elections.
We will target entry levels to increase exposure to Asian bond duration1 and Asian currencies which we will adjust based on the scope, magnitude and speed of implementation of new US policies.
Asian corporate bonds have had a very strong year, supported by reduced net supply and a constant investor appetite for yields above deposit rates. At current spreads2, corporate bonds seem expensive. So, from a valuation perspective, we are looking for higher yields before substantially increasing our Asian bond exposure.
1. An approximate measure of a bond’s price sensitivity to changes in interest rates.↩
2. The difference in yield between two bonds of similar maturity but different credit quality.↩