|Highlights – What's Next for Asian Fixed Income Markets?|
Asian bond markets have done well in the first eight months of the year on the back of stable global growth, benign inflation, and technical support. Positively, better growth prospects in the US and the Eurozone, coupled with sustained growth momentum in Asia, have provided tailwinds to the global recovery. Less certain is the timing and pace of the unwinding of quantitative easing by major developed market central banks, which could pose headwinds for the recovery and risk assets in general.
In the US, consumer and business sentiment have improved, while manufacturing indicators remain generally strong. Labour market conditions are robust, with the economy near full employment. Coupled with a healthy housing market, fundamentals for the US consumer appear positive. Inflation indicators that are closely monitored by the Federal Reserve (Fed) remain below the target inflation rate of 2.0%, suggesting that the Fed may continue to move gradually on rate hikes. That said, the minutes of the July FOMC meeting suggested that the Fed is likely to move ahead with a reduction of its balance sheet, possibly in September this year. Meanwhile, US financial conditions have eased despite the Fed rate hikes over the past three quarters, suggesting further room for policy normalisation. Less positively, political tensions in Washington have cast further doubt on the ability of the Trump administration to deliver on its pro-growth agenda.
Elsewhere, Eurozone recovery has grown more robust and broad-based. GDP growth is running at 2-2.5% pace, supported by healthy domestic demand. While the European Central Bank (ECB) had indicated that it is deliberating on a decision to scale back its Quantitative Easing (QE) programme in response to a stronger economic recovery in the Eurozone, inflationary pressures remain subdued. Furthermore, the timing and pace of the QE taper remains uncertain – the minutes of the ECB meeting in July shed little light on how soon the central bank intends to unwind its massive stimulus programme.
In Asia, the growth momentum remains strong. Asian exporters have largely benefitted from the upturn in global demand, although the export growth momentum moderated in 2Q17 on the back of softer electronics exports, while the base effects of commodity prices wore off. That said, Asian purchasing managers’ indices have remained buoyant, in line with improving developed market business sentiment.
Asian Credit Markets – Supportive Technicals, Valuations Remain Tight
Asian credits, as represented by the JACI Composite Index, have returned 5.36% year to date (as at end August), supported by spread tightening and Treasury gains. US Treasury (UST) returns had accounted for nearly half of total returns, as the UST curve flattened on the long end. Short end yields ended higher with the 2-year note at 1.33% while the 10-year note ended August at 2.12%. By segment, both the JACI Investment Grade (IG) and High Yield (HY) Indices have chalked up strong returns of 5.30% and 5.60%, respectively.
The flip side of the strong performance in Asian credit markets is that valuations remain tight, with spreads hovering near historical lows dating back to 2010. As at end August, the JACI yield-to-maturity was 37bps below the historical average of 4.76%, while on a spread basis, the JACI was close to 39bps below its historical average. Within the sub-segments, IG corporates provide more upside compared to HY corporates, on a spread-to-historical basis. IG corporates are currently trading at around 10bps above historical lows while HY corporates are already trading below the historical lows. Spread decompression has also been more pronounced at the lower end of the credit spectrum, as the spread differential between ‘BB’ and ‘B’ credit buckets remains very tight compared to historical levels.
Credit fundamentals for IG corporates are stronger compared to that for HY corporates, as IG corporates have stable EBITDA and better earnings profiles. Furthermore, IG corporates have been improving and deleveraging balance sheets over 12-18 months, scaling back capex, while softer commodity prices have also helped.
On the supply side, primary issuance continues to be very strong. New bond issuance has added up to US$180 billion YTD as of mid-August. Much of the new issuance has been from China issuers, particularly Chinese HY issuers. Indeed, HY corporate supply has already set a new record this year of total issuance close to US$55 billion supply, which is already ahead of the supply of US$36 billion chalked up in 2013. In comparison, bond issuances from countries such as India and Indonesia, which we have a more favourable outlook on, have been far more subdued this year.
That said, the technical picture for Asian credit markets has remained supportive due to robust inflows. Indeed, Emerging Market (EM) bonds have seen an inflow of US$64 billion for the first half of 2017. Within Asia, strong demand for new issues from domestic Asian investors – particularly Chinese onshore investors – had also provided the technical support for the Asian credit market. That said, going forward, we believe investors may turn more discerning towards specific segments of issuers, given that new issue supply is likely to remain heavy for the rest of the year.
Active Management is Key
The investment backdrop remains challenging in the second half of 2017 despite more favourable growth and inflation dynamics for Asian bond markets. Risk events in the market could surface, given the i) uncertainties surrounding the Trump administration, ii) geopolitical tensions in the Korean peninsula; as well as iii) rising risk premia and interest rate volatility from the tapering of QE by the Fed and the ECB. Hence, we expect volatility to spike periodically, especially during periods of risk-off sentiment in the markets.
In this environment, we believe active management is key to delivering returns across our portfolios. Our portfolios are thus actively managed to mitigate risk and achieve total returns. Managing through periods of volatility will be a key consideration and our portfolios managers are vigilant in managing downside risks, even as they focus on optimising returns while maintaining sufficient liquidity in the portfolios.
For more details on our views on credit preference as well as strategy for local currency bonds, read the full article here.