Asian bond yields won’t be hit by as big a shock as the market anticipates because expectations of aggressive monetary tightening to combat inflation are overplayed, says Aberdeen Asset Management.
In an interview with AsianInvestor, Adam McCabe, senior portfolio manager for Asian fixed income at the firm, sets out to defend the value proposition of Asian bonds in the context of the present macroeconomic backdrop.
He argues that policymakers have shifted away from simply raising short-end interest rates to counter inflationary pressures and are now using a broader suite of tools to achieve balance.
Traditionally, he notes, they referenced historical economic performance – largely driven by the external sector and leverage in the US – to gauge potential GDP growth.
But the change in the US fiscal position, combined with a willingness to use a broader suite of tools to combat inflation, “means that likely growth outcomes that were represented in the past are overstating what is likely to happen in future in terms of potential”, says McCabe.
Using South Korea as an example, he notes how its economy is driven by exports, which in essence have received a subsidy from policymakers in the form of currency intervention.
But he suggests policymakers are no longer willing to provide the support they once did in terms of currency undervaluation as they seek greater balance in the economy. Rather, they are focused on providing the necessary safety nets to foster domestic demand growth.
McCabe points to a shift in policy rhetoric in Thailand and Malaysia in 2010, reflecting an acceptance that currency performance needs to be more in line with economic fundamentals.
“It’s right to identify that conditions will tighten, but this does not necessarily come purely from the interest-rate instrument in the monetary policy toolkit,” he states. “It comes more from the allowance of gradual appreciation of currencies, and from greater use of administrative controls.
“If you believe, as I do, that there will be no aggressive tightening with respect to monetary policy and that these other policy levers will be used, then you are not going to get as much of a shock felt in terms of bond yields as the market may be expecting.”
McCabe, who joined Aberdeen as part of its acquisition of Credit Suisse’s asset management business in 2009, predicts that currencies will provide a key source of returns in 2011.
The firm is overweight Asian currencies against a basket of yen, euro and US dollar, not only on likely appreciation grounds but also because strengthening currencies help to offset imported inflationary pressures that higher food and energy prices may bring.
He foresees continued support for the peso, and expects the government to use the strength of its currency to pay down external debt, leading to a shift into local currency debt. “I think there is a very sound structural story and it will lead to improvement in rating agencies’ outlooks,” he says.
In Indonesia, McCabe believes that global investors have blindly been seeking yield, noting that foreign ownership of the country’s bond market stands at an all-time high of around 30%.
“If you have a market that is so dominated by foreign investors and you have a period where policymakers are challenged by questions of inflation, in that environment we believe it would be quite risky to own long-dated bonds,” he says.
But at the same time, he acknowledges that the yield in Indonesia is attractive from an absolute return perspective.
So rather than taking on the risk of a potential flight of capital and the sell-off at the long-end of the curve that could be associated with that, Aberdeen has been positioning its portfolios in the very short-end of the bond market.
“We think the market still has some reasonable fundamentals, but obviously we want to protect ourselves from the risks of capital flight in the event of there being disappointment with respect to ongoing monetary policy credibility,” he says.
McCabe also flags inflation-protection strategies as a key ingredient of Aberdeen's portfolio, noting that the firm has been a long-term participant in the Korean inflation-linked bond market.
“We believe the market in Korea consistently underprices the risk of inflation,” he says. “With a set of policies that are consistent with there being more inflation around than not, we believe that over the medium-to-longer term it makes sense to think about inflation protection from a relative-value perspective, rather than gain exposure solely to Korean nominal bonds.”
Aberdeen expects the break-even inflation rate in Korea to grind towards 3% and possibly higher. McCabe notes that the inflation-linked bond market is pricing a likely inflation outcome that is still below the central part of the Bank of Korea’s 2-4% target range.
“Whether it is from a forward-looking perspective on the outlook for inflation and inflationary pressures, but also from a present valuation standpoint, it warrants contemplating investment in inflation-protected securities,” he adds.
Aberdeen Asset Management has had an Asian fixed income team for over a decade. It started by managing a couple of closed-end, US-domiciled funds amounting to $3 billion, and is now responsible for about $6 billion under management out of its Asian headquarters in Singapore. It has about $3 billion invested in dedicated Asian fixed income markets.
McCabe is responsible for a five-strong Asian local currency bond team, focused on macro risk and managing local interest-rate exposures and currency risk. Aberdeen also has a credit management team of four, which undertakes bottom-up analysis of the balance sheets of corporate issuers and is sectoral-focused rather than country-focused.