How well investors did from Asian fixed income last year very much depended whether they needed to account for performance against the rising dollar. In 2017, it is looking like more of the same – at least for the next few months, say fund managers.
Manu George, senior investment director for Asian fixed income at Schroders, told AsianInvestor: "2016 was a real tale of two halves. During the first half there was a real push back into emerging markets, but then Asian markets started giving up those gains during the second half when [US president-elect Donald] Trump began gaining momentum and the dollar rose very rapidly.”
Yet while the greenback’s upswing erased gains, Asia still had a much better 2016 than 2015 both for hard-currency and local-currency bond funds.
The JP Morgan Asia Credit Index returned 5.8% against 2.8% in 2015. Likewise, the Markit iBoxx Asia Local Currency Bond Index gained 1.7% compared to a fall of 2.9%.
Over the past week, AsianInvestor has been examining whether the 30-year bond bull run is over, as an expected resurgence in inflation and rising Treasury rates change the very foundations and dynamics of global financial markets.
In the first of three articles, we considered the likely implications for US Treasury yields. Then we looked at which asset classes fund managers are favouring in this new world.
Today we examine Asia, a debt universe many fund managers believe is better insulated than other parts of the emerging markets. The region's economies have relatively lower inflation expectations, and bonds are partly insulated from rising Treasury yields because of their shorter duration profile.
Indeed, George believes Asia will weather potential volatility much better than Latin America, as it typically has in the past. “It’s the defensive space,” he noted. “And this year, that standing is bolstered by larger foreign exchange reserves and current account surpluses.”
But George is not happy with the general level of Asian corporate bond spreads.
“They’re not where we think they should be based on our view that rates are rising, and this will put pressure on corporate balance sheets by increasing their funding costs,” he remarked. “In general, we think they should be about 50bp to 100bp wider, so we’re not being as aggressive as we’d like to be right now.”
Both George and Ben Luk, global market strategist at JP Morgan Asset Management, agreed that a big uncertainty for Asian debt markets was a possible trade war between the US and China.
In a worst-case scenario, China might not only divest chunks of its holdings in US Treasuries, but also limit capital outflows – and that would remove a large slug of the region’s investor universe.
But it is the dollar’s performance above all that is holding fund managers back from investing in Asian local-currency markets, even though many believe they show value.
However, Schroders’ George said investors should not judge performance solely in dollar terms. “Clients sometimes forget that a portion of their investments are made in another currency and therefore they should judge returns against that currency and not against a dollar-based index.”
Bright spots: Indonesia and India
George added that the greenback’s recent run was on its last legs and would plateau soon, providing a good re-entry point. The US dollar index is up from its May 2016 low of 91.88, trading around the 100.77 level on Wednesday.
There has been a retracement of almost 2.5% so far this year, but fund managers believe this will soon reverse and predict a further 2% to 5% of upside. If and when it does show signs of peaking, George said he would favour Indonesia and Indian debt.
Indonesia was a firm investor favourite last year, recording government bond inflows of $8.1 billion, according to HSBC research. This put it second only to China in the emerging market universe.
George prefers the longer-dated part of the curve and Indonesian government bonds over credit, as “the country's corporate spreads are a bit too expensive at the moment".
He also said the rates market sell-off late last year had set investors up well for 2017. Indonesia’s 10-year government bond yields are back around the 8.3% level, he noted, having dropped as low as 7.1% last year.
India, too, has begun 2017 on a positive note, with government bonds recording net inflows from overseas investors, according to HSBC. This is because investors recognise it as one of the few markets in Asia where the central bank will continue in easing mode, as GDP was weaker than anticipated last year, George concluded.
Meanwhile, Korea – a country very exposed to rising trade protectionism thanks to its export-driven economy – has also begun the year recording net inflows into government bond markets.
JP Morgan Asset Management’s Luk said: “You can still get decent yields of around 3% in Korea. The market also believes the central bank has room to cut rates, since inflation is low and the current account is in surplus [5.9% at the end of 2016].”
However, Luk said he preferred Thailand and the Philippines because both were more insulated from protectionism, with economies more geared to domestic consumption.
Can China deliver?
For most investors, China is key to performance of an Asian bond portfolio given its outsized weight in terms of issuance, both offshore and increasingly onshore. It is now the world’s third largest bond market.
According to HSBC, China recorded the biggest inflows of any emerging market in 2016, with inflows from overseas investors totalling $26.4 billion by the end of the year.
George said recent yield moves were encouraging. “It varies by sector, but onshore yields have generally risen about 50bp to 100bp, so value is appearing again,” he argued.
He said inflows were likely to remain strong in 2017. “China should be included in global bond indices within the next three years, so portfolio managers will want to position for that before rather than after the fact,” he concluded.