Prudential’s Malaysia operation has pulled back on investment risk, especially in equities, as it gauges the potential outcome of a flattening US yield curve and mounting trade tensions on economic growth prospects.

Esther Ong, chief investment officer of Prudential Malaysia, told AsianInvestor earlier this month that it, like other major bond holders, is becoming more cautious in its investment stance.

“The [US] yield curve has flattened a lot and the market sees that as a sign of pricing in growth risk; some investors don’t think the Fed will be able to raise rates without having a significant [negative] impact on [US] growth,” she said.

Added to this are ongoing trade tensions, as the US continues to plan to impose a second round of tariffs on $200 billion of imports from China.

These macroeconomic and geopolitical uncertainties are prompting Prudential Malaysia to favour high-quality fixed income assets in its assets under management (AUM).

"Earlier (mid-year), we reduced a bit of our risk appetite [equities]. We are cautious about taking on more risk exposure, but are not bearish in our positions," Ong said, adding that the insurer has become cautiously positive on equities in recent weeks amid persisting global macro uncertainty.

Prudential Malaysia has about RM30billion ($7.3 billion) in AUM.

YIELD CURVE INVERSION

Ong’s concern about the US yield curve is shared by most international life insurers, which are typically heavy holders of bonds.

The yield curve represents the gap between the two-year and 10-year US government bond yields. Typically, yields on long-dated bonds are higher than those on short-dated ones, reflecting the opportunity cost ­­– and risk – of tying up money for longer periods of time.

The gap between two and 10-year Treasuries is traditionally around 150 basis points (bp) or more, but it has steadily shrunk since the beginning of 2017. It hit an 11-year low of 19bp on August 24, and has since hovered around 22bp, according to Fred Economic data. It is nearing a point of inversion, when the yields of 10-year Treasuries become lower than those of two-years.

Yield curve inversions typically mean investors have less faith in short-term economic conditions than over the long term, and they are often seen as portents of economic difficulty. The US Federal Reserve confirmed in a paper released on August 27 that a correlation exists between inverted yield curves and recessions, but it cautioned that the former does not inevitably cause the latter.

But there is little doubt that history is making investors nervous. And concerns are mounting that the yield curve will invert if the Fed continues on its expected path of rate hikes this year.

While the US economy appears to be in fine fettle today – it expanded by an annual rate 4.1% in the quarter ended June, its fastest pace in four years – the Trump administration’s escalating trade war with other nations and particularly China is increasingly muddying future prospects for growth.

While the US government is closing in on a revamped North American Free Trade Agreement (Nafta) and potentially an agreement with the European Union, tensions are mounting with China.

Esther Ong

Earlier this year it imposed a 25% tariff on $50 billion of Chinese exports, with China retaliating in kind. The US looks set to impose tariffs on a further $200 billion of exports in September. These antics could spur greater trade tensions and imply more downside for financial markets, noted Ong.

“Our view is that the global growth momentum is likely to moderate . However recession risk is not imminent in the near term, unless triggered by trade war retaliations, currency war and geopolitical risks," she added.

ASSET ALLOCATION

All of this holds implications for Malaysia, one of the most open economies in the world according to the World Bank. Its trade-to-GDP ratio has averaged at over 140% since 2010. A full-blown trade war could drag its growth to below 4% in 2019, according to Lee Heng Guie, executive director of the Socio-Economic Research Centre, a Kuala Lumpur-based think-tank.

“Malaysia will be affected via the global supply and value chains though at this current state, the impact is manageable,” he told local media last month.

Prudential Malaysia has responded to the environment by cutting back on equities, which are believed make up a fairly small portion of its AUM. It is also looking to potentially add more into high grade local debt positions.

“We favour investment grade Malaysian bonds, because we believe fixed income allocations will provide more stability during market uncertainty as well as a steady income stream,” Ong said.

She did not say how much of the insurer’s allocation was devoted to bonds,  but acknowledged it invests most of its AUM into fixed-income instruments. And Malaysian bonds have performed well this year. 

“MYR [Malaysian ringgit] debt has been one of the best performers in Asia and broader emerging market returns on MYR debt have been generated mostly by yield, while foreign exchange returns are flat,” a Standard Chartered report on Malaysia issued on August 17 noted.

The yield on the 10-year government bond has dropped from a 2018 high of 4.26% in late May to around 4% on August 28, according to Bloomberg data.

Local bonds continue to benefit from onshore investor demand, the report noted.

Given ample onshore liquidity, there is no urgency for the central bank to loosen market conditions although lower-than-expected April-June GDP print of 4.5% (annualised) has increased the possibility of a rate cut, the report said.