2019 midyear outlook—Asian fixed income

In our 2019 full-year outlook, we stated that our investment strategy had shifted from a defensive position to an offensive one. We felt that global bond markets were overly optimistic about the health of the United States and the global economy, which meant that interest rates were more likely to pause than go higher.

Moving into the second half of the year, we remain on the offensive, but have become nimbler when searching for opportunities given the rapidly evolving market conditions. In particular, we believe that Asian bond markets will continue to be shaped by the development of two macro issues identified in our annual outlook:

• Fed policy: After raising interest rates at its December 2018 meeting, the U.S. Federal Reserve (Fed) made a significant policy shift in January, declaring a pause in the interest-rate-hike cycle. As the United States and the global economy showed signs of lost momentum and increased uncertainty over China-U.S. trade friction, bond markets responded, and the 10-year U.S. Treasury yield dropped by over 70 basis points (bps) between the beginning of the year and mid-June.³ Will bond yields fall further, move sideways, or recover?
• China-U.S. trade tensions: Although China-U.S. trade tensions appeared to ease during the first quarter of 2019, they escalated in May after U.S. President Donald Trump threatened to—and ultimately—raised tariffs on Chinese imports. The United States also placed a prominent Chinese electronics manufacturer on a trade blacklist.⁴ We view the re-engagement in trade talks and negotiations between the two parties after the G20 meetings as a positive development. Also, the U.S. agreeing to partially remove restrictions against a leading Chinese telecommunications equipment maker⁵ indicates that slightly cooler heads are starting to prevail. In our view, the two countries will eventually reach an agreement in the second half of 2019 to avoid further economic damage and reduce the risk of a recession, ahead of the upcoming 2020 U.S. presidential election. Nevertheless, long-term tensions could remain beyond any agreement as the complex China-U.S. diplomatic relationship continues to evolve. Importantly, has the market fully priced in the prospect of ongoing China-U.S. tensions even after an agreement has been reached?

The answers to these questions will undoubtedly unfold during the rest of the year. However, we believe Asian bonds are well positioned due to the region’s strong economic fundamentals and policy room for monetary easing, which should provide ample opportunities in the areas of rates, credit, and currency.

The Fed’s monetary policy direction and moderate inflation conditions in Asia provide policy room for the region’s central banks. The Fed’s future interest-rate path is dependent on the evolution of the China-U.S. trade war, and we see room for two rate cuts in 2019. Whether these occur will depend on the progression of China-U.S. trade tensions and the subsequent impact these would have on U.S. economic growth. As noted, the prospect of Fed rate cuts has already been priced into markets, which are reflected in Fed fund futures, causing developed-market bond yields to overshoot on the downside.

In our view, this global backdrop can provide opportunities for Asian bond markets. Asian economies that raised interest rates in 2018⁶ now have enough dry powder to adopt accommodative monetary policies, a favorable environment for local currency bonds. Furthermore, the widened interest-rate differential between Asian and developed bond markets increases the appeal of Asian bonds, especially high-yielding bond markets. As a result, we’re constructive on the following markets:

• Malaysia’s bond market, which has been rated A- by all three major credit rating agencies,⁷ can provide relatively attractive real yields. Malaysian government bonds with longer-term maturity yields currently hover between 3.60% to 3.80%. Meanwhile, inflation levels were negative in early 2019, increasing to marginally positive territory in March—the lowest level in Asia.⁸ We believe that Malaysia also has room for further rate cuts after the central bank lowered the policy rate by 25bps in May.
• Indonesia’s bond market has gradually recovered this year, after a challenging 2018 that was memorable for amplified market volatility and six interest-rate hikes by Bank Indonesia. Indonesian government bond yields are currently trending lower, and the Indonesian rupiah is trading in a more stable band. After President Joko Widodo’s convincing electoral victory in April, and Standard & Poor’s credit rating upgrade in May, we believe that foreign inflows into the country’s bond market should accelerate. With more supportive market dynamics, Indonesia bonds are positioned to perform, given the potential for rate cuts in the second half of 2019.

We’re also looking closely at opportunities in other regional markets:

• The Philippines is on our radar due to an attractive rates outlook. The central bank was one of the most aggressive in Asia last year, raising interest rates by 175bps when it fell behind the curve on inflation. As headline inflationary pressures have since receded, the central bank has already cut rates by 25bps in 2019, with talk of more to come. Having said that, the Philippine peso remains highly volatile, largely due to a structural current account deficit. We’ll need to see greater currency stability and a narrowing current account deficit before turning meaningfully constructive on this market.

Despite notable volatility in global fixed-income markets, Asian credit spreads were generally well behaved in the first half of 2019. Investment-grade credits remained in a more stable range of between 200bps to 230bps, while high-yield credits were between 510bps to 635bps.⁹ Although there were periods of sell-off in the Asian high-yield segment, driven by the heightened global uncertainty, we remain positive on this segment for the second half of the year because of its attractive carry (which could offset further potential credit-spread widening). With careful credit selection, and by avoiding defaults, we believe that investors can earn an attractive yield in this space.

We think that Chinese policy initiatives¹⁰ designed to counter the impact of trade tensions is one of the main reasons behind the stability of Chinese and broader Asian credit spreads. With China accounting for a significant proportion of new issuance in the region,¹¹ the shift by the People’s Bank of China to an accommodative monetary stance has reduced liquidity pressures. At the same time, the Chinese government has implemented key targeted fiscal measures to support the economy.¹² This liquidity flow is the equivalent of quasi-easing measures by the central bank, and that’s why we see investment-grade and fundamentally sound high-yield credit spreads behaving well.

Overall, we like state-owned enterprise (SOE) credits due to government support and continued economic consolidation as the economy faces external and internal challenges. For example, we believe SOEs that are closely linked to government policies or have systematic importance should be primary beneficiaries, as the government rolls out plans to support local enterprises with infrastructure and related government spending; indeed, we’ve seen an uptick in onshore issuance by SOEs with lower funding rates as liquidity conditions have improved. The onshore default rates of SOEs have also remained low, as most defaults this year are from privately owned enterprises. We’re less favorable on the industrials space and those marginal names seeking financing.

We’re still constructive on the Chinese property sector, particularly developers with projects in tier-1 and tier-2¹³ cities. As the government continues to roll out stimulus, firms in the property sector with this footprint should prosper, while those with projects in tier-3 and tier-4 cities could face difficulties. In recent months, we’ve seen policy easing in selective cities in the sector, which has led to a recovery in developers’ contracted sales.¹⁴ Refinancing risks for China developers have been reduced, as many have prefunded their maturing debt through new bond issuances in the first four months of 2019.

The potential negative economic repercussions from trade tariffs on the U.S. economy and the lower U.S. yield environment reduce the scope for broad U.S. dollar strength. This should create opportunities for Asian currencies to strengthen in the second half of 2019. The trade-weighted U.S. dollar has gained by as much as 2%¹⁵ over the year to date, driven by safe-haven flows, but gave back much of these gains in June.

Given their sound fundamentals, Asian currencies have been relatively resilient. The Bloomberg JP Morgan Asia Dollar Index has lost only -0.2% over the year to date.¹⁶ For the second half of 2019, we expect the renminbi to trade in a less volatile band, providing a supportive backdrop for other Asian regional currencies to perform. In particular, we’re constructive on the Indonesian rupiah and Korean won. The Indonesian rupiah, which posted positive performance in the first half of 2019, should benefit from a narrowing current-account deficit and potential capital inflows due to its high-yielding nature. In contrast, the Korean won was the worst-performing currency in Asia during the first half of 2019.¹⁷ However, it should be helped by any positive developments in China-U.S. trade talks and a more stable renminbi.

Shifting Fed policy and the potential easing of China-U.S. trade tensions, coupled with room for further monetary easing, present a positive backdrop for Asian bonds. Despite macro challenges, we believe the combination of strong fundamentals and resilience make them well positioned in the current market environment. As we move into the second half of 2019, we believe investors could consider Asian bonds for compelling opportunities.

1 Between the start of the year and June 21, the JACI Investment-Grade Corporate Index rose by 6.63%; the Markit iBoxx Asia Local Bond Index rose by 4.74%. Bloomberg, as of June 21, 2019. 2 Bloomberg, June 21, 2019. The Indonesian rupiah, Philippine peso, and Indian rupee strengthened against the U.S. dollar year to date after weakening against the currency in 2018. 3 From the start of the year, the 10-year U.S. Treasury yield peaked at 2.8% and temporarily fell below 2.0% during intraday trading. Bloomberg, June 21, 2019. 4 South China Morning Post, May 30, 2019. 5 “Remarks by President Trump in press conference,” the White House Office of the Press Secretary, June 29, 2019. The president mentioned letting U.S. companies resume sales to China’s largest telecommunications equipment maker. China and the United States will be talking about taking the maker off the Commerce Department entity list. 6 Those markets include India, Indonesia, South Korea, and the Philippines. 7 Modody’s Investors Service, Standard & Poor’s, and Fitch Ratings. 8 Bloomberg, June 18, 2019. 9 Bloomberg, June 22, 2019. 10 These policies include injecting liquidity and a lower reserve requirement ratio. People’s Bank of China, as of June 2019. Throughout the first six months, the PBoC has increased liquidity support for small and medium-sized banks, conducted targeted medium-term lending facility (TMLF) and lowered the required reserve ratio. 11 JP Morgan, May 2019. China issuers have raised US$70bn from the market in 2019 year to date, accounting for 62% of total supply. 12 Bloomberg, June 11, 2019. Those policies include: lowering the value-added tax (VAT) tax rate in March and relaxing restrictions on how the proceeds of special bond offerings are used in June. 13 China’s tiered city system is broadly based on two measures: GDP and population size, with tier-1 cities being wealthier and more densely populated (e.g., Shanghai and Beijing) and tier-4 cities being much less wealthy and less populated. 14 “New home prices rise in almost all Chinese cities as lower mortgage rates, lighter restrictions spur demand,” South China Morning Post, May 16, 2019. 15 Bloomberg, June 21, 2019. 16 Bloomberg, June 24, 2019. The Bloomberg JP Morgan Asia Dollar Index reflects performance of a basket of Asian currencies against the U.S. dollar. 17 Bloomberg, June 21, 2019.