Asian Fixed Income: Asia’s fundamentals shine in uncertain times

This year has unfolded in a way that no one foresaw. Markets were initially filled with optimism after the United States and China signed a phase one trade deal in mid-January. However, the global spread of COVID-19 and March's oil price shock roiled global markets, leading to significant volatility and dramatic drawdowns. Unprecedented fiscal and monetary stimulus, coupled with seemingly successful containment measures, have stabilized markets, but many investors are still asking: What is the outlook for Asian fixed income markets in this highly uncertain environment?  

Our base case is that the initial “sugar rush” of central bank and government support should lead to a sharp economic rebound in the second half of 2020.  That said, the effect will eventually dissipate in developed markets toward late 2020 and the early stages of 2021. In fact, we expect that even when the global economy returns to “normal,” it will only be at roughly 70%-80% capacity compared with pre-COVID-19 levels.  

With that base case in mind, we see three major trends unfolding globally over the short term with implications for fixed-income investors.    

• Credit conditions in developed markets are expected to deteriorate further. This could come about due to slower growth and elevated levels of debt and unemployment. Governments should possess fewer policy tools to address their sluggish economies, particularly in a prolonged downturn. As a result, Moody’s forecasts a significant rise in the rate of global credit defaults in 2020,¹ while Fitch has already observed a noticeable increase in “fallen angels” in developed markets.² According to credit rating agencies, however, the default rate is expected to be lower in Asia-Pacific, and we believe the fallen angel risk is comparatively more manageable in this region.³
• Localization or regionalization will accelerate. The acceleration is expected over the medium to long term due to COVID-led supply chain disruption. More governments will be directly involved in sensitive and essential industries to ensure a stable supply of goods and reduce reliance on imports. Strategic sectors such as technology, semiconductors, high value-added manufacturing, and healthcare will receive increased government support. In addition, companies that previously relied on foreign funding could seek to return to domestic capital markets in order to minimize the potential issues in offshore funding channels due to rising geopolitical risks.
• The divergence in regional credit markets should continue. We observed that a number of Chinese high-yield industrial companies have recently failed to finance their U.S. dollar bonds, leaving the high-yield market skewed more toward Chinese property issuers. In addition, the uncertain macro environment could favor state-owned companies over privately owned firms, as we can see from 2019/2020, when defaults in China were largely concentrated in private companies.⁴

In this rapidly changing global environment, we believe that the fundamentals of Asian fixed income should come to the forefront. Indeed, the region still boasts a relatively attractive economic growth outlook,⁵ diversified and well-managed economies, sustainable sovereign and corporate debt levels, and higher yields that should make it attractive to global fixed-income investors.

We're positive on interest rate and credit opportunities for the second half of 2020.

Although many central banks in Asia have aggressively cut rates, several markets still have room to introduce further supportive measures. In particular, we remain constructive on Indonesia for a number of reasons. It has managed the COVID-19 outbreak well, and its government has already started to reopen the country, albeit gradually. Also, Indonesia’s macroeconomic fundamentals largely remain intact, and the country’s central bank has exercised prudence cutting rates, supporting the rupiah’s stabilization as the country's inflation rate hit its lowest level in almost two decades.⁶ While the Indonesian government has notably increased spending to boost economic growth in the current downturn, the fiscal deficit still remains at an acceptable level, especially compared with other emerging markets.⁷

Overall, we expect Indonesia to continue to offer attractive real yields and still have further room for interest-rate cuts in 2020. 

We believe that the most significant short-term opportunities lie in credit selection. Overall, Asia will not be immune from the general trend of credit deterioration; rating downgrades and defaults should gradually rise over the next two years,⁸ with a present, but more subdued risk of fallen angels compared with other regions.⁹

However, the region should be better positioned than its global peers—not only because Asian credit quality is high, with a sizable majority (roughly 77%) of the issues in the J.P. Morgan Asian Credit Index (JACI) rated as investment grade—but also because corporates benefit from a broad array of diversified funding channels, ranging from local banks to bond markets.

We believe investors should be constructive on the following credit segments:  

• China has arguably led the world on the path to economic recovery, and the People’s Bank of China should remain supportive amid escalating geopolitical tensions and continuing economic challenges. Investors should be notably positive on the state-owned enterprise and real-estate sectors. These segments are crucial to ensuring a prolonged economic revival and should receive robust government support.  While we are generally skeptical of local government financing vehicles, since many are linked to municipal or provincial authorities that may not receive expected support, there are a select few that are tied to strategic economic projects that should be attractive to investors.
• State-owned enterprises and quasisovereign entities compose roughly 40% of the JACI. We feel that this segment in the Association of Southeast Asian Nations is poised to weather the macro challenges, as many firms are national champions and enjoy access to diversified funding streams. They also have very resilient credit profiles and should benefit from continued monetary easing in the region.

Within Asia, we're more cautious on India.  

• Due to concerns over India’s significantly slower growth and already significant—and still rising—fiscal deficit, we believe it has relatively limited headroom to cushion further downturns. Having said that, the country also boasts several positives, such as comparatively low reliance on external funding (external liabilities account for just 6% of central government debt)¹⁰ and, in all likelihood, a narrowing current account deficit this year due to improving terms of trade on lower oil prices.¹¹
  
  Depending on how successful the Indian government is in meeting the growth and debt targets metrics set by the credit rating agencies, as well as the stance of the rating agencies (whether they take a pro-cyclical or a "looking through the cycle" approach), India's sovereign and quasisovereign ratings could be exposed to fallen angel risk, given India’s latest borderline investment-grade rating (Baa3/BBB).¹² The team will continue to monitor this situation closely.

Overall, we think that the global economy is likely to enter a rough patch over the next two years. Amid subpar growth, security selection will become critical as credit rating downgrades and defaults proliferate. However, we believe that Asia’s economic and corporate fundamentals, as well as attractive yields, should allow the region to shine in these uncertain times.  

1 Moody’s, April 29, 2020. The global default rate is forecast to reach 11.6% by the end of 2020. 2 Fitch webinar, May 12, 2020. “Fallen Angels in the U.S. and Europe,” May 2020. There have already been over 20 fallen angels recorded in March 2020 in the United States and EMEA. This is compared to roughly 50 fallen angels recorded in the Asian credit markets over the past 12 years. 3 Moody’s, April 29, 2020. The default rate in Asia-Pacific is forecast to reach 6.4% by the end of 2020. 4 Goldman Sachs, China Default Watch. 5 International Monetary Fund, June 2020. Forecast economic growth in 2020 for advanced economies is -8.0%, while for emerging and developing Asia it is -0.8%. 6 Jakarta Globe, June 19, 2020. Bank Indonesia expects the country’s GDP growth to range from 0.9% to 1.9% in 2020, but growth is expected to rebound to 5.0% to 6.0% next year. 7 Bloomberg, April 1, 2020. In the wake of the 1997 Asian financial crisis, Indonesia adopted a statutory 3% (as a percentage of GDP) annual fiscal deficit ceiling in 2003. In April 2020, the Indonesian government scrapped the fiscal ceiling until 2023 to boost the country’s fiscal response. Currently, the Indonesian government projects a 5.07% fiscal deficit in 2020.  8 Moody’s, April 29, 2020. Moody’s forecasts an increase in Asia’s high-yield default rate from 1.1% in 2019 to 6.4% in 2020. 9 Bloomberg, June 2020. Only roughly 8.0% of firms in the JACI are rated “BBB-,“ and 65.0% of those firms are government-related entities with greater support than traditional corporates. 10 Fitch, June 18, 2020. 11 Standard and Poor’s, June 10, 2020. 12 On June 1, 2020, Moody’s Investor Service downgraded the government of India’s foreign currency and local currency long-term issuer ratings to “Baa3.” On June 10, 2020, S&P Global Ratings affirmed its “BBB-“ long-term and “A-3” short-term unsolicited foreign and local currency sovereign credit ratings on India.