A monthly review and outlook of the Asian Quality Bond market.
Market Review - as at May 2019
After 4 months of spectacular rally, Asian credit market finally caved in to the US-China trade war which took a turn for the worse. Not only did Trump increased the tariffs on Chinese exports, he also issued an executive order that restricts US companies from doing business with Huawei, which led to Google limiting the access Huawei phones had to its services. This brought about a bout of spread widening in the credit market with moves more pronounced in Huawei and technology related names. As a result, JACI spread widened by 19 bps to end the month at 270bp. Nevertheless, total return for the JACI was a positive 1.04% thanks to the strong rally in US treasuries as market is now pricing in 2 rate cuts, each of 25 bps, before the end of the year. The positive return in May brought year to date return to a very strong 6.35%. For the month, Investment grade bonds outperformed high yield on both spread and total return basis. By country, spread returns were mostly negative with Indonesia, Pakistan and Sri Lanka the worst performers.
Just as we thought Jokowi’s victory in the recent election will bring about more stability and continued economic progress, a riot broke out in Jakarta which led to six deaths, over 700 injured and 200 arrested. Protests began after the General Election Commission announced the official votes count and thereby declaring Jokowi the winner of the election. It soon turned violent as rioters supporting the defeated presidential candidate Prabowo started burning cars and buildings and attacked policemen using rocks, petrol bombs and fireworks. While protest are common in Jakarta, a riot of this magnitude was probably last seen more than twenty years ago when Suharrto was ousted. Subsequent to the riot, Prabowo’s campaign lodged protests against the election results with the Constitutional Court. They argued that the convincing 10% plus margin of victory of his rival, President Jokowi, was fraudulently obtained. The riot along with the negative sentiments in the market dragged Indonesian sovereign and quasi spreads wider by more than 30bps.
Over in India, the Bharatiya Janata Party (BJP) led coalition emerged victorious in the general election. BJP won 350 seats which was more than the 336 won in the 2014 election, allowing Prime Minister Narendra Modi to retain power for a second term. The immediate focus for Modi now would be the composition of the new cabinet which is likely to be announced in early June and the budget, likely by mid-July. Key issues Modi needs to address would be how the government can revive the sluggish growth and what further structural reforms he will implement following the hit and misses during his first term.
The most noteworthy credit event during the month has to be the seizure of Inner-Mongolia-based Baoshang Bank by the People’s Bank of China and China Banking and Insurance Regulatory Commission. The authorities said they will only guarantee Baoshang depositors and creditors with less than 50 million yuan at the bank, and negotiate with everyone else which suggests haircuts for some creditors. This led to speculation whether it marks an end to the implicit backstop for banks that has served as a linchpin of the country’s financial stability for decades.
Supply was slower during the month with a total of USD 18.9b issued, approximately 40% lower than April. Nevertheless, year to date issuance at USD 122b is still a 26% increase over the same period last year.
The First State Asian Quality Bond Fund returned 1.4% for the month of May on a net of fees basis.
The positive return was largely attributed to the spectacular rally in US treasuries which more than offset the credit spread tightening.
On a relative basis, the fund has outperformed the index as our overweight in credit along with security selection both added value from January to April. Our overweight in US interest rate duration which we held since the start of the year also contributed positively to our excess return.
Asset Allocation (%) 1
Top 10 Issuers (%) 1
1 Source: Lipper & First State Investments, Nav-Nav (USD total return) as at 31 May 2019. Allocation percentage is rounded to the nearest one decimal place and the total allocation percentage may not add up to 100%. Fund inception date: 14 July 2003. Performance is based on First State Asian Quality Bond Fund Class I (USD - Acc) is the non-dividend distributing class of the Fund. *The benchmark displayed is the JP Morgan Asia Credit Investment Grade Index.
During the month, we changed our credit positioning from overweight to short as we turned cautious amid the intensifying US China trade war. We also reduced our long duration in US interest rate duration following the sharp rally even though we believe interest rates will continue to head lower as US growth slows.
By country, we remained underweight in Philippines sovereign on tight valuations. We do not like India banks and corporates as valuation does not reflect the fast weakening fundamentals. We are also underweight in Indonesia as we believe all the good news have been priced in following the spectacular year to date performance in Indonesian spreads. Within China, we are overweight Investment grade property, Banks’ leasing companies and Asset Management companies while underweighting core SOEs, banks and LGFVs (Local government financing vehicles).
While growth concerns especially in the developed markets are likely to persist, the technical backdrop for risky assets including Asian credit has improved significantly in the near term following dovish rhetoric from both the Fed and the ECB. The Fed has all but ended their rate hike cycle, while the sharp downward revision by the ECB on both the growth and inflation outlook means that rate hike now looks like a distant possibility. What this means is the chase for yield is likely to continue though we would exercise caution given how sharply the market has rallied. We would also question the effectiveness of developed markets’ ultra- easy monetary policies following a decade long of reckless money printing and what else could these central bankers do should we get another severe crisis.
Much focus by the market recently has been on the inverted yield curve in the US and the possibility of a recession. Recession or not, what is clear to us is that growth in the US has peaked around Q3 2018. In the absence of new fiscal stimulus; which will be especially hard to get approved just one year prior to the next election, it will be difficult for the US growth to surprise on the upside in the year ahead. While economic data could see a rebound following the end of the US government shutdown coupled with the possibility of a positive development around trade discussion between China and the US, effects from the previous rate hikes and monetary tightening cannot be discounted as that has been a drag on growth. Voicing concerns around the growth outlook, the Fed has effectively ended the hiking cycle and put an explicit end date to quantitative tapering. While market cheered this move and is likely to welcome another round of quantitative easing by the Fed, we are skeptical on the effectiveness of these measures ten years on. We are also of the view that the Fed took too long to start normalising interest rates and that balance sheet has also grown too large to the point that they now have limited ammunition in their war chest should we get another crisis. Against this backdrop of no more rate hike, slowing growth and a potential flight to quality should the next crisis hit, we turned more bullish on US treasuries. We maintain that the treasury curve will fully flatten to an even lower level of around 2.25-2.5%.
The situation in Europe is even more dismal. The above trend growth for a large part of 2018 proved to be short-lived with the ECB now slashing both growth and inflation for this year aggressively to around 1%. At the same time, rate hikes is now pushed back to beyond 2019 even though we were skeptical right from the start whether they can even deliver any hike at all. The toolkit that the ECB has to tackle the next crisis now look even lighter than that of the Fed. Four key leadership jobs including the President of the European Parliament, European Council, European Commission and ECB are set to change hands in 2019. These could hopefully bring about some positive changes but at this juncture we are not holding our breath.
Despite being at the receiving end of Donald Trump’s provocation, China’s nimbleness in diversifying its export markets away from the US has allowed them to cope better than the US in this trade war. More importantly, commitment from the government to maintain stability is strong ahead of the 70th anniversary of the founding of the People’s Republic of China on the 1 October, which means we are likely to hear more positive development coming out of China in the near term. This has been evident so far this year as the government aggressively cut tax while the People’s bank of China launched a bill swap program to help improve liquidity of perpetual bonds issued by banks. As a result, confidence has improved and credit growth has picked up.
The slowdown we were anticipating for the rest of Asia since the start of the year did materialised. The region’s exports tumbled amid a maturing global trade cycle, ongoing trade war between US and China and lower commodity prices. While exports could stabilise should we get a positive outcome around the discussion between the US and China, we need to see a meaningful turnaround in semiconductor sales before we can declare a bottom in the current export downturn. The tightening cycle amongst Asian central banks is now officially behind us as data continues to disappoint in the past few months. In fact market is now expecting rate cuts in countries including India, Indonesia and Malaysia. Inflation is almost non-existent in Asia thereby providing central banks the ability to cut rates aggressively if they need to. While India, Indonesia and Philippines are still running current account deficits, the levels look manageable and are far from those crisis levels during the 2013 taper tantrums. Upcoming election in Indonesia and India may bring about some volatility should we get an upset, though our base case remains that they will be non-event and post-election, we could see some fiscal measures being roll out should the weak growth persists. Thus while challenges remain, Asia looks to be in a relatively good shape to deal with further slowdown especially when compared to the developed nations.
Asian credit has rebounded strongly during the 1st quarter with JACI IG spreads rallying almost 30bps from the peak of the sell-off. Coupled with the even stronger move in US treasury yields the Asian credit as an asset class has delivered exceptional returns for investors. Valuation is now looking less attractive with JACI IG spreads at around 190bps. However, technical backdrop still look very strong and with spreads at 40bps off recent tights, we would not rule out further tightening should credit fundamentals remain stable. The next round of earnings in the coming months should provide further clues as to whether that trend will continue. Our bullish outlook on US treasuries means they should further enhance returns for investors or at least provide a buffer for spread widening should the market retrace. In this quarter, our key focus would be to continue to explore opportunities via the new issue market and further increasing portfolio diversification through high quality names in Hong Kong and Singapore and South Korea. Credit selection and relative value analysis will likely continue be key drivers of excess returns.
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