Last year was one that many investors in Asian bonds might like to forget. The Bloomberg JPMorgan Asia Dollar Index (ADXY) was 4% weaker, the benchmark J.P. Morgan Asia Credit Index (JACI) was down 0.77% overall, and the noninvestment grade portion of that index posted a return of -3.20%. In our view, asset returns may see some recovery in 2019, but given the divergence in some country-level dynamics, we are taking a more cautious approach in our overall Asia portfolio positioning.
In our latest Cyclical Outlook, “Synching Lower,” we described our expectations for a synchronized global slowdown over the coming year, and Asia will not be immune. This year is likely to see further rebalancing in Asian economies to address this slowdown as well as the geopolitical risks that have developed over the past 12 months. We believe that China will continue to experience headwinds to growth, but as investors, we see opportunities, with valuations for certain issuers starting to look attractive. We aim to maintain flexibility to increase exposure in the event of further mispricing or dislocation. In India, short-dated financial bonds and higher-quality quasi-sovereign issuers should remain resilient.
We are still cautious on Asian local currency markets, particularly for those countries with low carry, a slowdown in cyclical growth, unattractive valuations and more exposure to U.S.-China trade conflicts, including South Korea and Taiwan. We are focused on identifying country-specific opportunities and carefully selecting credit positions as valuations and fundamentals suggest that certain credits are becoming “cheap,” particularly if current market sentiment improves.
China: Three major headwinds in 2019
While Chinese growth was quite robust in early 2018, the second half saw a marked slowdown due to the government’s continuing deleveraging campaign and trade tensions with the U.S. We expect growth over the coming year to remain on a downward path, with a central forecast of around 6%. Domestically, consumption is weakening, and we are clearly seeing a more negative trend in retail sales. Industrial production is also beginning to slow – some of its recent strength can be attributed to the front-loading of exports ahead of U.S. tariffs. The property market is starting to adjust lower, and further moderation seems likely based on monetary statistics, such as credit and money supply growth. Contraction in the shadow-banking system is particularly acute at the moment, with rising defaults.
In 2019, we believe that China is facing three major headwinds:
- Trade conflict with the U.S.
- The process of domestic deleveraging
- Slumping consumer confidence and a lack of “animal spirits.”
While the government is putting policy responses in place, we anticipate that these will need to be ramped up over the course of the year.
During the G20 summit and in subsequent negotiations in late 2018, a more conciliatory tone was struck between China and the U.S. While this may reduce the left tail risk for the time being, there is still considerable uncertainty that the 90-day truce will be extended or result in a sustainable deal.
On domestic deleveraging, we have seen Chinese policymakers adjust monetary policy closer to an easing bias. They have lowered money market rates by close to 75 basis points (bps), reopened onshore bond markets for financing and given more support to the private sector by asking banks to allocate more loans toward that segment. Although we do not anticipate a rate cut in the near term, the People’s Bank of China (PBOC) will likely cut reserve requirements, if necessary, to maintain liquidity in the system.
To tackle the slide in consumer confidence, China’s government has taken a more expansionary fiscal stance, in particular tax cuts amounting to over 1% of GDP for households and corporates. However, we expect the impact of these fiscal measures to be muted as tax cuts have a low multiplier effect and some form of government spending via infrastructure may be needed to cushion the slowdown.
As investors, we are mindful of the shrinking current account balance – despite its large trade surplus with the U.S. and the front-loading of exports, in 2018 China registered the first deficit since 1993. Taken together with monetary policy divergence (with the PBOC now on an easing path while the U.S. Federal Reserve may hike further in coming months), we expect this will place pressure on the yuan, although more range-bound behavior is likely over the shorter term pending the outcome of trade negotiations.
For investors with exposure to onshore Chinese bonds we see a tactical opportunity as China’s expected inclusion into the Bloomberg Barclays Global Aggregate Index will increase demand for these assets. This is further bolstered by our expectation that the PBOC will maintain more accommodative monetary policy to cushion domestic growth. We are mindful, however, that the index weight increase will be gradual and phased in over many months, and our current assessment is that valuations are slightly rich based on fundamentals and liquidity.
We believe more significant value has been created in China’s U.S. dollar-denominated credit, with recent spread widening largely driven by the macro headwinds and funding stress from the deleveraging campaign. The supply-demand technical has also been weighing on the market: heavy issuance coupled with fund outflows. Net supply for 2019 should be greatly reduced, improving the technical picture. While overall we have adopted a more defensive posture, interesting opportunities have emerged in select sectors where bellwether issuers are trading at or close to distressed levels. We continue to believe that bottom-up credit analysis is crucial to ensure that we avoid weaker issuers and those with a heavy refinancing schedule ahead.
India: Politics likely to generate volatility
India’s recent state assembly election saw the incumbent Bharatiya Janata Party (BJP) losing some major races. As a result, we expect the market will price in the risk of fiscal slippage since the BJP is anticipated to resort to populist measures ahead of the 2019 general election. Another political issue to consider is the appointment of the new Reserve Bank of India governor following the December 2018 resignation of Urjit Patel. During his tenure, the central bank had a strong focus on inflation targeting, and a new governor may include other government-directed initiatives in its policy consideration. We are encouraged, however, that the recent weakness in food inflation is likely structural, which should allow more flexibility for potential rate cuts.
In the banking sector, the first half of 2018 saw a sharp spike in nonperforming loans (NPLs), but we expect growth in new NPLs to moderate in 2019. However, overall NPL stock remains substantial and will require a relatively long time to digest. Over the course of 2019, we expect Indian credit growth to remain subpar, at around 10% per year versus normalized credit growth of around 15% that might be more suitable for India’s overall growth level. The recent liquidity squeeze at nonbank financial companies (NBFC) has been driven by individual poor liquidity management, as well as banks’ caution on credit risk.
We do not think there is a structural liquidity shortage in the Indian financial sector; banks are the dominant players and are well-funded by deposits. A recent positive development is the introduction of the Insolvency and Bankruptcy Code (IBC). We believe that the IBC has real teeth and should prove successful in deterring willful defaulters and, in turn, should reduce nonperforming asset formation in the system.
For global investors, shorter-dated issuance from leading banks and high quality quasi-sovereign names should be resilient and could provide an investment opportunity if spreads widen due to volatility stemming from the general election and concern over NBFC stress. We are neutral on the Indian rupee and are inclined to add to our duration position given current inflation trends.
Indonesia: Risks and opportunities
We expect Indonesia to maintain growth in 2019 given its more domestically driven economy, which may help it weather any secondary impact from trade conflicts better than its regional neighbors. The country’s banking system is healthy with good margins, low NPLs and scope for credit expansion, while its stable external debt dynamics and fiscal discipline should continue to support its investment grade sovereign rating from leading global credit rating agencies, Standard & Poor’s, Moody’s and Fitch.
However, 2019 is an election year, and there is uncertainty around the election results, which markets may not be fully pricing in yet. The current account is also in persistent deficit despite 175 bps of rate hikes and around 8% depreciation in the Indonesian rupiah (IDR) versus the U.S. dollar in 2018.
With this context, we favor Indonesia’s U.S. dollar-denominated sovereign bonds, along with its quasi-sovereign issuers. We are more cautious on local currency government bonds given the increasing uncertainties around the election. Even in an incumbent re-election scenario, we see potential for Bank Indonesia to increase rates further in response to the government normalizing energy prices and a subsequent consumer price index (CPI) rebound toward the upper end of the central bank’s 2.5%–4.5% target band.
Currently, we are neutral on the IDR even though it appears attractive based on real rates, carry-to-volatility ratios and other fundamental indicators. The currency is quite sensitive to foreign flows from emerging local currency bond investors, and a turnaround in sentiment could provide a catalyst for stronger IDR performance.
The Philippines: External debt unattractive
Growth momentum in the Philippines is firm, and we expect foreign direct investment into the country to continue over the cyclical horizon given low labor costs and domestic market potential. These investments are being largely channeled into the manufacturing sector. Along with the growth in the country’s infrastructure development, this is causing deterioration in the current account as a result of heavy capital goods imports. Real rates in the Philippines are in negative territory, while inflation continues to surprise on the upside, suggesting the central bank is behind the curve. We are therefore more inclined towards underweighting the local currency.
External debt valuations are typically expensive relative to the country’s fundamentals, but the tight valuations have been anchored by strong demand from Filipino banks’ treasury books. In the past, demand was driven by excess U.S. dollar liquidity due to strong inbound payments. Given muted dollar loan growth, this resulted in banks buying the country’s external debt due to home bias and its low regulatory capital risk weights. With recent changes in the current account dynamic, Filipino banks are no longer flush with dollar liquidity, and the technical support for the Philippines’ external debt will be reduced going forward. As a result, we favor an underweight position in the country’s external debt as we anticipate valuations will be adjusted from current tight levels.
Cautious positioning in Asia for 2019
Within the context of a synchronized global slowdown, we are positioned more cautiously overall in Asia. We have seen respite in some key areas of concern, with the U.S.-China negotiations seeming to defuse an imminent trade war, Chinese stimulus starting to offset the deleveraging impact from early 2018, and expectations for fewer U.S. rate rises, which would limit the rate differential between the U.S. and the rest of the world. However, we do not believe these are sufficient conditions for increasing “risk-on” positions yet. Instead, for 2019 we are focused on identifying country-specific opportunities and carefully selecting credit positions where we see value and remote default risk.