The Asian credit market is looking less attractive to investors, but value can be gained with some finesse
Jim Veneau says despite instability in the euro zone, the strengthening US economy and an over-supply of Asian bonds have made the Asian fixed income space challenging
Asian credit markets have begun to stabilise after a sharp sell-off, which began in mid-April and intensified during the first half of May. After a flat return in March, the JP Morgan Asian Credit Index (JACI) posted a -0.66 per cent return in April. It then fell a further 0.71 per cent through May 9 before rebounding. Through May 25, JACI’s return was modestly negative at -0.12 per cent.
The sudden and severe sell-off in April and early May has brought a return to relative value opportunities in Asian credit. What remains challenging is positioning for relative value without substantially changing overall portfolio risk levels. At a minimum, the spike in volatility argues for a continuation of cautious risk positioning at an overall portfolio level, but it also implies more opportunities for active portfolio management to generate performance with systematic and well-executed pair trades.
Despite negative shifts in investor sentiment over concerns over recent emerging market vulnerability centred on Turkey and now fresh euro zone concerns over Italy, a review of macro fundamentals shows some weakness but overall support for continued global growth.
The preliminary release of first-quarter gross domestic product data in the major economies showed a mixed picture. European reports indicated a marked slowdown in activity relative to the fourth quarter of 2017. However, the bigger picture is that Europe’s growth rate remains healthy and the European Central Bank (ECB) is working towards communicating on how it exits quantitative easing and negative interest rates. While interest-rate expectations have eased a little, there should be some more concrete guidance from the ECB in June.
The US also saw a modest easing of growth in GDP data in the first quarter of 2018, registering a 2.3 per cent annualised growth rate after a 2.9 per cent outcome in the fourth quarter of 2017. However, the slowdown was less marked than in Europe and other data reports have continued to be strong, including reports on the housing market and consumer confidence.
There has been little data to suggest that the Federal Reserve will hold back from its three additional expected rate increases in 2018. The benchmark US Treasury yield rose by more than 20 basis points during April, reflecting the strength of growth and inflation data as well as concerns about increased Treasury supply.
This is likely to remain a feature of the US market for some time as the effects of looser fiscal policy have an impact on the economy. So far in 2018, the US Treasury market has delivered almost -2 per cent in total returns in dollar terms, which for European investors translates to a hedged return of -2.8 per cent.
The macro environment means that European yields will remain low for some time – at least until the ECB sends some stronger signals about ending quantitative easing and moving away from negative interest rates – and that the cost of hedging any US dollar exposure back to the euro will remain a significant negative cash-flow.
Some significant outperformance of US fixed income relative to European bonds would be necessary to offset the cost of hedging and we are not quite at the point in the cycle where this is likely. A major question for all global fixed income investors is whether the ECB will be able to begin its adjustment process towards more normal interest rates before the Federal Reserve has completed its tightening cycle.
Back in Asia, the US dollar bond sell-off started locally as a result of a drop in demand from private bank clients and onshore wealth management vehicles that could no longer keep up with a heavy bond supply pipeline, particularly from Chinese property developers. The primary bond pipeline also effectively forced secondary market prices to adjust lower as well.
With support for the Asian US dollar bond market already weak due to the factors described above, the situation began to deteriorate more noticeably when global emerging market sentiment began wobbling from a combination of a stronger US dollar, rising US Treasury yields and soaring oil prices fanning the flames of the emerging market bush fire into Asia through Indonesia. Long-duration sovereigns and quasi-sovereigns as well as relatively longer dated high-yield corporates bore the brunt of the negative price movement.
On the local currency front, high-yielding local currency bonds have suddenly lost a bit of appeal as offshore US dollar bonds have substantially cheapened while local foreign exchange volatility has worsened.
Eventually, exchange rates will reach levels that make high-yielding local currency bonds attractive again, but focusing on relative value opportunities in the offshore credit space currently makes more sense.
Jim Veneau is head of fixed income, Asia, at AXA Investment Managers