A monthly review and outlook of the Asian Quality Bond market.

Market Review - as at May 2020

Sentiment towards Asian credit continued to improve in May, supported by news that most major economies are starting to reopen after coronavirus-related shutdowns. This news was well received by credit investors, as it suggested company profitability could start to improve. At the same time, there was further optimism around the development of a vaccine for COVID-19, which also supported risk appetite.

The JACI returned 2.07% over the month, benefiting from a narrowing in credit spreads across Asia. Pleasingly, gains in May mean returns from the JACI have returned to positive territory in the calendar year-to-date – a reasonable outcome given the extent of the sell-off earlier in the year.

Treasury yields hardly moved at all during May and did not therefore influence performance one way or the other. Our short duration position in the US Treasury market was maintained. Again, this strategy did not affect performance in May, but remains in place in anticipation of slightly higher Treasury yields in the months ahead.

China’s plan to impose new national security laws in Hong Kong was among the most significant news in Asia over the month. Some commentators suggested this was a further indication that China is seeking to increase its control over Hong Kong, which was supposed to maintain autonomy from Chinese rule until 2047 at the earliest. This development threatened to reignite tensions between the US and China, only a few months after the two superpowers agreed a truce on their trade dispute. Indeed, US officials suggested trade agreements with Hong Kong could be reviewed following the news. Concern around this issue dampened sentiment in the final few days of what was otherwise a strong month for Asian credits. 

Companies took advantage of strong demand by issuing large quantities of new bonds. Several high profile issues came to the market, including a jumbo multi-tranche deal from Chinese conglomerate Tencent. On the whole, these new tenders were well supported by investors. This underlined the appetite for yielding investments against a background of very low government bond yields and cash rates. That said, activity in the secondary market remained slightly lower than before the COVID-19 crisis. Bids from market dealers remained sporadic in some names, underlining the importance of careful issuer selection and ongoing monitoring of portfolio holdings.

Q2 2020 Investment Outlook

We started the year with a fairly sanguine outlook and sentiment, but this did not last for long as the widespread coronavirus outbreak caused havoc in economies and financial markets. Initially the disease was expected to be contained within China, but it has evolved into a global pandemic. Despite the inevitable economic downturn due to closures and disruptions, the coordinated response by central banks and governments around the world is encouraging. Travel restrictions and shutdowns implemented worldwide are providing some comfort that governments are aware of the severity of the pandemic and the scale of the task they have in controlling it.

Investors have effectively written off any chance of meaningful economic growth in the 2nd quarter of this year and conditions could remain subdued in the 3rd quarter. Singapore’s GDP contracted at an annual pace of -2.2% in Q1, prompting the government to revise down its full year forecast to between -1% and -4%, from the previous -0.5% to 1.5% range. This contraction is likely to be typical among other economies in the coming months. The US Federal Reserve has acted swiftly and aggressively to cut policy rates to close to zero, although this move is only likely to boost confidence rather than improve conditions in the real economy. We expect more interest rate cuts and quantitative easing from central banks around the world in the months ahead.

In terms of the global credit market, for a couple of years now we have been concerned about limited liquidity in secondary trading. Conditions worsened during March, when the credit market was effectively frozen as it was during the 2008-9 Global Financial Crisis. This was partly due to intense regulations on banks’ ability to take on risk post the Global Financial Crisis, which has led to poor secondary market liquidity. Banks no longer have the balance sheet capacity to take on risk. Consequently when investors look to sell bonds as they did in March, pricing becomes perilous as there are no bids from banks.

The Federal Reserve is unlikely to concede that it may have contributed to the latest sell-off by over-regulating banks, but it was quick to announce primary and secondary market facilities in March. This allows them to buy up to US$200 billion of shorter-dated investment grade corporate bonds, providing some much-needed support to the global credit market. The scope may seem small relative to the US$8 trillion market capitalization of the US investment grade credit market, but the program could nonetheless pave the way for larger-scale purchases in future. We see this as an important development in helping to support credit markets, particularly given the prospect of widespread downgrades to credit ratings. In some cases, these downgrades are likely to result in more forced selling among ‘fallen angels’ from the investment grade universe.

Governments around the world have started rolling out fiscal stimulus packages, which we believe will be more effective than monetary policy in propping up economies and supporting sectors in distress. The US$2.2 trillion fiscal stimulus package in the US dwarfs the US$800 billion package that was rolled out during the Global Financial Crisis. Following news that the June 2020 Olympic Games will be postponed until next year, Japan has also vowed to roll out massive stimulus. Other Asian central banks are pursuing similar policies – the two stimulus packages recently announced in Singapore, for example, amount to a combined 11% of GDP and Malaysia has announced a MYR250 billion (US$57 billion) package. The big question is whether these unprecedented stimuli will be sufficient to offset the coming downturn, particularly if the pandemic persists for longer than anticipated. We remain particularly concerned about developing economies with large populations and rudimentary medical facilities. As well as the potential human cost, the prospect of a prolonged growth slowdown could also worsen poverty issues in these countries.

It will be interesting to see how credit markets react with central banks slashing policy rates towards zero and governments rolling out aggressive stimulus packages. Markets rebounded quite sharply following the Global Financial Crisis following coordinated central bank and government actions that helped restore confidence and trust in the financial system. This may not necessarily be the case this time around, particularly as it remains unclear how long it will take to bring the spread of coronavirus under control. For markets to stabilize, we will likely need to see a slowdown in the rate of new reported cases and a full containment of the virus globally for markets to fully turn the corner. During 2003, China, Hong Kong and Singapore were affected by SARS for around five months. In comparison with coronavirus, SARS spread more slowly but had a higher mortality rate. Adding another three months to the coronavirus pandemic for its possible containment would bring us to the end of October, assuming a March start date when the virus spread globally. Against this background, it is plausible that markets could gyrate primarily based on sentiment rather than fundamentals for the next few months. More positively, we could see a strong ‘V-shaped’ recovery in both markets and economies if the virus is contained more quickly.

In our previous outlook three months ago, we advocated waiting for a pullback in credit spreads before adding risk. JACI Investment Grade spreads have since widened by more than 100 bps, with many A-rated names trading at more than double their 5-year average spread. While the call proved prescient, there was a feeling of “be careful what you wish for” during March’s market dislocation. Nevertheless, our investment philosophy and process are expected to add value over the full credit cycle. Holding names with strong credit fundamentals should help us ride out this period of volatility and generate favorable performance when the coronavirus pandemic is defeated and as markets eventually recover.

Source: Company data, First State Investments, as of 9 June 2020.

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