Asian Quality Bond Monthly review and outlook

Asian credit gave back gains from the previous two months. The JACI Investment Grade Index returned -0.50% in August, to some extent dragged down by worsening sentiments on China. China’s languishing property sector took a turned for the worse on news that Country Garden had missed coupon payments on its dollar bond. Spreads in Investment Grade (IG) Asian credit widen by 10bps. Adding to the fray were the hawkish moves in US Treasury yields, with market voices suggesting that the US would be able to avoid a recession. 10 year US Treasuries moved 13bps higher, ending the month at 4.09%.

Most Asian Investment Grade credits experienced varying degrees of selloff from China’s property woes. The earlier part of the month saw spreads in Chinese Financials widening on risk-off sentiment, before recovering towards the end of the month. Fitch downgraded China Great Wall Asset Management to A- from A with a negative watch, citing the asset management company’s weakened capitalization versus its peers. Earning releases over the month portrayed a mixed picture among investment grade corporates. Oil and Gas companies, CNOOC and Thai Oil, reported declines in profitability over 1H 2023 due to lower oil prices. In Chinese technology, names such as Alibaba, Baidu and Meituan saw better than expected results for 2Q23 from China’s regulatory easing on the tech sector. Considering the mounting macro uncertainty and how much Asian IG spreads have tightened over the year, we deem valuations to be rich and maintain a defensive position in anticipation of negative headlines that might trigger further sell-offs.

Spreads in quasi-sovereign names in Indonesia leaked wider over the month as the general risk-off fallout rippled through Asian markets. Names such as Pertamina, and PLNIJ saw spreads widen up to 13bps on broad market pessimism.

The primary market for Asian Credit was quiet as issuers stayed on the sidelines amid weak market conditions. Year-to-date issuance remain just below 40% of year 2022’s volumes. By issuance size in the USD Asian Credit market, Asian Development Bank (ADB) came to the market with the largest issuance — a USD 4bil bond.  

The Fund reduced credit risk by selling property exposures in higher priced names, cutting positions in higher beta Chinese exposures that are vulnerable to second order impact from further distress in China’s property sector, and taking profit on names that sat on gains. 

On a net-of-fees basis (SGD terms), the First Sentier Asian Quality Bond Fund returned -1.87% in August, underperforming its benchmark by -1.21%.

Positions in Chinese property led to a mixed outcome for the Fund. Exposures in New World, Shimao and Country Garden detracted from performance, though an underweight in Longfor partially added to returns. The Fund’s exposure in high quality quasi-sovereigns also detracted from performance as investment grade credit spreads widened. Exposure in Malaysian Government bonds and the Japanese yen also detracted from performance due to the strength of the US Dollar.

The upbeat tone that underscored most of the first half of 2023 faced some challenges as we entered the second half of 2023. Even as prices remained high across developing economies, headline inflation numbers dampened as compared to the previous year. However, growth in Europe showed signs of faltering, and China’s slowdown loomed like a dark cloud over the horizon even as the US economy printed strong numbers that portrayed strong consumption, wage growth and still low unemployment numbers. We saw more downgrades than upgrades in the overall Asian credit space, although fundamentals have remained mostly intact amongst high quality credits. In supply technicals, the primary market issuance for Asian Credit remains extremely slow, providing additional price support for credits as tightening spreads helped offset the rise in interest rates.

We expect the second half of the year to be more revealing of actual economic conditions as the effects from policy transmission surface with more clarity. It is difficult to fathom rate hikes amounting to more than 500bps not having any effect on the US economy. We attribute a large part of stronger than expected headline growth to a sharp increase in household debt in the form of credit card and home equity loans, rather than a robust job market and strong wage growth. In an already debt-fueled economy, more restrictive credit conditions will also further restrict growth as interest rates stay elevated for the near future.

In the US, we believe we are close to the end of the current rate hike cycle. Cooling signs in core inflation numbers offer the Fed an opportunity to take a pause and assess the impact of the past year of rate hikes before deciding on their next step. However, the historically low unemployment rate also lead us to believe that Fed will unlikely cut policy rates this year. Barring a sharp deterioration in US economic growth, the US Dollar may stay strong in the coming quarter as long as it maintains a favorable interest rate differential against the EUR and JPY. Bank of Japan’s next move should be closely watched as any signs of change to its Yield Curve Control policy will have significant implications for the course the dollar’s strength. Within the region, we have turned cautious on Asian currencies as they are now vulnerable to a US, China or global recession scenario as risks and uncertainties continue to mount.

China’s slowdown has led to ripple effects across Asian economies. The growth outlook in Asia is showing signs of weakness especially for exports oriented countries including Singapore, South Korea and Taiwan. This also suggests that global demand including those from developed economies have been weak and are likely to stay lackluster. Barring a major stimulus from China, headwinds from China’s slowdown would inevitably mean a prolonged period of weak exports numbers from Asian economies. Countries with a stronger domestic story, such as India and Indonesia, are likely to fare better.

The fall of industry stalwarts in China’s property space has been alarming, to say the least. Until Chinese regulators come through with stimulus significant enough to inject optimism to the property market and increase property sales, default risk remains high among private and mixed ownership developers. With continued weakening of technicals and deteriorating fundamentals, we see a low probability of strengthening in the property sector in the short term. While the default of Country Garden hasn’t been our base case scenario, the market bloodshed could turn uglier and imply the intent of Beijing to let natural selection run its course. On the upside, albeit painful, this would also mean an acceleration of the consolidation of China’s property sector in the longer run. 

Inflation in Asia has thus far been fairly under control when compared to developed markets, giving Asian central banks more flexibility to pause rate hikes and potentially cut rates to spur growth should the need arise. There are clear signs that inflation in most Asian countries are likely to continue trending lower, unless food and energy inflation rear its ugly head and cause a spike in headline inflation. We remain constructive on the region’s longer-term growth prospects as Asian economies continue to move up the value chain in the global economy.

We adopt a cautious tone in Asian IG credit and remain selective in Asian High Yield. With signs of slowing earnings and weaker economic activity in the region, fundamentals of Asian Investment Grade (IG) corporates remain sound. However, considering the mounting macro uncertainty, valuations are starting to look rich, despite modest weakening in Asian IG credit metrics within still solid territory. Nevertheless, high all-in yields well above 5% does makes this asset class attractive from an income carry perspective. Our bias is to look for idiosyncratic and relative value opportunities. In Asian High Yield (HY), survivors in the Chinese high yield property sector may provide short-term trading opportunities. Significant upside returns potentially reside among distressed names who survive the debt restructuring process, and these names could benefit from improvement in pre-sales figures. 

Source : Company data, First Sentier Investors, as of 31 August 2023