investment viewpoints
2020 Asian credit: finding safer, reasonable yields
In last year’s Asian credit outlook, we were categorically bullish. Emerging market (EM) credit yields were elevated after the 2018 sell-off, US Treasury yields were significantly higher than US trend growth and inflation, the Federal Reserve had just begun moving towards an accommodative stance and China had announced policy loosening. In all honesty, it was not a difficult call except for market participants who were overly worried about short-term volatility.
‘Cheap’ and oversold markets typically do not last long, and true enough, emerging credit delivered double-digit returns in 2019. By year-end, yields dropped to levels that could hardly be considered attractive on an absolute basis. Despite that, since December we witnessed a further “melt-up” in conditions. This melt-up refers to both emerging Investment Grade (IG) spreads and high yield (HY) yields capitulating even tighter.
It is easy to dismiss these melt-up rallies as being caused by year-end technical factors or temporary fund flows. Instead, we believe structural factors are very much at play. Present already for many years, these structural factors include: shifting demographics, high system-wide indebtedness in developed markets (DM), lack of room for fiscal stimulus in most emerging markets, low productivity and a growing savings glut. Various regions are now facing secular stagnation, where anticipated savings outweigh business investment plans, with no policy solution in sight.
The fixed income challenge
As such, we are faced with the single biggest challenge for fixed income investors – where to find safer and reasonable yielding investments? We believe this challenge will become even greater in 2020 due to a demand and supply mismatch for USD assets. Demand for fixed income from retirement savers in the US and North Asia is set to soar. Yet this demand will coincide with an expected decline in the net new supply of USD credit bonds in major global markets. In USD-denominated IG, for instance, high redemptions loom, and less bond funding is anticipated to arise to fund M&A because of the strength of equities.
We are faced with the single biggest challenge for fixed income investors – where to find safer and reasonable yielding investments?
As fixed income investors we cannot escape the trend, but we can estimate the upcoming imbalance of demand and supply, and subsequently calibrate our portfolios with adequate yield, duration and duration-times-spread. Reinvestment risk has risen substantially in our opinion, and hence our bias is to run our credit portfolios with longer spread-duration.
From a cyclical perspective, we believe global EM growth will likely pick up and that the gap between EM and developed market growth will likely widen from 230bps in 2019 towards 250 to 300bps. This should likely drive higher capital flows into Asia and EM, and hence support higher yielding assets and sentiment. In China, supportive factors include: the expected stabilisation of Chinese growth (after the phase 1 trade deal is settled with the US); and China’s continued accommodative fiscal and monetary stance.
Key themes for 2020
Our key themes for 2020 centre around the imbalance in global high-grade markets that will likely provide supportive conditions for credit spreads in Asia. Thus we see richer USD valuations in the US driving marginal reallocation towards EM and Asian IG. There is also the strong prospect of Asian credit technicals strengthening further.
We expect evolving market segments to come to the fore because they provide reasonably attractive credit spreads on a relative basis, in our opinion. Such segments include Chinese property and China’s Greater Bay Area development, in which we see opportunities. Asia’s evolving energy transition should come into focus, especially following 2019 Indian bond issuance in the renewable energy sector. Lastly, we believe Indonesian HY continues to offer value, while the Middle East could offer spread and diversification prospects.
Our key themes for Asian credit in 2020 are:
- Richer US valuations in the US to tilt investors’ marginal allocation towards EM and Asia IG
- Asian credit technicals to strengthen further amid lower net supply and new investor groups
- Chinese property: industry consolidation and business transformation to dominate
- China’s Greater Bay Area to provide increasing investment opportunities
- Rapid growth in the Asian renewable energy sector and a focus on Indian project finance
- Indonesia HY to continue offering value
- The Middle East’s growing high grade universe to grant spread and diversification opportunities
Overall, we expect EM spreads to grind tighter and spread volatility to soften, albeit from already optically tight and low levels, respectively. Investors could need to work twice as hard to identify yield opportunities and grab them before other investors, lest such opportunities seemingly disappear.
Two potential risk factors that we see for portfolio returns are: single credit blow-ups in HY that could easily eat into returns given overall low portfolio yields; and any potential steepening of the US Treasury curve as global growth stabilises in 2020 from its weak patch in 2019.
Putting aside these risk factors, we firmly believe the single biggest challenge for fixed income investors is set to intensify in 2020 – where to find safer and reasonably yielding investments.
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