This has been quite a midsummer’s nightmare for investors, coming off an escalation of US-China trade tensions, a tantrum over the renminbi, and slowing growth in major economies, alongside a frenzy in the bond markets over curve inversions.
Amid the turbulence, there’s one notion universally agreed on by investors - the current market sentiment is fragile and weak, with rising risks of a recession. Sill, we believe this turbulent period serves as a good environment to engage in active investing within Asian debt markets to both target income opportunities and manage risks.
Top-down: What do the latest tariffs mean for Asia?
Despite all the negativity, the good news is we’ve already had quite a few rounds of trade tariffs to serve as a guide of what to expect:
1) Current economic data doesn’t take into account the additional tariffs that will be imposed on certain products from September. We already know, based on history, that tariffs typically have a transmission lag of one to two quarters.
2) We should also expect a continued delay in capital expenditure or other goods purchases, particularly in Asian countries, resulting in further trade deceleration.
3) Regionally, inflation concerns and slowing growth are likely to tilt Asian central banks on the dovish side.
Assuming more tariffs come, economic data is likely to decelerate further but also prompt increased policy responses by Asian central banks to ease and offset growth headwinds. Rate cuts will be positive for local bond duration (i.e. bonds with longer maturities) but also negative for some Asian currencies due to interest rate differentials versus the US.
As such, investors may benefit by keeping exposure towards longer maturity local government bonds coupled with active management in currency risks.
Bottom-up: Which markets still offer opportunities?
Whilst the top-down suggests exposure to longer maturity bonds, the bottom-up selection is where there are good opportunities for investors - especially in a backdrop of increasing amounts of negative yielding debt in developed markets.
Asia, in particular, offers a few sweet spots as parts of these markets have lagged the US Treasuries rally. Meanwhile, all bonds are still positive yielding.
The key idea for us, is to find a middle ground between countries that offer sufficiently attractive bond yields, but also have additional policy headroom for more easing if the economic climate deteriorates further. Some favored investments in this backdrop include:
1) Chinese government bonds:As shown above, although China rates have been grinding lower this year they have certainly lagged the rest of the world. We believe Chinese government bonds (hedged) still offer decent value given the current low yield backdrop and can still act as a trade escalation hedge – which will be particularly relevant in the coming months.
2) Malaysian government bonds: Malaysia offers a decent yield of over 3%, while still providing comparably better policy headroom relative to other Asian markets. Current account is also in surplus and the effective exchange rates are cheap, which helps partially offset some degree of currency weakness.
3) Indonesian government bonds: Indonesia remains a country of interest in Asia as its fiscal metrics have shown gradual improvement, but conversely the current account deficit is likely to come under pressure with a strong US dollar (USD). Although this sounds negative at first glance, we argue that 2019 is comparatively a better backdrop for Indonesia versus 2018 when the markets were under pressure from a mix of rising US interest rates, quantitative tightening and a strengthening USD. As interest rates are likely to continue to ease globally, Indonesia should emerge as one of the better high yielders to invest once USD stability emerges.
Implementation: Are investors best served by simply buying an index?
Although there is a compelling investment case for buying local government bonds, one should not simply purchase exposure to a bond index.
As shown below, the returns so far this year were diverse and offered opportunities for investors. In particular, some investments would have benefited from tactical foreign exchange hedging and long duration bias, while some others such as the Philippines and Thailand did remarkably well regardless of currency hedges.
Amid elevated uncertainty and volatility, we believe a more active management style is critical for investors, particularly in strategies with the ability to capture returns resulting from macro themes as we are more likely to have further episodes of start-stop on risk sentiment, followed by roller-coaster thrills in asset pricing for the time being. It is thus imperative for investors to utilize skilled security selection to navigate the markets.
Jason Pang is a fixed income portfolio manager at J.P. Morgan Asset Management.