As we head into 2018, we expect Asian bond markets to be affected by opposing forces. Global growth and low inflation are potent drivers for emerging market performance. Central banks in the US, Europe and Japan will only cautiously remove their accommodative policies, allowing financial markets to continue performing well.
Among the possible offsetting forces include the negative impact of higher oil prices on parts of Asia which are large energy importers. China remains an unknown; a sharper-than-expected moderation in growth could have negative implications for much of Asia. Markets will take their cue depending on the sequence of these events but we expect the year to be generally positive for Asian fixed income.
Improving global growth will continue
The US economy has also picked up steam, with increased capital expenditure and stronger productivity supporting the recovery. We expect the usual seasonal bumps to appear in Q1 but these could be offset by positive sentiment from US tax reform legislation.
In Europe, the recovery seems to be on track, helped by the ultra-accommodative European Central Bank and solidification of the EU political compact. Given that any form of monetary tightening will likely be very gradual, we expect the recovery to continue.
Meanwhile Japan is now posting its longest economic recovery in decades. Nevertheless, the Bank of Japan has maintained negative rates and keeps 10-year government bonds at zero yields through ongoing purchases.
China has been growing faster than expected and has thereby contributed to advanced and emerging markets’ economies.
Low inflation and accommodative monetary policy
Demographics, technology and globalisation are all keeping inflation unusually tame. Even the Federal Reserve (Fed), which has seen a marked improvement in the US labour market, has expressed greater concern that low inflation might be more persistent than initially thought. We expect global central banks to only gradually remove monetary policy accommodation.
While the above forces will play an important role in supporting Asian bonds and currencies, there are a few headwinds which will periodically adversely impact markets.
Chinese growth will moderate and oil prices will remain close to recent highs
In China, we expect slightly slower growth rates due to monetary policy tightening, supply side reforms and environmental policies. The Chinese leadership has communicated its main policy goals during the 19th Communist Party Congress.
Growth targets were de-emphasised, containing excessive leverage was highlighted and tackling pollution was made a priority. While these policies are positive over the medium run, they could cause a slowing in Chinese demand for Asian exports.
In the commodities space, OPEC and Russia have been managing oil supplies effectively. Political risks in the Middle East will remain a focus and supply concerns in medium-sized producers will help keep a risk premium in the energy markets.
On the demand side, the stronger global growth and ongoing demand from China and India have been supportive.
Risk of rising protectionism
Trade negotiations under President Trump’s administration have been less concerning than initially feared. However, we have kept the risk of protectionism high on our radar. The North Atlantic Free Trade Association negotiations have stalled and the US administration could impose more trade sanctions on China or even threaten to withdraw from the World Trade Organisation framework. Asian countries are heavily involved in global trade and would suffer significantly if growth were to weaken.
For currencies, our broad view is that the US dollar will continue its weakening trend which started in early 2017.
Stronger global growth is often not favourable to the dollar as US investors deploy their capital to international markets. As other advanced economies catch up with the US, their expected investment returns rise on a relative basis.
Bottom-up selection crucial
We continue to favour countries with strong fundamentals and scope for improvement. The table below illustrates the countries whose currencies we prefer based on our expected fundamental changes: stronger global growth and capital expenditure, commodity sensitive currencies and higher yielders which benefit from easy global financial conditions. The last two columns highlight political risk which affects mainly South Korea and long-term valuations which incorporate currency changes vs trading partners and adjusted for inflation differentials.
The Malaysian ringgit benefits from an attractive long-term valuation and from higher commodity prices. But there is some lingering political risk around next year’s election. The Indonesian rupiah shares many of the similar factors but offers an ever higher real yield of about 3% (10-year yield).
The global fundamental factors which we mention above will support investment flows into emerging market local bonds and specifically into bonds of countries with higher real yields such India, Indonesia, China and Malaysia. We expect bond markets of more developed countries to perform only somewhat better the US bond market. Taiwan, Hong Kong and South Korea bonds should be more range-bound.
Credit where it’s due
We expect credit markets to remain in a sweet spot thanks to stronger growth which will keep default rates low. Corporate bond spreads are also expected to be kept low thanks to low interest rate volatility.
Investors’ rapacious appetite for income, which is a direct consequence of very low policy rates and central bank bond purchases, should continue during most of the year. We also expect the positive momentum in equity markets to support credit markets.
Another major theme in the credit market is greater differentiation between issuers. Security selection will be even more important as new issuers access the capital markets.
