Outlook 2018 - Asia IG bonds: The great unwind

Outlook 2018 - Asia IG bonds: The great unwind

Asian investment grade bonds have a good longer-term outlook but could encounter challenges in 2018. Uncertainty around the unwinding of the US Fed balance sheet, and disappointing Chinese growth, could cause markets to reprice, but that volatility may introduce opportunities for savvy investors.

What is your investment outlook for Asian investment grade bonds in 2018?

In 2018, I believe the key drivers will be the unwinding of the Fed’s balance sheet, and a slowdown in the Chinese economy. I think monetary conditions will continue to generally tighten in the US, so I expect yields to move higher. US Fed tightening--and ECB tightening, which should follow--are likely to lead to wider spreads as markets reprice credit risk, but those moves usually result in overcorrections.

Eventually, I think the Fed will give up the centre stage to China during 2018. I anticipate investment appetite across sectors including manufacturing, property and infrastructure, to slow down, leading to disappointing growth numbers.

I expect US Treasury yields to then fall in response as investors seek some safety, but credit spreads to tighten following what is likely to be a market overshoot when investors reprice risk following US and European tightening.

In the longer term, I am constructive on Asia IG, primarily on the back of technical drivers. I expect the market to grow to $1 trillion by 2020, and expect that to garner increased attention from researchers and consultants, raising the profile of the asset class globally. Continued demand from onshore China, and marginal increased interest from European institutions, should provide support.

Chart 1: US and European yields could rise in 2018 on central bank tightening

Source: Datastream, November 2017

Chart 2: China’s economy could slow down in 2018

Source: Datastream, November 2017

What do you think could most surprise investors next year?

Unlike rising interest rates, the Fed’s balance sheet unwind does not have historical precedent, so it is something I plan to watch carefully. Quantitative easing is just one of the central bank’s monetary policy tools but it has led to bull market in fixed income for the past decade. The reverse of QE, tapering, is something we have not previously seen. It’s likely that the market could at times be surprised by some of the reaction to the Fed’s unwind.

I also expect China to surprise investors. Growth held up well in Q3-2017, and economic data has been supportive so far, but I think we will see a slowdown beyond what most market participants expect. Given the size and importance of China both regionally and globally, any downside surprises to growth will likely cause a notable market reaction.

On the positive side, as the Asian bond market continues to grow and mature, we will see more new issuance and greater sector diversification. As seen in 2017, the record new supply of bonds has provided attractive opportunities, and has been well-absorbed by the market. I see this as a continual source of value.

How do you plan to capture the best opportunities and add value for investors?

Given Asia IG spreads are at post-global financial crisis lows, I remain cautious of the tight valuations in the market. Increasing liquidity may be wise to ensure adequate levels during periods of market volatility, and to have dry powder ready to invest in new issues. As the market widely expects a strong supply in the next few months, and new bonds typically come with a new issue premium, it makes sense to be positioned to capitalise on opportunities on high quality credits.

Given the historically tight spreads in the market, many investors are watching for a correction. The market tends to overreact to stress, and I believe this would provide some good entry points to add high-conviction names.

There could also be opportunities for tactical allocations to names in countries where there is value. For example, I added exposure to high conviction Korean credits when valuations were cheap amid geopolitical volatility. I will continue to rotate into countries with attractive values that can tactically enhance yields and returns.

ERIC WONG is a portfolio manager at Fidelity International. Eric has over 13 years of investment experience. Prior to joining Fidelity he was an emerging market debt portfolio manager at BGI Blackrock.

Eric holds a BA in Economics with minors in Computer Science and Spanish from Stanford University.


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