Asian fixed income markets have continued on their merry way over the past months as extreme monetary policies have kept investors’ risk appetite and search for yield alive and well. Expectations that central banks will continue on this path raises the prospect that current market conditions and flows into emerging markets and its higher yielding opportunities may prevail for some time to come.
Ashley Perrott is Head of Pan Asia Fixed Income within UBS Asset Management and has over 30 years’ experience in fixed income markets. He and his team are responsible for the portfolio management of all Asian fixed income funds and mandates, covering both hard and local currency strategies. This also includes country specific portfolios, such as onshore China fixed income investments.
The decision by UK voters at the end of June to exit the European Union feels like a lifetime ago in market terms. Nervousness was quickly replaced by the view that central banks would have no choice but to leave policy rates very low for even longer, with further stimulus necessary and forthcoming. The ‘hunt for yield’ became the catch-all phrase that drove subsequent behavior. Emerging markets have been a significant beneficiary of the flows and portfolio reallocation that have ensued, having driven strong returns across all emerging market asset classes.
Naturally, investors and market participants have become concerned that the flow story and the hunt for yield have driven markets too far too fast. This has almost been conditioned into everyone since 2008, reinforced by regular periods of market turmoil - the European sovereign crisis of 2011/2012, the taper tantrum of 2013, commodity collapse of 2014/2015 and constant changes to US Fed tightening expectations - and nobody wants to be the one left standing when the music stops. The key then is to determine if and when the music stops.
As it has been since 2008, the DJ’s spinning the music for the market are still the world’s central bankers. Despite numerous shifts in the probabilities being assigned to the Fed’s attempts to normalize its policy, what is clear to everyone, (including the Fed in its dot plot), is that the neutral policy rate has declined substantially for structural reasons. What does that mean? It means even if the Fed manages to implement the second rate rise in this tightening cycle, it will be very difficult for them to keep raising rates because monetary policy is not as accommodative as it would seem. Remember, it took a full year of back and forth regarding the timing for the start of the tightening cycle, for the Fed to hike once in December 2015. We have suffered the same back and forth this year for what might be exactly the same result - one tightening step (maybe) by year end. Moreover, if this possible tightening coincides with what is likely to be a shift down in the dot plots for future years, markets should probably hear one message - don’t fear the Fed.
While there appears to be little to fear from the Fed, the Bank of Japan and the European Central Bank continue to actively pursue quantitative easing and are likely to extend and possibly expand it further yet. This provides a positive backdrop for risk assets in general, and emerging markets in particular. Why? As a significantly tighter US monetary policy has generally been associated with periods of emerging market stress, a low likelihood of such a tight monetary policy paints a bright picture for emerging market assets, particularly fixed income.
Recent flows into emerging markets have only modestly offset the enormous outflows that had occurred over the previous three years since 2013, implying a substantial scope for further inflows. However, there also has to be improvement in the fundamentals to make it a sustainable medium term trend.
On this front, emerging market economies have seen considerable adjustment, policy options have been taken, exchange rates have weakened, and the foundations for a more sustainable domestic growth path broadly put in place. Green shoots of improvement in industrial production and exports are beginning to show, and the growth differential versus developed markets stabilizing and improving. Inflation is the odd exception as it is dormant across Asia and policy makers have little concern in this area, providing room to cut policy rates if necessary. These fundamental improvements should further support a continuation of the positive flows to Asian fixed income.
For USD denominated Asian credit, the global central bank and economic backdrop continues to argue in favor of positive return outcomes. The opportunities coming from both investment grade and high yield Asian bonds will likely see ongoing investor interest, supported by an investor base both in the region and outside the region that continues to look for places to find yield and income. Whilst valuations have become more elevated, they are not extreme and positioning remains well below the pre-taper tantrum levels.
It is not a time to be complacent given various uncertainties and risks in the economic and political sphere, but for now it does appear to us that central banks will continue to generate support for Asian fixed income returns, particularly in the hard currency investment universe.