While the investment environment in 2010 can be contrasted with 2009 in many ways, the themes of ultra-loose monetary policy and liquidity injections have remained very much the order of the day. Indeed, as the developed economies have struggled to keep growth alive by deliberately fuelling asset prices, the Asian countries have remained a destination of choice for the investment flows created by these policies. While this investment undoubtedly reflects the relative strength of the Asian region in terms of its banking systems, government balance sheets and economic growth potential, we believe the key question as we enter 2011 is how much more can be absorbed in the short term.
The issue of “hot money”
Our main concern for Asian bond markets in the short term is the issue of QE-related (quantitative easing) “hot money” – specifically, that the latest flood of inflows seems to be driven more by liquidity and momentum as opposed to a recognition of the underlying attributes of the market. Positioning risks have consequently increased over the past few months as investors have crowded into both corporate and government bonds and, in our view, the risk/reward balance in several markets, particularly those with historically low yields and risks of illiquidity, looks increasingly unattractive.
Slower growth all round?
A second concern relates to the outlook for global growth. 2010 saw a developed world recovery on the back of industrial restocking and fiscal stimulus, but, as the impact of these measures has begun to fade, underlying structural cracks are being exposed.
Furthermore, 2011 is necessarily going to be a year of austerity for many developed countries. This will leave global central banks with little choice but to leave interest rates near zero for as long as possible. The US is clearly looking to support growth with a second round of quantitative easing; however, with QE1 unable to tackle the fundamental cracks in the US economy (including stimulating sustained private sector demand growth), we are not confident that QE2 will be able to repair them either.
Asia, in contrast, has continued to power along despite the issues facing the West, but we are concerned that slower growth in the Western world will spill out on a more global basis during the coming year. Countries like China and India are still performing well; inflation is moderating in most Asian economies; and domestic demand continues to be robust.
Nevertheless, industrial production in the more export-dependent Asian economies has now started to slow, and domestic consumption in the region has clearly had a boost from record low interest rates and asset price inflation. As a result, property prices have heated up in markets like Singapore, China and Taiwan. Policies to tackle the risks of such overheating and pre-empt any future economic damage are, therefore, likely to remain in place into 2011.
Where to invest?
With positioning risks growing, a potentially weaker economic environment globally, and historically low yields in several of the less liquid Asian bond markets, we remain cautious on the Asian region as we enter the new year.
Our view is that the best non-cash opportunities currently reside amid the relative safety of high grade government bond markets like Hong Kong, Singapore, South Korea and Malaysia. As well as being likely beneficiaries during any periods of risk aversion, these markets have the attractions of good liquidity and historically steep yield curves (a large discrepancy between short- and long-term yields).
With US interest rates expected to remain near zero throughout 2011, and Asian central banks generally remaining in favour of lower rates, we believe a healthy total return can be achieved within these markets as the discrepancy in yields corrects. In turn, the generally good level of liquidity in these markets means we can act more tactically, capitalising on good profit-taking opportunities during periods of volatility.
Currencies — don’t be short-changed
As far as currencies are concerned, we are continuing to avoid any risk within our Asian bond portfolios as we enter 2011. The story in 2010 has been one of strong appreciation within Asian currencies as the weight of liquidity and ultra-low interest rates have encouraged significant levels of investor exposure. At the same time, speculative short US dollar positions have moved close to all-time highs, and talk is now turning to the subject of currency wars and the likelihood of further unilateral regulatory measures in Asia to try and discourage further flows.
Much as for the other asset classes, our key concern regarding currencies going into 2011 is the overall level of positioning risk — particularly given the strong correlation between Asian currencies and Asian equity markets. Indeed, we believe the main threat in the short term is that a disappointment in global growth prompts a shake-out among risk assets, which, in turn, sees Asian currencies depreciating and the current plethora of short US dollar positions unwind.
When it comes to the longer-term story, however, we believe the same fundamental arguments hold for Asian currencies as they do for Asian bonds — the relative strength of the region’s banking systems and sovereign balance sheets, the stronger economic growth potential, plus greater yuan flexibility in the future should all help attract further inflows. Therefore, while our concerns about a risk asset shake-out keep us cautious, in the meantime, we will be exploring possible long-term opportunities during periods of market stress and positioning shifts.
Credit where credit is due
Turning finally to Asian corporate bonds and, following significant inflows and a hunt for yield against an ultra low interest rate backdrop, this area of the market no longer appears cheap. That said, Asian credits do still offer a reasonable yield pick-up versus similarly rated US credits and we expect this enhanced yield to attract further capital in 2011 (particularly within high yield). This demand should be underpinned by the fact that Asian credit fundamentals remain relatively strong, with sound banking systems and lower corporate leverage — compared with the worrisome sovereign credit profiles of the US and many European countries.
It is important to note, however, that the Asian credit market is relatively small and liquidity tends to drop off significantly during volatile periods. Geopolitical risks, inflation concerns and asset price bubbles in Asia, together with event risks outside of Asia, mean that Asian credit markets are likely to experience further periodic volatility. Our strategy consequently remains centred on a number of core corporate holdings (mainly in high-yield) with sound credit profiles and reasonable valuations, and on waiting patiently for opportunities to increase our credit exposure. - by How Phuang Goh, theedgemalaysia.com.
How Phuang Goh is head of Asian Fixed Income, based in Singapore. After five years with the Monetary Authority of Singapore, How joined Schroders in 1994, taking on responsibility for the investment strategy and day-to-day management of Schroders’ Asia ex Japan fixed income portfolios. He is a CFA charter holder, with a degree in accountancy from the National University of Singapore.
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