The US Treasury market sold off last week on growing fear that the Federal Reserve might start an early exit from its quantitative easing policy. This wreaked havoc in Asia’s local bond markets and boosted volatility in credit spreads. While volatility may persist, the fundamental question is whether Asia’s current economic cycle justifies the steepening in local yield curves. We think the region’s still-anaemic growth cycle, combined with the very tame inflationary pressure, suggests that the region’s local bonds are good value, especially if yields spike up further. While reduced liquidity flowing into local markets may act as a headwind, it could well keep investors cautious and help make valuations even more appealing over time, in our view.
Noting the changes in the 10-year bond yield in the US and major Asian markets over the past month and the past week, a couple of points stand out. India outperformed massively over the past month, which is justifiable on fundamental grounds— a sharp economic downturn and the Reserve Bank of India’s ongoing rate cut cycle.
Outside of India, all markets sold off indiscriminately, with Hong Kong enduring a particularly noticeable sell-off, due mainly to the Hong Kong dollar/US dollar currency peg. The jump in bond yields in Indonesia, the Philippines, Singapore, South Korea and Thailand was roughly on a par with that in US Treasuries, while the surge in Taiwanese, Malaysian and Chinese yields was more moderate. However, on a weekly basis, all Asian yields failed to follow the modest retracement that the US yield made.
In the event of a further US Treasuries sell-off, we believe that India, China and Taiwan are likely to be the preferred defensive markets.
From a fundamentals perspective, we think the following trends will continue to dominate in most Asian countries, keeping bond yields relatively benign and yield curves flat.
1. Growth remains below trend
Asia’s aggregate GDP growth slowed to 6.1 per cent year on year in first quarter of 2013. If we exclude the exceptional V-shaped trough in 2008/2009, the current growth rate is the slowest in 10 years. GDP growth in the region, excluding China and India, slowed to a mere 3.1 per cent year-on-year pace in the first quarter — also a level not seen in a decade. The bottom line is that there is no capacity issue here that will boost underlying inflationary pressure.
2. External demand to act as a drag
The export cycle has been very unexciting by Asian standards, with year-on-year export growth remaining in the single-digit territory for more than a year and dwindling to a mere three per cent in March. The cycle still lacks any sign of recovery besides a recent bounce in a very narrow range of electronic items, such as semiconductors and certain telecommunication products. We are skeptical about the sustainability of such a tech-specific export revival. In fact, non-tech exports continue to look uninspiring.
3. Domestic demand is not strong
Asia’s domestic demand has barely managed to hold steady and has been unable to compensate for the export slack. So, a downturn in Asia’s industrial output growth has been protracted. Excluding China’s very steady output, the region’s production growth decelerated to below one per cent year on year in March.
4. No inflationary pressure
Asia’s inflation, at marginally below three per cent year on year in April, has been benign. In fact, there are signs of renewed disinflation, thanks to lower commodity and food prices. A slowdown in Taiwan’s May inflation to just 0.7 per cent year on year and Indonesia’s surprisingly low 5.5 per cent inflation last month, despite worries about a tight economic capacity, are a case in point. In short, Asia’s inflation picture does not gel with higher bond yields or steeper yield curves.
5. Opposite direction with fed
In contrast to the US Federal Reserve, which is anticipated to scale back its “QE3” monetary easing policy, Asian central banks are still apt to err on the side of easier policy. The Reserve Bank of India is only halfway through its easing cycle, and we expect it to cut rates by a further 50-75 basis points (BP) after last month’s 25 BP reduction. Similarly, we have added one more 25 BP rate cut in our forecast for South Korea (following a 25 BP easing in May) and changed our projection for Thailand to a 50 BP reduction from “no change” previously (after a 25 BP easing in May).
Indonesia will probably be the only country that is likely to buck the trend with a rate hike, but even that depends on whether the government cuts local fuel subsidies as promised. Higher domestic fuel prices would obviously exacerbate inflationary pressure, but this remains a politically sensitive issue.
Anthony Chan, Asian sovereign strategist - global economic research, AllianceBernstein