Asian G3 credit: further to run, but volatility on the way

Hayden Briscoe, head of Asian fixed income at UBS, explains why Asian bond markets have rallied so strongly and why he believes that China needs to bring back its shadow banking sector.

It has been quite a year for Asian G3 bond markets. The negative predictions, which ranged from muted to doom-laden at the end of last year, have given way to a raging bull market during the first four-and-a-half months of 2019.

Can it continue? Hayden Briscoe, head of fixed income, Asia Pacific at UBS Asset Management, believes that it can.

Hayden Briscoe, UBS AM

In the following interview, he argues that global bond markets will be rejuvenated by a resumption of quantitative easing as governments realise how fast the world’s credit impulse is fading.

He also argues that China needs to unblock the domestic funding pipes to private sector companies by partially re-instating the shadow banking sector it has spent the past year dismantling.

Q It’s been incredible year for Asian credit and particularly high yield so far. Have you been surprised?

A No because we went overweight Asian high yield and particularly Chinese property in November last year. It was our single biggest call in the world.

We could see that the Chinese banks had cleared out their bond inventory after getting hosed when everything sold off. Around the turn of the third quarter, they just capitulated and sold everything.

I was actually surprised that the secondary market flows weren’t bigger. But it meant the Chinese banks started the year with no inventory on their books and that put the market on a very good footing.

How did you play that?

We initially ran a barbell strategy using duration. We did that until late in the fourth quarter.

Then when we decided that was less likely to work, we adopted a barbell strategy using credit default swaps and by shorting Asian sovereign credit.

We’ve now reduced our overweight in Chinese property to a more neutral stance. But we’re sticking with our overweight for the sector in global multi-sector funds, which need to be invested in high yield for the income.

So do you think the Asian credit rally has run its course?

We think there’s further to run. This is still the standout fixed income asset in high yield today.

Asian spreads should continue compressing to US and European high yield levels. But it’s true that everything has rallied hard and fast.

At the beginning of the year, we thought that Asian high yield would generate 10% to 12% during 2019 on a total return basis. We’re already around 10% after only four-and-a-half months.

From now on, it could be a grind for the rest of the year. We think there’ll be a lot of volatility and that’s one reason why active management is on its way back.

Why? Passive investment management has worked very well for the last decade.

When people talked about going passive, what they were actually doing was making an active decision to buy momentum and market cap.

And you’re right. For 10 years that strategy has worked very well and growth has outperformed value. More importantly, everyone believed that the US Federal Reserve had their back, so investors just piled into the highest yielding bond fund they could find.

And fixed income fund managers would always buy on the dip, often into the highest yielding piece of rubbish they could find as well, believing that market momentum would do the rest.

But that’s reversing now and the tide has gone out. Cross asset valuations are breaking down; value is outperforming growth.

You’ve got a situation where both the US dollar and gold are strong, when normally they would be heading in the opposite direction to each other.

This necessitates a different style of investment management. Fund managers need to become a lot more tactical.

And that’s why those high yielding Asian bond funds I just mentioned are still generating negative returns on a 12-month basis. They carried on buying all the peripheral stuff that was yielding, say, 30 cents on the dollar.

But distressed hasn’t bounced back even within the property sector. It’s the core credits that were trading around 60 or 70 cents on the dollar, which have re-bounded.

So that’s what we’ve been focused on and it’s generated huge alpha. We’ve become far more tactical than we were in the past. We’re rotating sectors. We’re putting risk on, taking it off.  

And what does that mean for China’s asset management industry, which is in a state of huge flux?

When it comes to offshore assets, Chinese investors are pouring over the border with their QDII quotas. That’s just starting.

But the re-alignment of the Chinese asset management industry means that banks can no longer buy assets directly. They have to go through funds, which are capped at 10% to 20% of assets under management (AUM).

The funds aren’t big enough yet for what the banks want to do. We’re in a transition period.

Right now, we’re at the stage where the government has formulated the policy, but the rules and implementation are yet to come. The banks are looking to hire people and to try to work out what the rules are as they set about establishing proper asset management divisions. 

How do China’s non-bank asset management firms fit into all of this?

Everything is coalescing back around the banks, so the P2P and fintech players have basically been crushed.

This will help to get rid of some bad market practices such as fixed NAV funds. Fund managers were manipulating their annualised yields by doing a repo at, let’s say, quarter or year-end when yields tend to spike, then realising the profit and posting that as the fund’s annualised yield. 

Moving to variable NAV is much better, but that means funds need capital behind them. So that’s why a lot of the new fintech players, which don’t have the capital, are trying to shift their assets to other asset managers.

How far advanced is the dismantling of the shadow-banking sector?

I think that China needs to get its shadow back. The liquidity, which Chinese government has been pumping into the financial system, isn’t getting to the real economy.

The piping’s stuck. The fact is that banks don’t dominate lending to SMEs anywhere in the world because it’s too risky for them. They want years of tax records.

The policy of bringing back all these assets onto banks’ books is good in theory, but maybe not in execution. Shadow banking ended up with lots of negative connotations about it, but in practice it’s all about securitising assets.

One good channel to get liquidity moving would be through entrusted loans because that’s quite regulated now.

What does that mean for the wider economic impact?

China is going through an L-shaped recovery not the U-shaped one you would have typically seen in the past. Cycles are also getting longer. We’re calling it the 3-Ls.

In the past, three-year cycles used to fit neatly into China’s five-year plans. But now that Xi Jinping is in power, there’s less focus on one single five-year plan as there is a policy continuum.

We think that China is experiencing six- to eight-year cycles now.

The property market is already six-years into a cycle, but we still see quite high margins at the big property companies.

The gap between pre-sales and what they’ve finished building relative to pre-sales is the widest that it has ever been. They have just got to finish building and as they finish they’ll get the money coming out of the trusts.

These companies will turn into big cash boxes from a creditor perspective. That won’t be great for equity investors, but it will be for credit investors.

For the first time in my career, I’m hearing CFOs talk about de-leveraging and retiring debt.

And yet they still seem to be raising a lot of debt.

Deleveraging takes a while. It isn’t necessarily a big theme for this year, but it’s where they’re going longer term.

There will still be high supply this year.

The good thing is that the onshore fundraising pipes are open again. The property companies can fund themselves domestically and toggle between the US dollar-denominated bond market and the renminbi one.

That’s what makes this asset class unique. In Europe and the US, high yield borrowers tend to be boxed into one currency and one investor base.

What’s your view on US interest rates and the likelihood of a recession?

We are definitely tipping over into one, but I don’t think the US realises it yet.

The main problem is that there is no more credit impulse in the world anymore. It started happening in 2014 when the US, European, Japanese credit impulse slowed down.

China stepped in and grew the credit impulse but that’s gone into reverse. There’s no-one else coming now. There’s no credit impulse.

There are also no US dollars and I think that’s the most important issue.

The financial markets are very focused on US interest rates, but the US dollar squeeze is the most important thing. I don’t think there’s much understanding within the US Federal Reserve about how this works from a mechanism perspective.

The technical shortage is very clear. Every month, the quantitative tightening policy means that $50 billion is being taken. And then there are all of Trump’s policies, which are sucking dollars back into the domestic economy.

On the other side of the coin, borrowing outside of the US has exploded. This means that the US dollar hasn’t started selling off even though everyone thinks it should because the US is running a twin deficit.

You can see how this is playing out among the Chinese banks. As soon as they hit a wall funding themselves in US dollars, they went into Hong Kong dollars instead. That’s why it keeps hitting its pegs.

Australian banks are being forced to fund at much higher levels over Libor and are clearly desperate. Emerging market countries are struggling to roll debt over.

Everyone is short of dollars so I foresee a big blow off top in the currency. That’s one of the major risk scenarios.

So where does all this end?

There will be more quantitative easing to get dollars circulating again. At some point, we’re talking helicopter money and after that inflation.

But that’s still way off in the future. Today, demographics and technology are putting a structural dampener on inflation. But ultimately, it will be the other way.


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