Asia’s local government bond markets attracted record inflows in 2010, driven by the region’s relatively stronger economic outlook, credit fundamentals and higher yields. Martin Hohensee, head of Asia fixed-income and credit research at Deutsche Bank, gives FinanceAsia his thoughts on whether this theme will continue into 2011, along with his broader outlook for fixed income in Asia.
Capital flows into Asia and emerging markets in general was the major theme of 2010. Do you expect this to continue in 2011?
In 2010 the familiar capital pull-themes of “increasing emerging/Asia allocation” and “reserve diversification” got a significant boost from the realisation of systemic risks in the US and Europe. The resulting capital-push could be an undercurrent in financial markets for the next several years, while Asia’s enviable fundamentals encourage flows into the region over a similar horizon.
Given the tendency of capital flight from crisis countries (the developed world in this case) to create asset bubbles in the recipients of that capital (Asia), regulators will be tempted to interdict market forces with capital restrictions of various kinds. Because of this, and the volatility that naturally comes along with heavy capital flows, we would warn against complacency over short-term horizons. Heavy investor positioning and regulatory interventions are bound to create volatility around a generally bullish trend for Asian assets.
Over the course of the year, we expect a shift in emphasis from capital-push factors to more typical capital-pull dynamics. One interesting feature of the capital flows in 2010 was the predominance of bond-related inflows relative to equities. Bond inflows were “pushed” into Asian markets because of the collapse of yields in “risk-free” bond markets (Bunds and Treasuries), and also the recognition of risks in peripheral European sovereign bonds.
In 2011, as systemic risks in Europe appear better contained (eventually), the US recovery becomes more firmly grounded, and Asian regulators discourage bond inflows, markets will return to more typical cyclically-driven behaviour. In that situation capital-pull dynamics would lead to equity investors boosting Asian exposure to increase their leverage to a global economic recovery. The shifting target of capital inflows could also create volatility to the extent that it is not well synchronised.
Can bond markets repeat their stellar returns of 2010?
The backdrop of continued capital inflows, reasonable current account balances, and gradually more flexible currency policies leave us bullish on Asian FX returns, albeit with short-term bouts of volatility. But from current levels it would be almost impossible for 10-year local government bonds to repeat the 10% to 30% total (currency and local market) returns of 2010. We expect bond yields in almost all countries in Asia ex-Japan to rise above forward implied yields, but not so sharply as to create negative local currency returns. Our cautious view on duration is driven by the beginning of some -- and extension of other -- rate hike cycles, increased bond supply in several markets, and perhaps most importantly a shift towards equities from fixed income by foreign and domestic investors.
In this case, the shift in focus of capital flows is an important issue. In quite a few markets domestic investors have already lost interest in bond markets as yields dropped through their yield targets. If foreigners lose interest in bonds then yields would have to rise substantially in order to bring levels back to domestic investors’ yield targets. The closure of this gap between the foreign and domestic bid could be a rocky time for a few local bond markets.
Does your bearish bias on duration exposure extend to credit products?
Actually the short end of credit curves are probably a nice place to put on carry trades in that kind of environment. When we look at valuations on the global credit surface from a quantitative perspective we find it to be generally inexpensive given the outlook for default rates, ratings migration, and the level of interest rates.
Of course, we could explain an excessive risk premium with unusually high systemic risks centred in Europe or geopolitical risks in our own back yard. But barring any unravelling in these areas, global credit valuations are reasonably attractive. And approaching the Asia/global credit relative valuation question from a number of angles, we’re consistently led to believe that Asian credit is especially cheap.
Bottom-up credit fundamentals are improving among Asian corporates even faster than they are at a global level, while the banking sector seems better positioned for the upcoming regulatory overhaul. We find interesting bottom-up credit stories across the Asian credit universe, including segments of the China property and banking sectors.
We also think that local currency bond markets, India and Indonesia in particular, are a very interesting way of enhancing yields over government bond markets.