Q&A: Mixed performance by Asian frontier markets

Valuations have cheapened as frontier markets grapple with fiscal discipline and collapsing commodity prices. That is the conclusion of Clifford Lau, head of fixed income, Asia Pacific at Columbia Threadneedle Investments based in Singapore. 

Over the past month, FinanceAsia has been running a series of Q&A's with some of the region's leading fixed income fund managers. Here Lau explains why falling bond prices across frontier market debt may be setting the stage for a new rally.

How would you describe your overall trading strategy and has it been changing recently?

Clifford Lau: Yes. In the past, we could afford to hold less liquid credits. These names were still tradable most of the time, as market makers had bigger balance sheets. Now, we find trading liquidity is pretty thin and that doesn't give us much headroom to invest in small deals.

There's also no prospect of being able to trade within a reasonable bid-ask range unless we have a strong conviction that the credit development of our investment will deliver strong upside, which isn't impossible. So now when we construct our list of core holdings, credit liquidity has become our priority investment consideration.

And what about the last few months? How have you coped with the volatility?

Actually Asian G3 markets have delivered a decent performance relative to other asset classes. We've changed our investment by going long on duration, adding benchmark sovereign exposures and trimming credit spread risk.

This is in line with our view that global rates and US rates in particular are no longer at risk of moving higher. This is especially the case after the Bank of Japan’s surprise negative interest rate move and poorer risk-reward prospect across the Asian spread market. 

What's your view on Asian G3 markets for the rest of the year?

The performance of Asian credit markets has become externally driven. Therefore, the outlook is going to be highly sensitive to macro headlines relating to oil prices, US growth, geopolitical risk and how China is micro- and macro-managing its economy to avoid a hard landing. 

We don't think there's anything too alarming in fundamentals of Asian economies, although a few countries may see their current accounts and fiscal deficits come under increased pressure. We're comfortable staying invested in Asian G3 markets, but we're mindful that aggressive ratings downgrades could see more fallen angels crossing over to the sub-investment grade category. 

Asian frontier sovereign credits have performed poorly. In Mongolia's case this is because of collapsing commodity prices. In Sri Lanka's case, it's about lack of fiscal reform discipline. 

Regardless, we don't expect broad-based defaults by Asian credits. Valuations have cheapened quite a fair bit and we think this has set a better foundation now for our market to outperform.

What’s your view on the direction of US Treasury rates? 

The data coming out from the US isn’t that bad and the market has been under-pricing the risk of a US rate hike. Hence, US Treasury rates are rich. The US yield curve has continued to flatten, which makes the long end vulnerable to any rate normalisation if expectations of another US rate hike are back in the spotlight.

The introduction of negative interest rates by the Bank of Japan in January has had profound implications on the trajectory of interest rates globally. It affirms the common belief that rates are going to stay lower for even longer. 

Nevertheless, the rates market does not look cheap. However, we expect a number of Asian central banks to continue pursuing monetary easing, with cuts to interest rates or banks’ reserve ratios. This leads us to stay invested in the Asian local rates market even though valuations are a bit stretched.

I also think the US dollar's strength will be tamed by government officials and probably investors, unless the US economy continues to exhibit a trend of above-average growth in the second or third quarter of this year.

What impact is the weight of Chinese capital having on the pricing and trading of Asian G3 debt?

These capital inflows supported spread performance early last year, but that doesn't mean Chinese credit spreads won't be subject to a market sell-off, as we saw during the Chinese equity rout last summer and early this year. 

I don't agree with those who say Chinese investors lack credit analysis. I'd say the research dialogues between the buy and sell sides and between buy-side peers has been pretty frequent. It's improving corporate governance and investor relationships. 

I think Chinese credits will continue to lead development in both the primary and secondary markets. Chinese representation in the Asian G3 market will continue to grow.  It is a challenge managing increasing China risk in the overall asset class, but it also offers us attractive opportunities amid China’s continued efforts to liberalise its financial markets and open up its capital account.

So which sectors do you think look interesting in China?

There are a few macro themes we can participate in from medium to long-term long positions, such as reform of state-owned enterprises, the “One-Belt, One-Road” initiative, the strong growth potential of China’s internet and technology sectors and the positive impact of the easing cycle to support the Chinese property sector.  

However, it isn't uncommon to see Chinese credits going overboard with their capital expenditure plans. The mainland’s negative rating outlook is putting a lot of pressure on weak Chinese credits which have a low BBB rating and risk falling into non-investment grade.

What's your view on South East Asia? Will we see much issuance this year?

I think we'll see mostly corporate issuances from this part of the world, although we don’t think there’ll be an overwhelming amount of new paper.

Indonesia should still provide a constant supply of US dollar bonds, as it will continue to incur both current account and budget deficits, which will need financing from the US dollar credit market. The country’s economy and currency have stabilised and this could soon reignite issuer and investor interest in Indonesian high-yield corporate bonds.  

You mentioned the problems with some of Asia's frontier markets. Do you expect poor performance this year?

Each Asian frontier market faces its own unique set of headwinds.

For Sri Lanka, the hype over the unity government being formed is over and the budget disappointed on the fiscal consolidation front. The biggest risk to this sovereign would be its balance of payments crisis and refinancing risk. 

We're constructive on Pakistan's medium-term growth prospects, particularly after the IMF approved the Extended Fund Facility. The country seems committed to improving its structural weaknesses as well as strengthening its fiscal position to fulfil its commitment to the IMF. 

We think Mongolia should be a booming economy over the medium term, but it faces domestic and external challenges over the near term. Domestic headwinds include the elections in mid-2016, while external challenges include sluggish commodity prices and softening Chinese demand.

So overall, we expect Asian frontier markets to a deliver mixed performance this year.