Global cross-currents challenge Asian fixed income markets

Emerging Asian market bonds have been on a bumpy ride since the second half of 2021.

The combination of a resurgence of Covid-19 cases and rising default risk in the Chinese property sector dampened the region’s economic sentiment, causing significant capital allocation considerations for investors - from more turbulent markets and asset classes to those with more stable outlooks. This has not proven to be straightforward.

Then came more shocks this year: The ongoing Russia-Ukraine conflict has brought oil prices to an 8-year high, exacerbating the already rising global inflation trend. The subsequent decisions by central banks in countries from the US to Brazil to the UK to accelerate interest rate hikes, coupled with the relatively slower responses by their Asian counterparts, are prompting fixed income investors to reassess their asset allocation to the region.

While some analysts argue that Asia is now, more than ever, better positioned to withstand external shocks, they are also calling into question the relative attractiveness of its bond markets under the current market conditions. Traditionally, the region is seen to offer good risk-adjusted returns among global emerging markets, thanks to its relatively stable political and economic environment and strong representation in Emerging Market indices. But as bond yield differentials between Asia and the rest of the world continue to gyrate amidst the large moves in the global bond markets, the idea of it being a “safe haven” may not be the most relevant in the current environment.  

Take the large economies as examples. Brazil raised its key interest rates by half a percentage point on June 15 and signalled another hike in August, bringing the total increase to 11.25 per cent since March 2021. On the same day, the Federal Reserve announced its biggest rate hikes in nearly 30 years, lifting its key interest rates by 75 basis points to a range of 1.5 to 1.75 per cent. The decision, the third hike since March, comes after US inflation surged in May and was higher than market consensus. Canada, UK and Australia have also raised rates, while the European Central Bank has announced plans to do so later this summer.

In contrast, China and Japan, the world’s second and third-largest economies, are bucking the tightening trend as domestic growth slows while inflationary pressures are not quite what we’re witnessing in other parts of Asia. The Renminbi has lost about 5 per cent against the dollar this year, while the Japanese yen has depreciated around 15 per cent. When combined with the rise in US rates, this results in further downward pressure for other Asian currencies. The Korean won, for example, has lost about 8 per cent this year. In the past, Asian countries often welcomed cheaper currencies as it could make exports cheaper to foreign buyers. But the prospect of economic slowdown and weaker demand in their major markets, particularly the US, may dampen trade volume.

Thus Asian central banks now face a dilemma. On one hand, they are under increasing pressure to follow the rest of the world in adopting more aggressive tightening policies. This would allow the region’s local currency bonds to reprice more quickly and boost their appeal to global investors, as well as stem some of the currencies’ depreciation against the US dollar. Yet doing so risks dragging down local economies that are only just showing signs of genuine recovery from the impact of the Covid-19 pandemic, so this is by no means a clear path for policymakers.

As mentioned at the beginning, other than the uncertainties surrounding interest rate hikes, another factor that will keep the Asian credit markets on edge in the near to medium term is the health of Chinese property developers. While the extent of the loss to homebuyers, contractors, and employees will likely take months to be fully assessed, it serves as an important reminder to investors who have long underestimated the credit risks inherent in bonds in their portfolios.

The market continues to watch closely for steps the Chinese policymakers might take to potentially introduce reforms in the real estate sector and the broader economy, which will likely involve a prolonged period of accommodative monetary policy. With inflation in the US showing no signs of cooling in the near term, the current scenario has put the largest economies in the East and the West on diverging monetary policies, adding further uncertainties and risks to the overall global financial markets. This will also test the strength of the Renminbi, often seen as a proxy for broader Asian currency markets.

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As we look towards the coming months, there’s no denying that further volatility is highly likely as market participants try to make sense of it all. Yet if we zoom out and take a broader perspective, there’s little doubt that Asian economies will continue to open up and grow their bond markets as more global investors now see them as indispensable to their portfolios. Global asset markets are going through a significant re-pricing and Asian fixed income is very much in the mix.

As a leading electronic trading platform for global emerging markets, the flows that we saw corroborate this market sentiment - that is, as Asia credit spreads have been widening and local bond market yields are rising, the global investor activity has been materially skewed towards the selling of bonds. Investors will keep looking for opportunities in Asian debt markets and move in again when the risk-reward dynamics become more favourable.