Market temperature indicators suggest fixed income investors should look to Asia for opportunities

AS the physical world continues its war against the coronavirus pandemic, the financial world seems to have passed its judgement with regard to the future, at least if we are talking about the US. Even with deaths on the rise, the economy in a deep freeze, and job loss numbers at unprecedented levels, the S&P 500 rallied 28 per cent between its trough on March 23 and May 15. The technology-heavy Nasdaq index did even better, hovering at slightly above its end-2019 level last Friday.

One factor frequently cited by market participants who argue for the sustainability of the rally is that big technology stocks like Amazon and Netflix have propelled the swift market rebound, and tech firms should be resilient against the global pandemic. While there is some truth to this observation, my review of data suggests it is not exactly the case.

For instance, the performance of the equal-weighted version of the S&P 500 (+27 per cent from March 23 to May 15) and the small-cap stock index Russell 2000 (+25 per cent) wasn't far behind the (cap-weighted) S&P 500. And the two indices actually outperformed the latter prior to last week's losses, when simmering US-China tensions and warnings by Fed chairman Jerome Powell and other Wall Street heavyweights about downside risks put a damper on market momentum.

I have asserted elsewhere that it is futile to try to predict whether financial markets have bottomed, so this commentary is not questioning the permanence of the strong advance.

Instead, I believe it is more important to understand where we stand in terms of market conditions and investor sentiment, which have profound influence on prospective returns. We can look at a couple of "market temperature" indicators to have a sense of how and where we should position our portfolios from a fixed income perspective.

Firstly, issuance volumes of SGD corporate bonds over the two months ended April fell to the lowest since at least 2009 (comparing to corresponding months). Over the same period, the amount of G3 currency bonds issued in Asia was the lowest since 2012.

Record issuance

Meanwhile, the US corporate debt market has seen weeks of record issuance, supported by back-to-back record floods of investment-grade ("IG") bonds in March and April. And despite receiving only partial backstopping support from the US Federal Reserve, April's offerings of high-yield ("HY") US corporate bonds added to a surprisingly large US$29 billion, according to Bloomberg data.

The stark disparity between investor sentiment in Asia and the US happened despite April being the worst month for US business activity. The IHS Markit Flash US Composite PMI Output Index released last month signalled the fastest contraction in private sector output in the survey's history.

In the meantime, helped by the region's experience of coping with other recent epidemics and perhaps cultural norms that are more obedient to government guidance, many Asian countries have been relatively more successful in containing the outbreak. Countries like China, South Korea, and Taiwan have started to ease containment measures, while Singapore, although having seen a surge in confirmed cases since early April, has one of the lowest case-fatality ratios globally.

Valuations are also illustrating the divergence between investor psyche in Asia and the US. Since the Fed's March 23 announcement that it will buy corporate bonds, credit spreads of US bonds have narrowed significantly. The Bloomberg/Barclays IG corporate bond yield spread narrowed from a high of 373 basis points ("bps") on March 23 to 208 bps on May 15, while the HY spread plunged from 1,100 bps to 757 bps over the same period.

After the rally, yields and spreads of both US HY and IG bonds bear little resemblance to levels reached during the 2008 global financial crisis. This was despite Moody's recently forecasting the US default rate to climb to 14.4 per cent by March 2021, which is very close to the peak default rate recorded in 2009.

Less severe

Essentially, at least from the financial asset prices point of view, investors seem to be thinking that the problems facing the US are less severe than during the 2008 GFC, or even the corporate earnings recession in 2015-2016.

In contrast, although Asian bonds have also retraced some of March's losses, credit spreads remained significantly wider than their US counterparts. The disparity is especially apparent in the IG sector, where spreads of Asian IG bonds (249 bps) have swung from a substantial discount of 95 bps against US IG to a premium of 41 bps, over the March 23-May 15 period. Asia HY bond spreads are still close to double digits (in percentage terms), at 962 bps as at May 15.

Of course, the market may eventually be proved right that the unprecedented government stimulus programmes are enough to overcome similarly unprecedented economic problems. It is probably not a coincidence that the market rally started right after the Fed announced its massive quantitative easing. In addition, policymakers have learned a great deal from previous recessions, with stimulus measures that were taken after months of deliberation in the previous episode, being rolled out just weeks after the outbreak worsened. The world has reason to believe that the economy will see a lasting upturn in business activity after coronavirus restrictions are lifted.

But how do we quantify the impressive stimulus programmes in terms of their impact on corporate earnings and market valuation? And is there a point at which public rescue operations, particularly the extraordinary step of buying speculative-grade corporate debt, become undesirable in terms of their longer-term ramifications?

V-shaped recovery

While I agree with the market consensus of a V-shaped recovery in the economy, my disagreement is with the amount of confidence that we could place in this guess. As US infectious disease expert Dr Anthony Fauci recently said during a Senate testimony: "I am very careful, and hopefully humble in knowing that I don't know everything about this disease." I believe that is also the right attitude to our investment approach in this pandemic.

Given today's valuations, I think prices of Asian bonds provide more scope for the possibility of downside scenarios, so investors can be more aggressive in terms of their portfolio positioning for Asian corporate debt. Conversely, if my observation of a more relaxed investor sentiment in the US is correct, we should favour a relatively defensive stance in US bonds.