Bond opportunities increase as financial markets mature
A key outcome of the maturing Asian financial markets has been the emergence of the Asian bond market as an alternative asset class to the developed bond markets of the US, Europe and Japan. Bond issuance in Asia has grown rapidly with companies now able to use the local bond markets as an important source of funding.
These trends have driven a tremendous increase in liquidity in Asia since 1997, with the local currency debt market now estimated at $1.6trn and the US dollar-denominated market estimated at $150bn. There is a group of 11 central Asian banks committed to enhancing the liquidity of the local markets by issuing sovereign bonds and enhancing debt derivative markets across Asia.
Asian bonds, particularly local currency debt, are lowly correlated with other asset classes and therefore provide a good diversification of risk within an investment portfolio. The exposure to local currencies offer opportunities for potential currency appreciation, with the US dollar seen as fundamentally overvalued relative to Asian currencies, and with relative value possibilities between forex markets in the region due to differing economic fundamentals.
The size of Asian foreign exchange reserves and positive balance of payments positions support the likely appreciation of local currencies, while ensuring more stability in the local foreign exchange markets. The ongoing revaluation of the Chinese Renminbi is likely to benefit other Asian currencies as the position of regional competitiveness is maintained. Asian bond markets can outperform the developed bond markets as the inflationary outlook in the region remains relatively benign. Regional inflationary pressures are contained by low labour costs while exchange rate policies (allowing an appreciation) are being used by some central banks to fight imported (largely commodity) price pressures.
The structural improvements in domestic financial systems since the crisis of 1997 mean countries are in a much better position to determine the most suitable monetary policies for their own economic situations and set interest rates accordingly. Amid easing inflation, some central banks in the region appear willing to stimulate domestic drivers of growth by easing monetary policy.
Asian credit also presents better value than developed market credit with the yield on BB-rated Asian corporate bonds approximately 40 basis points higher than its US equivalent. Asian corporate bonds are more conservatively rated by the credit ratings agencies, due to the perception of more prevalent corporate governance issues. Nevertheless, the actual bond default rate has been very low, with just one occurring in the past five years. Furthermore, the Asian bond market is also less susceptible to the risk of deterioration in credit quality through leveraged buy-outs, due to the large number of family-owned and government- backed companies in Asia, which can exert significant blocking influence in these deals.
A strategic allocation to Asian fixed income is an important component of the Credit Suisse (Lux) Total Return Asia Pacific Fund. Since its inception three years ago, the Asian fixed income pool (in US dollars) has returned about 3.5% a year in excess of the US government and agency bond benchmark, or approximately 4% a year in excess of Libor. In 2006, the portfolio returned approximately 9.8% compared to 5.2% from the US government bond benchmark. Opportunities are being exploited for some non Asian core-plus style fixed income mandates.
Asian local currency bonds have a very low correlation to other bond markets and in our opinion look relatively cheap. We believe these markets offer opportunities for us to add real value to our clients’ portfolios, as many of them have pockets of inefficiency.
The sharp retreat in emerging market equities last year, on indications of a slowdown in the US economy, sent a shudder through Asian economies. Much of the negative investor sentiment was linked to the perceived dependence of these countries on exports to the US and the willingness of US consumers to spend. However, this knee-jerk market reaction largely ignored the expansion in domestic consumption occurring in tandem with rising economic growth.
merging markets are regarded as being very cyclical. However, there is enormous change happening in the composition of emerging market growth drivers and also on the dependency of both the economies and companies on outside growth. There is currently such a strong underlying trend in domestic growth that one can argue the cyclicality of emerging markets has decreased. Another indicator driving the May 2006 downturn in emerging market equities was due to emerging market debt and the majority of currencies not correcting as severely as stocks or other global credits.
Asia’s projected growth in 2007 should remain robust despite tougher external conditions. Strong domestic demand in almost every country in the region will underpin GDP growth, and we have revised upwards our GDP growth forecast for Asia ex-Japan to 7.5% for 2007. The revision reflects stronger-than-expected domestic spending in Indonesia, Singapore and Hong Kong, while China and India continue to be the dominant drivers of growth in the region. Although risks to monetary policy are present in select markets such as China, Singapore and India inflationary pressures are well contained and some central banks in the region, notably in Indonesia, Malaysia, Thailand and the Philippines are keen to stimulate domestic investment and consumption by easing their monetary policy.
In China, monetary tightening will continue with the government allowing the currency to appreciate gradually. These measures, although aimed at reducing liquidity, are unlikely to see a significant slowing in economic growth in the near future. Exports are likely to soften amid weakened US consumption, which should keep Beijing away from drastic tightening, but robust consumption and large investment in infrastructure should offer a cushion for sustained growth.
We maintain a bullish forecast for India, with expectation of 8.5% GDP growth this year versus consensus of 7.3%. The main risks are rising interest rates and inflation. But we are positive on investment growth, and industrial production data continues to show strong expansion across the basic, consumer and intermediate goods sectors.
As Asia’s dynamic economic growth continues to outpace the rest of the world, we expect the region’s share of total global GDP to rise to 20% from 15% over the next few years.
Robert Mann is head of investments in Asia for Credit Suisse Asset Management