Fundamentals and technicals to remain supportive.
9 January 2024
Asian Fixed Income Team
Fundamentals
Macro
The year 2023 turned out differently than we initially envisioned. Throughout 2023, investors have eagerly watched US jobs data and inflationary readings, debating the timing of the last rate hike. Recent rhetoric from Fed officials suggests the central bank is not ruling out another increase in 2023, as labour market conditions remain tight, business activity continues to be more robust than expected and inflation stays above the Fed’s 2% target. Global growth defied any kind of recessionary expectations although interest rates have been raised further and cuts that the market anticipated continue to be postponed. The current macro and market backdrop may see little or minor change with growth expectations for major economies remaining low and some inflation stickiness resurfacing as we head towards 2024. We foresee the policy environment remaining restrictive, as monetary authorities continue to assess the cumulative impact of tighter financial conditions on inflation and the economy. The resilience of major economies, particularly the US, is prompting the markets to embrace the “higher for longer” narrative for interest rates. While this has weighed on total returns in 2023, the move higher in rates may also increase investors’ incentive to lock in historically high all-in yields with yields at post-Global Financial Crisis highs.
Over in Asia, the challenging external environment—prompted largely by rapidly weakening growth in China since the second quarter of 2023 together with a delay in the revival of the semiconductor industry cycle—has weighed heavily on trade recovery in the region. We expect economic activity in most Asian countries to remain broadly stable in 2024. On the other hand, China’s recovery momentum may be a significant wild card for regional growth. Although Chinese policymakers have unveiled a raft of measures to spur growth, economic momentum remains sluggish and labour market sentiment is still lacklustre. India and the Philippines are expected to register fairly robust growth in 2024, and open economies like South Korea and Singapore may benefit from a pick-up in exports.
We expect most central banks to keep policy rates unchanged, at least for the first half of 2024. China will likely be an exception, with the possibility of additional monetary accommodation to support the sluggish economy. Monetary policy is expected to remain relatively tight as central banks in the region face still-high US interest rates and grapple to anchor their currencies. As for inflation, China may see a slight acceleration from low levels, while disinflation trends are likely to continue in the rest of the region. Looming elections in India, Indonesia, South Korea and possibly Singapore mean policies in these countries could lean towards supporting growth. Although we expect increased fiscal support ahead of these elections, the size is likely to be minimal.
Credit
Going into 2024, we are more confident that credit quality is long past the peak. Nevertheless, any weakening in corporate credit profiles started from very strong levels, with higher debt-to-capital ratios, leverage ratios and tighter liquidity positions. The US hiking cycle, with interest rates raised higher than the market anticipated and rate cuts not forthcoming in the near term, heightened concerns about corporate borrowers having to adjust to a funding environment with higher-for-longer costs. Unlike the past few hiking cycles, during which the Fed and other central banks tightened financial conditions in response to a combination of firming inflation and robust economic growth, the ongoing tightening cycle is unfolding against a backdrop of decelerating growth and persistently high inflation.
This global macro environment creates a more challenging fundamentals backdrop for Asian credit. However, we believe there are strong mitigating factors that can support Asian credit fundamentals. In China, the recent step up in fiscal measures suggests that the country’s policymakers are aware of the challenging environment. This further raises expectations for policymakers to deliver additional measures to help broaden out China’s recovery and boost economic growth in 2024. Importantly, China is enacting measures to lower funding costs and ensure adequate financing availability for privately-owned enterprises (POE). Although the measures have so far not been very effective for POE property developers, it could mitigate refinancing risk and lower the financing burden for the rest of the corporate sector. Outside of China, corporate credit fundamentals across the region are expected to stay resilient although the region’s economic growth is expected to be slow in the first half of 2024. While non-financial corporates may experience a slight weakening in leverage and interest coverage ratios stemming from lower earnings growth and incrementally higher funding costs, we believe that most have adequate ratings buffers, especially Asian HG corporates.
Oil prices could remain elevated and volatile heading into 2024. A multitude of forces ranging from climate change, regional conflicts and macroeconomic cycles are creating significant concerns in the market and making oil prices volatile. In such an environment, we see a mixed picture for companies along the value chain in this sector for 2024. We expect upstream companies continuing to do well in this environment, while downstream refining and petrochemical companies may face headwinds in the form of weakened profitability.
We see Asian technology firms’ credit fundamentals remaining relatively resilient, although geopolitical tensions continue to be an overhanging risk for the sector. Asian technology firms in the dollar bond market are, in general, industry leaders with low balance sheet leverage. For hardware companies, there are increasing signs that demand may have bottomed for various sub-segments such as those related to personal computers, smartphones and memory chips. At the same time, domestic regulatory risks which were a key concern in previous years have decreased significantly for Chinese technology firms.
We are cautious on the real estate sector overall as the high interest rate and weakening macroeconomic environment could dampen property demand and prices for developers and landlords. Within the China property sector, we prefer developers with state-owned backgrounds with stronger contracted sales and funding access. Outside mainland China, we believe most Hong Kong developers within the dollar bond market will be able to withstand the near-term pressure of falling property demand and prices, supported by their low gearing ratio and historically prudent financial policies. Singapore’s commercial real estate market has remained resilient; we continue to hold a positive view on the retail, hospitality, and industrial & logistics sub-segments thanks to continued tailwinds for these sectors. On the other hand, we remain cautious on the office space sector.
In general, the Asian banking sector remains resilient. With strong capital, adequate loan loss buffers, robust liquidity and expectations of stable profitability, we retain our favourable view on banks. We positively assess the capital structure of large players with strong fundamentals as non-call risk is seen to be minimal for such issuers’ bonds while being watchful on asset quality.
Valuations
Asian credit spreads tightened in 2023 against a challenging macro backdrop, although much of it reflects the tightening in the Asian HG space. At the index level, Asian HY spreads also tightened. However, this was distorted by index rebalancing in the wake of defaults and the removal of several large China real estate issuers from the index.
Despite the tighter spreads year-to-date, Asian HG credits have not been without volatility. Spreads widened notably in mid-March 2023 following the collapse of several regional banks in the US, and the forced merger between Credit Suisse (CS) and UBS, which triggered the write-down of CS Additional Tier 1 (AT1) securities. Despite having much stronger fundamentals, Asian bank capital instruments were not immune to the events, although the observed spread widening was much more muted. However, following the liquidity and regulatory measures implemented by authorities in the US and Europe, which helped prevent the worsening of the banking turmoil, Asian financial spreads tightened back along with their global counterparts.
In the second half of 2023, Asian HG spreads displayed remarkable resilience and stability, moving within a narrow range of 160 basis points (bps) to 175 bps (1). This was despite (1) increasing concerns over China’s growth recovery, (2) further weakening of China’s property sector after initial optimism towards the country’s post-pandemic reopening faded, (3) continued pressure from rising US Treasury (UST) yields and hawkish rhetoric from the Fed and other major central banks and (4) ongoing US-China geopolitical tensions. Part of this resilience stems from robust sovereign and corporate credit fundamentals across most of the Asian HG space, including the non-property HG credits in China. At the same time, a low gross supply of new issues and negative net supply provided technical support to spread valuation. The rise in yields, while a headwind to broad market sentiment, also served to attract all-in yield buyers with longer-term perspectives.
Looking into 2024, we expect most of the factors that supported Asian HG spreads in 2023 to remain in place. However, with current Asian HG spreads near historical lows and at relatively tight levels relative to developed market spreads, a significant part of the positive factors seems to be priced in, limiting the room for further tightening. Additionally, there are also negative risk factors including a potentially sharper-than-expected slowdown in global growth and higher domestic interest rates exerting an incremental but nevertheless negative impact on Asian economies and corporate credit fundamentals. All these factors suggest that Asian HG spreads may trade sideways with a mild widening bias in 2024. There is also risk of some decompression with the spread differential between BBB-rated bonds and A-rated bonds tightening from 78 bps at end-2022 to 66 bps as of this writing in end-2023, which is some distance below 90 bps, the average over the last five years (2) .
Developments in the China property sector continued to impact Asian HY spreads throughout 2023. However, with the much smaller weight of the China HY real estate sector, the influence of this sector on the overall Asian HY space is likely to decrease going forward even though volatility within the sector will likely remain. In turn, the direction of Asian HY spreads will increasingly be influenced, in our view, by developments in the Macau gaming space, India HY, Indonesia HY and unrated issuers across the Philippines and Hong Kong. Given the myriad cyclical and structural drivers for each of these sectors, it is difficult to call the direction for overall Asian HY spreads in 2024, although the current spread level remains wide and appears to offer room for compression over the medium term.
Chart 1: Asian high-grade spread
Chart 2: Asian high-yield corporate spread
Technicals
We see the technical backdrop for Asian credit remaining favourable in 2024. Elevated UST yields and cheaper onshore funding alternatives, particularly in China and India, have resulted in a second year of very subdued primary issuance in Asian of US dollar (USD) credit in 2023. As these factors are likely to remain, at least in the first of 2024, we expect another year of low gross supply of around USD 100 billion to USD 120 billion*. This is slightly higher than in 2023 as we expect issuance to pick up somewhat in the second half of 2024 with yields in the US dollar market expected to become more conducive to issuers. As with 2023, a large part of the gross issuance will likely be for refinancing, leaving net issuance at a manageable level. While issuance from China and India are likely to remain low, we expect issuance from South Korea to stay at a high level, along with a steady supply of Indonesia and Philippines sovereigns.
In addition, we see potential for fund flows to turn more positive for Emerging Market (EM) and Asian credit. The persistent rise in UST yields and elevated front-end rates in developed markets have been a powerful driver of EM bond fund outflows in 2023, along with investor concerns over China’s growth recovery and geopolitical tensions. However, with the Fed seemingly nearing the end of its rate hike cycle potentially easing in the second half of 2024, conditions could turn more favourable for global investor allocation into EM credit. For Asia, a potential stabilisation in the Chinese economy and easing of geopolitical tensions could be additional incentives for fund inflows into Asian credit.
Strategy
Our base case envisions a slowdown in global growth in 2024, with the US in particular losing some of its exceptional strength seen in 2023. At the same time, inflation is likely to continue moderating across the developed world—albeit at a slower and more uneven pace than in 2023. The aggressive policy rate hiking cycles by major central banks could be nearing an end, although the timing of the easing pivot will remain uncertain. Against this backdrop, UST yields are seen declining moderately from current levels.
Closer to home, the sustainability of China’s recovery momentum remains a significant wild card. The effectiveness of various measures that have been announced by the Chinese authorities to support its property sector will be key to the spread performance of the China real estate sector. This sector is now a smaller segment of the Asian credit market today but is still an important driver of overall performance given the scale of potential spread tightening or widening. Elsewhere, macro and corporate credit fundamentals across Asia ex-China are expected to stay robust despite some slight downward pressure. We see demand and supply technicals for the Asian credit market remaining favourable. However, given the current spread level and quality compression that has taken place, particularly on the HG side, some caution is warranted as we head into 2024 given the prevailing uncertainties.
We therefore head into 2024 with a slightly defensive view in terms of overall credit risk. We have a slight preference for taking greater credit exposure at the front-end considering the flatness of the credit curve. We believe outperformance can be derived from sectors that we believe will perform well despite the more challenging global backdrop. These sectors include Macau gaming, upstream oil & gas, India renewables and financial subordinated debt from strong jurisdictions such as Singapore and South Korea, while remaining cautious on the real estate sector. As always, credit selection within each sector and country will remain a key differentiator as well.
We see balanced risks to our base case scenario. One material downside risk is continued US economic resilience alongside a reacceleration of inflation dynamics, which could prolong the Fed’s rate hiking cycle. This would necessitate an even more defensive stance and outright caution regarding duration. On the other hand, a faster disinflation process with no hard landing in developed economies could see an early shift by global central banks towards monetary easing, which could support further spread compression across global credit markets. A stronger than expected recovery in China’s property market along with further thawing in US-China relations are other positive risk factors that could necessitate changes in outlooks as we progress through 2024.
* The forecast is not necessarily indicative of future performance
(1) Source: JP Morgan, Bloomberg, Dec 2023
(2) Source: JP Morgan, Bloomberg, Dec 2023
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