Price pressures in Asia have eased and remain benign overall, allowing many central banks in the region to pause their tightening cycles and evaluate when to start cutting rates. Although inflation globally has trended meaningfully lower in recent months, the strength of the US labor market has compelled the Federal Reserve (Fed) to remain on its tightening path.
abrdn’s Global Macro Research is forecasting that the US economy will enter recession over the medium term as companies and consumers feel the pinch of elevated interest rates. High rates have made holding cash a profitable trade, creating inertia for investors to move into credit or longer-dated bonds. However, the Fed will need to normalize rates at some point, especially if the US economy starts to slow in line with consensus forecasts.
US data to end-August on job openings, unemployment rate, and wage growth indicate that high rates may finally be cooling the jobs market – implying the Fed is at or near the peak of a rate-hiking cycle which began in March 2022. That increases the imperative for investors to act and lock in longer-dated yields to capitalize on an evolving rate environment and potential increase in market volatility. The key question for investors surrounds timing.
We believe the higher yields on offer in Asia’s credit markets as attractive, giving investors the chance to build portfolio duration via exposure to a region with strong growth potential.
Drivers of return
Commentators have pointed to 2024 as “the year of fixed income”. Certainly, changes in interest rates promise to be a major driver of returns, most notably in the investment grade segment where investors stand to benefit from higher quality credits subject to fewer risks.
Asia's credit markets offer exposure to dynamic economies with strong growth potential and include high-quality global issuers. The investment-grade segment comprises state-owned enterprises and well-capitalized issuers with good bank relationships and access to funding – key factors to power them through a downturn.
The US dollar Asian credit market has generated a return of 3.28% year-to-end-August, beating the Barclays Global Aggregate Index (0.74%), Bloomberg US Corporate Bond Index (2.76%), and equities counterpart the MSCI Asia ex-Japan Index (2.55%). It has delivered attractive risk-adjusted returns over the past 10 years (Chart 1).
Chart 1. 10-year risk-return profile
Source: abrdn, Bloomberg, June 2023.
With Asian credit yields touching multi-year highs – one of the most attractive entry points for the asset class in recent memory – only makes the investment opportunity that much more compelling.
Chart 2. JADI spread vs. yield
Source: Bloomberg, JP Morgan, July 2023.
Yet, despite this relative outperformance, Asian credit remains under-owned by investors internationally, with many only gaining exposure to the asset class via allocations to broader emerging markets.
Quality is key
Given high funding costs and economic overhangs, the liquidity and ability of companies to refinance will be key for investors to keep tabs on – challenges that we believe are better navigated by strong issuers and those with more stable credit profiles. As such, we see value in moving up the quality spectrum in Asian credit.
We are less bearish on the outlook for China's economy than some. We don't see major contagion risks from debt problems in its real estate sector, with the government working to boost its domestic economy. It's worth remembering that the government has capacity to change policy quickly, which can have rapid ramifications for the market. Understanding policy direction in China is critical, and some companies remain well-placed to benefit from government support. Policy rhetoric has troughed, and we see headwinds turning into tailwinds as the government focuses on developing segments such as artificial intelligence and a domestic technology ecosystem. Lastly, we see potential value in China's tech sector, which houses some of the nation's biggest firms.
We also see potential value in Korea's A-rated US dollar credit market on a relative and historical basis. A large proportion of these issuers are state-owned enterprises, which are closely tied to the government's credit risk. Concerns about credit risks in Korea's bond market have driven a widening in spreads in the financial sector. But proactive measures from the regulator and well-capitalized balance sheets suggest the risks are contained – pointing to an investment opportunity.
We see some attractive opportunities in high-yield, where our preference remains for subordinated paper from stronger issuers, or issuers that benefit from recurring contractual cash flows such as renewable energy projects and gas utilities. We view this as a way to increase income potential while navigating challenges from high funding costs and a prospective increase in volatility.
The prospect of a US recession allied to a stuttering Chinese economy has seen many Asian policymakers pause rate hikes and look towards easing monetary conditions. That increases the imperative for bond investors to act, or at least prepare to act.
With Asian credit yields at multi-year highs and a peak in US interest rates likely on the horizon, this offers an opportunity for investors to lock in yields ahead of a potentially lower rate environment. Asian credit also offers potential portfolio diversification benefits, with global exposure to the asset class low.
Ultimately, investors could take this chance to transition out of cash to buy quality Asian credits with high relative yields that we believe are better positioned to ride out a downcycle. This may very well be a potential window of opportunity that, we believe, investors may want to take advantage of.
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