Asia Rates: Flows, Positioning & Valuation (May 2022)
- Broad-based weakness in foreign appetite for Asia local currency govt bonds persisted into May.
- EM bond funds are clearly more bearish Asia vs more bullish other EM.
- Funds’ biggest bond underweight is in Thailand bonds. Biggest currency underweight is in CNY.
- Korea, Malaysia and Indonesia bonds screen slightly cheap while China and India bonds screen rich.
- Reversal of reopening theme see ASEAN equity inflows decline.
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There have been some tentative signs of stabilization in Asia local currency macro markets. However, it is probably too early to conclude that the worst is over. The multiple external headwinds that underpin weakness and outflows from EM assets since March, from hawkish Fed, Russia-Ukraine conflict to China slowdown and CNY depreciation worries have not gone away. A hawkish Fed and the fallout from Russia-Ukraine are likely to be with us for some time, and therefore, we are not expecting relief on those fronts anytime soon. We however think China is likely to be the decider - If Chinese growth and CNY prospects can turn around, that would be a boost to anchor Asia local currency markets via trade and financial linkages.
Asia central banks are finally starting to tilt hawkish and with it, easing market worries that Asia may be behind-the-curve. RBI hiked off-cycle, while the latest BOK, BNM and BSP hikes were against consensus. Fixed income returns are likely to be under pressure for some time as Asia central banks are still in the early stages of tightening and liquidity withdrawal. We think a proper recovery in fixed income returns is more likely to be later this year when China's outlook could be much improved, Asia inflation expectations could eventually catch up to actual prints and the DM hike cycle would be more advanced.
In this month's report, we monitor the latest foreign outflows from Asia bond/equity for signs of moderation. We add a new section on EM bond fund positioning to track how fund managers are positioned across EM bonds and currencies. We update our bond valuation models for recent increases in yield levels and fluctuations in risk factors to assess if Asia bonds have cheapened or richened.
Bond Flows – Foreign Appetite Still Weak
Broad-based weakness in foreign appetite for Asia local currency government bonds persisted into April and May. Unsurprisingly, South Korean bonds were the only bond market to register an increase in foreign holdings in April – a USD1.7bn increase in KTB holdings more than offset a USD1.2bn decrease in MSB holdings. Foreign demand for Korean bonds is likely supported by market perception that there is sufficient yield buffer from overpriced Bank of Korea rate hikes and during times of uncertainty and weak risk sentiments, KRW-USD cross-currency bases also allow for relatively cheap and stable hedging of FX exposures.
The rest of Asia bond markets continued to see foreign outflows in April. Most notably, foreign holdings of China’s CGBs and PBBs fell by USD6.5bn and USD6.3bn respectively, the size of declines moderated from March but were larger than February. China bonds are likely to face continued outflow pressures in the coming months, as the trend of yield differentials is expected to move against CGB/PBBs (vs in favor of global bonds), the diversification potential of CGB/PBBs is expected to weaken (due to smaller scope for yield declines) and CNY volatility could persist for some time.
Foreign holdings of Indonesia bonds fell by USD1.2bn in April and USD0.9bn in May month-to-date. As long as outflows from EM bond funds persist, IndoGBs' high weights in key benchmarks mean that fund managers would likely have to keep selling IndoGBs, even if they could actually be bullish IndoGBs and maintaining an overweight position in their portfolios.
In Malaysia bonds, foreigners cut MGS/MGII holdings by USD0.6bn in April, a second straight month of reduction. Foreigners could be somewhat disappointed by recent currency returns due to MYR's inability to benefit off a commodities-driven terms-of-trade boost. Prospects of elections being held this year could also be causing foreign bond investors to turn more cautious.
Across Thai GB/T-Bill/BOT bonds, foreign holdings were unchanged in April, after the outsized USD3.2bn of reduction in March. We think tourism recovery trades could return towards the end of 3Q and we should see a resultant pickup in foreign buying of Thai bonds.
Across India FAR and non-FAR bonds, foreigners continue to reduce holdings at a consistent monthly pace of around USD0.5-1.0bn. We think foreign flows could turnaround ahead as the Reserve Bank of India has recently pivoted hawkish and INR carry has sharply repriced higher and is significantly improved compared to start of the year.
Fund Positioning – Bearish Asia vs Bullish Other EM
Across bond and currency exposures, EM bond funds are clearly more bearish Asia vs more bullish other EM. Amongst the larger country weights, for bond exposures, fund managers' biggest underweight is in Thailand (2.1% UW), followed by Indonesia (0.5% UW) and Malaysia (0.4% UW). For currency exposures, fund managers' biggest underweight is in CNY (2.3% UW), followed by THB (1.1% UW). What's also notable is that, in April, fund managers had across-the-board reduced their exposures to Asian currencies. Especially in the CNY, where they significantly increased their underweight exposure from 1.1% UW in March to 2.3% UW in April. In contrast, fund managers appear to be quite bullish other EM bond markets - They hold moderately-sized overweight exposures in the bond and currencies of Brazil, South Africa and Mexico.
We think that EM bond fund managers' relative bearishness on Asia is primarily because the Asia region is generally still quite early in its rate hike cycles. Therefore, a peak in Asia bond yields is likely further out. In contrast, other EM countries such as Brazil and Mexico are more advanced in their hike cycles and by extension, have likely built more carry buffers. In addition, Brazil and South Africa are large commodity exporters while most of Asia are importers.
Fund cash levels decreased from 5.86% in March to 4.83% in April. Managers likely took advantage of the sharp cheapening in EM bond yields to deploy excess cash and add positions.
10Y Asia Bond Yield Valuations – Inflation Expectations Starting to Bite
Based on our Yield Decomposition Approach (YDA), with the exception of Thai bonds, excess risk premia (valuation buffer) embedded in 10Y Asia bonds have extended their declines in May. The extent of month-on-month deterioration in valuation buffers is relatively larger in South Korea, Malaysia and Indonesia bonds, and relatively more modest in China and India bonds. Against the regional trend, Thai bonds were able to see their valuation buffer slightly improve, primarily because of recent outsized increases in Thai yields (10Y higher by 35bps month-to-date). Unlike in April where higher US real rates were the chief cause, higher Asia inflation expectations were equally consequential in driving excess risk premia lower in May. In terms of rich/cheap calls, our YDA approach suggests that 10Y China and India bonds remain quite rich. 10Y South Korea, Malaysia and Indonesia bonds are still slightly cheap, but with their valuation buffers fast compressing, they are approaching fair value.
In May, our ARVI indicator points to an across-the-board improvement in 10Y Asia bond valuations (i.e. bonds are cheaper vs April). The simple reason for the difference in direction of month-on-month valuation changes between YDA and ARVI is because YDA models Asia bond valuations on a standalone basis while ARVI models Asia bond valuations against US Treasury. And in May month-to-date, 10Y US Treasury yields have declined by 15bps while 10Y Asia bond yields are generally risen (some by as much as 20-35bps).
Combining both our YDA and ARVI analysis, we think 10Y South Korea, Malaysia and Indonesia bonds screen as slightly cheap. On the other hand, 10Y China and India bonds screen as rich. There is some uncertainty around Thai bond valuations, primarily due to the difficulty of estimating the recovery timeline for the current account. Therefore, we refrain from making a rich/cheap call for 10Y Thai bonds.
Equity Flows – Reversal of Reopening Theme
The January-April trend of foreign outflows from East Asian/Indian equities contrasting with strong inflows into ASEAN equities saw some extent of reversal in May. We think this reflects investors' paring back of "reopening" trades due to recent global market volatility. Month-to-date, foreigners have net sold USD0.6bn of Indonesian equities vs April's large net purchase of USD2.8bn. In Thai equities, foreign net purchases slowed to USD0.1bn in May vs monthly average purchase of USD0.9bn in the first four months of the year. In Malaysian equities, foreign flows dipped into a small deficit of USD0.1bn in May, the first outflow month of the year.
For South Korean and Chinese equities, there has been some signs of stabilization of foreign sentiments in May. Foreigners have continued to net sell Korean equities, though the size (USD0.8bn month-to-date) is encouragingly small relative to prior months. In Chinese equities, offshore investors net bought USD0.8bn via Northbound Stock Connect, a second straight month of small inflows after March's outsized outflows of USD7.1bn.
In terms of foreign flows, Indian equities continue to face significant outflow pressures. Foreigners net sold USD4.1bn in May, a fifth straight month of large foreign selling.
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