Asia Rates: Flows, Positioning & Valuation (November 2022)
- Peaking Fed expectations and China reopening optimism provide a conducive environment
- Indonesia and India government bonds are seeing larger-than-usual foreign inflows in November
- China-US yield differentials should improve. We have seen the worst of outflows from China bonds
- Large underweight positioning on Thailand contributed to the recent outsized rallies
- Valuation headwinds suggest that Asia government bonds could lag the recovery in returns
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Broad risk sentiments towards Asia assets have been supported of late and we are seeing a pick-up in inflows into Asia equities and bonds. The latest US inflation print shows a decline and downside surprise, encouraging market expectations that US inflation would continue to fall in 2023 and the US Fed is approaching the end of this hike cycle. Growth-positive news out of China, particularly the shift towards more targeted COVID measures and support announcements for the property sector, are boosting market optimism that China is moving closer to reopening and growth is on an upward trajectory from here.
From the perspective of broader Asia region, November's large pullback in broad USD and US rates volatility, due to peaking Fed expectations, provides a conducive environment for Asia bond markets to recover into year-end. China's gradual reopening and improving domestic demand prospects would also have positive spillovers to the rest of the region via trade and tourism, boosting prospects for bond total returns.
Bond and Equity Flows
For foreign inflows into Asia bonds, we have high frequency data only for the high yielders - Indonesia and India. Both are seeing larger-than-usual foreign inflows in November. Month-to-date, there has been USD0.7bn increase in foreign holdings of IndoGBs, representing the largest monthly increase in 14 months. For GSecs, foreign holdings of FAR and non-FAR bonds have risen by USD0.3bn and USD0.2bn respectively in November. Combined inflows are larger than earlier in the year when index inclusion expectations ran high. The larger-than-usual inflows into IndoGBs and GSecs should suggest that other Asia government bonds such as Korea KTBs and Thai LBs are also seeing strong inflows in November.
Specifically for China CGBs, we have likely seen the worst of outflows. CGB yields are firmly on an upward trajectory while UST yields appearing to be peaking, suggesting the CH-US yield differentials would widen from here and be less of a drag on foreign appetite for CGBs. In October, foreign holdings showed a smaller contraction compared to September - CGB holdings fell USD0.8bn and PBB holdings fell USD2.7bn. We don't expect foreign investors to rush back into CGBs, but they should gradually return on higher CGB yields and China's improving cyclical outlook.
For Asia equities, foreign inflows into Chinese (via Northbound Connect) and Korean equities have been large, while inflows into Indian and Thai equities are relatively moderate. Rest of ASEAN (Indonesian, Malaysian) equities are seeing small outflows. There appears to be a rotation away from Indonesia and Malaysia markets which are more domestically oriented economies and have positive exposures to broad commodity prices, and towards markets that would more directly benefit from China's reopening and recovery. Such as Thailand due to large composition of Chinese tourists, and Korea via higher trade exposure with China.
Based on our valuation measures, risk premia in Asia bonds are low and valuations lean expensive across the board. Compared to peers in other EM regions (LATAM, CEE), Asia central banks have certainly not hiked as early and as much. Post an eventual peak in broad USD and US rates, valuation headwinds suggest that Asia bonds could lag the recovery in returns, compared to other EM bonds.
In October, EM LC bond funds increased their underweight bond position on China CGBs, to 1.9% from 1.3% in September. Conversely, they reduced their underweight bond position on Thai LBs, to 1.7% from 2.2% in September. Asia FX positions were relatively unchanged. Funds continue to underweight Asia, seemingly to also offset the overweights they run for Mexico, Brazil and South Africa.
We do not have funds data yet for November but would make some forward projections. Large underweight positioning on Thailand, in both bond and FX exposures, likely contributed to the recent outsized rallies seen in Thai LBs and THB FX. Coming into November, underweight positioning was also quite large for China CGBs and CNY FX, but they have rallied less compared to other index members. Despite the improvement in China' cyclical outlook, recent high COVID cases and intensifying risks of lockdowns is likely to make the reopening process a bumpy one. Fund managers are likely still cautious on China and have not rushed to cover their underweight positioning.
Recent developments are encouraging; we suggest paring back of underweight Asia positions. We don't think we can comfortably say that we are already at an inflection point and Asia bond inflows and returns would rebound from here. We are also cognizant that all it takes is another strong US CPI or jobs print to swing the market narrative back to sticky US inflation and higher Fed terminal rate.
Korea KTBs and Thai LBs should outperform ahead due to a high-beta to US rates (that are peaking) and larger trade/tourism exposures with China.
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