Asia Rates: Flows, Positioning & Valuation (February 2023)

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A string of upside surprises to labor and price data this month have reversed the narrative on Fed rate path and weighed on risk appetite for Asia assets. Repricing for the Fed to end its cycle at a higher rate and hold for longer continues to run, and while Fed uncertainty stays high, global investors are likely to stay on the sidelines or sell to take profit after the large Asia rally between November and January. It doesn't help that the China reopening/recovery trade is also losing momentum, due to the recent lack of positive news/catalysts. We are already seeing signs of flows reversing out of Asia equities and bonds, and that is likely to extend in the near-term. Positioning on Asia bonds and FX should be less of a concern in terms of the associated risk of sharp market moves, as investors have generally been underweight Asia in recent months.

Despite the less positive macro backdrop and outlook, we think investors should look for dip opportunities to selectively buy into Asia bonds. For bond investors who had missed out on the November-January rally, February's pullback creates better entry levels compared to start of the year. As we have written in our Annual Outlook, Korea KTBs and ThaiGBs are two regional bonds where we hold an overweight stance coming into 2023. February's bounce in KTB yields, largely a beta move to rising US rates, provides a much-improved entry level and greater scope for duration gains. On ThaiGBs, the Baht remains a constructive story (tourism recovery, lower transport deficit) and though there are some concerns around demand-led inflation, we think BOT would be more cautious about the overall growth recovery and hike rates by less than priced.

Bond and Equity Flows

The outlook for foreign inflows into Asia local currency government bonds is turning less positive. Increased uncertainty around peak Fed rates and re-emergence of USD strength are key near-term headwinds, but there are also other negative structural factors, including geopolitics and relative bond valuations. 10Y US Treasurys are now back at around 4.0% yield and thus offer improved carry and risk-off hedge, compared to start of the year. Under these circumstances, it would be challenging to expect global investors to increase allocations to Asia bonds.

IndoGBs had seen three straight months of large foreign inflows between November and January. But in February month-to-date, the flows have flipped, and we are tracking USD0.4bn of outflows. While Fed uncertainty is high, appetite for EM carry/high-beta is likely to be suppressed. Fortunately, strong locals' demand has stepped in to replace foreign, helping IndoGBs to hold their price.

For China CGBs, foreign investors reduced their holdings by an outsized USD9.7bn in January - This is the largest monthly reduction in a few years. Our outlook is for outflow pressures to persist in coming months, largely due to geopolitics. Some international investors could choose to cut holdings further to limit tail risks arising from renewed US-China tensions. We also get the sense that investors' optimism on China recovery has waned, due to the recent lack of new positive catalysts or data. Meaning that more speculative investors could choose to take profit in the near-term.

Korean MSBs and KTBs saw declines in foreign holdings of USD2.6bn and USD1.9bn respectively, in January. Foreign holdings could move lower ahead, as the stock of outstanding MSBs have been on a downward trend and asset-swapped MSB and KTB yields have deteriorated due to recent tightening in cross-currency bases.

The one bright spot has been foreign inflows into Thailand bonds. In January, foreign holdings of T-bills increased by USD0.5bn, while that of government bonds increased by USD0.2bn. Foreign holdings of BOT bonds increased by USD0.6bn. Like November and December, inflows were primarily into shorter-duration T-bills and BOT bonds, certainly as a play on the tourism recovery and a stronger Thai Baht.

Outlook for foreign inflows into Asia equity markets are also weakening, just like for Asia bonds. Previously strong inflows into North Asia equities (China, South Korea) have significantly moderated in February. In February month-to-date, net purchases via Northbound Stock Connect amounted to a mere USD1.8bn, against January's massive USD20.9bn. Net purchases of Korean equities also moderated from January's USD5.2bn to USD1.3bn in February. The China reopening/recovery trade is clearly losing momentum, as investors express doubts about the strength and durability of China's recovery, especially as the property sector have yet to show clear turnaround signs.

Bond Valuations

Based on our valuation measures, excess risk premia in 10Y Asia bonds remain low compared to historical. On a relative peer-to-peer basis, Indonesia bonds are the cheapest and Thailand bonds are the richest. While 10Y US Treasury yields (risk-free benchmark) stay supported, it would be challenging for Asia bond valuations to cheapen ahead. Though Asia bond valuations are generally rich, the strength of bond demand from locals (who care less about external variables such as FX and US yields) could offset cheapening pressures.

Fund Positioning

In January, major EM bond funds maintained neutral positions on broad EM bond and EM FX exposures. At the regional level, funds remained UW on Asia bond (1% UW) and neutral on Asia FX exposures.

Focusing on Asia weights, the biggest month-on-month change in bond exposure was in IndoGBs where fund managers increased their OW to 0.7%, from 0.3% in December. For China CGBs and ThaiGBs, fund managers kept large UW exposures at 3.4% and 1.4% respectively. Positioning on Malaysia bonds stayed roughly neutral.

For Asia FX exposures, fund managers further trimmed their UW on CNY FX exposure to 1.5%, from 1.7% in December. Positioning on other Asia FX were kept roughly neutral.

Looking ahead, we could see a reversal in some of the recent trends in positioning. One, increased Fed uncertainty could see fund managers pause on raising their OW positions on IndoGB and IDR FX. The recent trend of fund managers increasing their UW on China CGB vs decreasing their UW on CNY FX could also reverse, as market confidence on the China reopening/recovery trade has been waning. We continue to be surprised that major EM bond funds are neutral on THB FX, despite the large amount of market optimism around Thailand's tourism recovery. This could suggest that the bullish market positioning on THB FX is currently being led by speculators/fast money, rather than by real money investors.

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