Asia Rates: Flows & Valuations (April 2022)

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April's US nominal and real rates trend are not conducive for foreign demand and inflows into Asia local currency government bonds. Faster-rising US Treasury (UST) nominal yields are reducing the relative attractiveness of Asian carry - Month to date, 10Y Asia-US yield differentials have already tightened 20-35bps. In the current context, where growth outlooks are being revised lower across the globe amidst global USD strength, prospects for EM Asia duration and currency gains are likely to be judged as low and insufficient to compensate global bond investors for the reduced carry. On US real yields, 10Y have surged 50bps in April and turned positive. Such sharp upward moves historically correlate with poor foreign inflows into Asia because it reflects hawkish repricing of Fed expectations. This report looks at recent foreign inflows into Asia equities and local currency government bonds to assess if they are indeed declining.

Since our March report, Asia ex-China local currency government bonds have significantly sold off, but it does not necessarily imply that valuations have cheapened. The reason is that bond-related risks have grown over the past four weeks, whether it is the Fed signaling an earlier start to balance sheet normalization, Asia inflation continuing to surprise to the upside, or the outlook around Asia's external balances appearing to be weakening. We have updated our bond valuation models by adjusting for recent increases in risk factors to assess if Asia bonds have cheapened or richened in April.

Equity Flows – ASEAN vs Non-ASEAN Split

The Asia trend of foreign outflows from East Asia/India equities contrasting with inflows into ASEAN equities extended into April, though the sizes of net flows are noticeably smaller compared to February and March. For China, offshore investors net sold USD1.0bn via Northbound Stock Connect in April month-to-date, much smaller than the net sale of USD7.1bn in March. In Indian equities, foreigners net sold USD1.7bn in April month-to-date, a seventh straight month of outflows. In South Korean equities, outflows by foreigners have been persistent since 2020, and this month saw net sell of USD3.0bn so far. As long as foreign investors continue to net sell Korean equities, it would be hard for us to turn bullish on Korean Treasury Bonds.

ASEAN equities are seeing more foreign buying in April month-to-date. Foreign net purchases of USD0.7bn in Indonesian equities are fairly large relative to its recent history. While net purchases of USD0.2bn in Thai equities and USD0.1bn in Malaysian equities are relatively small, the continued inflows are encouraging if we consider that foreign investors have persistently net sold these markets between 2018 and 2021.

Bond Flows – Large Foreign Outflows

As explained above, the global growth backdrop and US rates dynamics are unsupportive of foreign appetite for Asia local currency government bonds, and the latest flows data confirms that. Korean bonds are the only bond market to register an increase in foreign holdings in March – a USD2.4bn increase in KTB holdings more than offset a USD1.5bn decrease in MSB holdings. Korean bonds can be considered a regional haven, as they tend to see robust inflows (likely asset-swapped/fx-hedged) during times of uncertainty and weak risk sentiments.

There were large foreign outflows from the other bond markets in March. Most notably, foreign holdings of China’s CGBs and PBBs fell by USD8.2bn and USD6.3bn respectively, the extent of declines exceeding February sizes. CGBs are likely to see foreign holdings decline in the coming months as the CGBs' yield advantage has disappeared alongside this year's selloff in global bonds and expectations of aggressive rate cuts by PBOC are now low. Global bond investors will likely consider the outperformance potential of CGBs to be much smaller going forward.

The large foreign outflows from Thailand and Malaysia’s government and central bank bonds were likely due to domestic idiosyncratic developments. Foreign bond investors cut holdings of Malaysia MGS/MGII by USD1.0bn in March, likely due to bond duration concerns post the government's announcement of a new round of member withdrawals from EPF. Foreign investors cut holdings of Thai T-Bills/BOT bonds/ThaiGBs by a combined USD3.2bn in March, the largest in many years. As we had written in the March report, earlier in the year, there had been outsized foreign buying of shorter-tenor T-Bills and BOT bonds, likely to position for tourism recovery and a stronger currency. Some of those positions likely unwound in March as the travel prospects of two key tourist groups dimmed - Russian tourists because of financial sanctions on Russia and Chinese tourists because of COVID spread and lockdowns in China.

India GSecs saw an aggregate USD1.0 decline in foreign holdings across FAR and non-FAR bonds in March and a USD0.2bn decline in April month-to-date. Indonesia IndoGBs saw USD2.9bn of decline in foreign holdings in March, though it is encouraging that foreign selling pressures are abating in April.

10Y Asia Bond Yield Valuations – Broad Deterioration

Though 10Y Asia ex-China yields are higher by 25-35bps in April (China yields higher by 6bps), our valuation approaches suggest that 10Y bond valuations have deteriorated (richen) after we account for recent increases in the various risk factors.

Our ARVI indicator points to an across-the-board deterioration in valuations in April. The extent of deterioration was largest in Malaysia, China and Thailand bonds. Notably, China and India’s bonds have now turned rich in April, from slightly cheap in March. Thailand bond valuations stay the richest due to 10Y yield levels being anchored low by BOT's relative dovishness, while bonds in the rest of Asia have, to a larger extent, adjusted to higher DM yields. Even with April's richening, Malaysia, South Korea, Philippines and Indonesia bond valuations remain cheap by our indicator. Looking ahead, we see a low likelihood of our ARVI indicator rising in the near term (i.e., Asia bond valuations improve) due to our outlook of rising Asia-US inflation differentials and weaker Asia current accounts. By extension, the scope for Asia-US yield differentials to tighten ahead is likely low.

Our Yield Decomposition Approach (YDA) draws similar conclusions as our ARVI indicator. Excess risk premia (valuation buffer) embedded in Asia bonds have declined across all bonds in April, with the size of declines most significant in Thailand bonds and relatively more modest in Indonesia and India bonds. The broad decline in excess risk premia is primarily driven by the repricing higher of US real rates and, to a much smaller extent, repricing higher of Asia sovereign credit risks and Asia fx vols. Medium-term Asia inflation expectations appear to be generally unchanged month-on-month and have not contributed to the decline in excess risk premia. In terms of rich/cheap calls, same with our ARVI indicator, our YDA approach suggests that Malaysia, South Korea and Indonesia bonds are cheap while China and India’s bonds are slightly rich. The key difference between our ARVI vs YDA calls is in the case of Thailand bonds, where ARVI sees as extremely rich while YDA sees as slightly cheap. We think the chief reason for the difference is because YDA doesn't explicitly factor in changes in Thailand's current account dynamics (which have deteriorated post-pandemic) while ARVI does. Therefore, for Thailand bonds, we are leaning more towards ARVI's call and see Thailand bonds as quite rich.

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