Asia Rates: Flows, Positioning & Valuation (July 2022)
- Foreign bond outflow pressures did not ease in June
- Investors sold out of other regional bonds and increased allocation to South Korean bonds in June
- EM bond funds maintain broad underweight positioning on Asia duration and currency
- Fund managers increased the size of their underweight China duration position to 1.0% UW in June
- The richening trend for Asia bond valuations seems to have ended. Expect a cheapening trend in 2H
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Asia is hit by a combination of more aggressive global/regional rate hikes and US/Europe growth slowdown worries. With inflation prints yet to moderate in major economies, major central banks are expected to hike through 2H despite signs of softening economic activity. As external financial conditions tighten, outflow pressures around Asia equities and bonds could persist.
Asia inflation continues to rise and the window for tightening appears to be narrowing due to a weaker external demand outlook. Asia swaps are now pricing for more frontloading and the impending end of this hiking cycle. The front-end of Asia swap curves are flattening decisively with 1y1y-1y curve spreads sharply compressing 70-100bps over the last month. This contrasts with the persistent steepening from mid-2021 to mid-2022, where the front-end kept extrapolating hikes and building hike premium. Though Asia swaps are pricing for late-cycle dynamics, 10Y Asia bonds are not sufficiently cheap to buffer against the various possible late-cycle risks ahead of us. The richening trend of 1H seems to have ended and we expect a cheapening trend for 10Y Asia bonds in 2H.
Real money investors (EM bond funds) are still maintaining a broad underweight positioning on Asia duration and currency. From a technical perspective, the underweight positioning can be seen as a positive as real money will have to short-cover when the outlook for Asia local currency markets turns around or valuations get sufficiently attractive.
Bond Flows - Persistence of broad outflows, safe-haven Korea bonds the exception
There has been no easing up of foreign outflow pressures from Asia local currency government bonds. At this point, we are probably not quite at a turnaround in foreign appetite and sentiments towards regional bonds. In June, foreign holdings of China’s CGBs and PBBs fell by USD8.4bn and USD5.3bn respectively. Since March, the combined size of monthly declines in CGB and PBB foreign ownership has been in a tight USD12-15bn range, though the relative proportions between CGB and PBB outflows have varied. Looking ahead, we think the flow trajectory could get more volatile as foreign investor sentiments fluctuate between recovery optimism and renewed lockdown worries. There could also be flow volatility around news headlines of possible tariff rollbacks, which if it materializes, would be expected to boost total returns of CGB/PBB.
Foreign holdings of Indonesia IndoGBs continue to decline, by USD1.1bn in June and USD1.9bn in July month-to-date. Outflows from IndoGBs have been quite persistent since 4Q21, likely reflective of IndoGB's perceived higher beta to aggressive central bank rate hikes and the onset of global liquidity tightening. Earlier in the year, bond outflows were more than offset by equity inflows. But now that Indonesian equities are also seeing outflows, the financial flow outlook for Indonesia seems to be dimming.
Both Thai and Malaysia bonds saw fairly large outflows in June. Foreign investors reduced holdings of Malaysia MGS/MGII by USD1.0bn in June, though they marginally added USD0.1bn to their MTB/MITB holdings. They also cut their holdings of Thai bonds in June, by USD1.1bn of Treasury bills and bonds and USD0.1bn of BOT bonds. The inflows outlook for Thai bonds is likely to remain subdued, considering Thai yields remain one of the lowest in the EM bond universe.
Across India’s FAR and non-FAR bonds, foreigners have cut holdings for six straight months. Bond holdings were cut by USD0.5bn in June and USD0.2bn in July month-to-date.
When foreign bond investors were worried about global growth slowdown risks and broad dollar strength in June, they likely sold out of other regional bonds and increased allocation to South Korean bonds. South Korean bonds were the only regional bond market to register an increase in foreign holdings in June – a USD3.5bn increase in KTB holdings more than offset a USD1.0bn decrease in MSB holdings. Historically, South Korean bonds has tended to receive safe haven-type inflows during risk-off periods, likely reflective of the high beta of South Korean bond yields to US bond yields, and the relative ease of hedging out FX exposures.
Fund Positioning - Larger underweight in China duration, ZAR is now the second-biggest currency underweight
In June, EM bond funds remained largely underweight Asia vs overweight other EM heavyweights (such as Brazil, Mexico and South Africa). Amongst the larger country weights, for bond exposures, fund managers' biggest underweight is Thailand (1.8% UW), followed by China (1.0% UW) and Indonesia (0.6% UW). They also hold a moderate overweight position in Mexico bond exposure (0.9% OW). For currency exposures, fund managers' biggest underweight is in CNY (2.5% UW), followed by ZAR (1.5% UW) and THB (1.2% UW). On portfolio duration, fund managers were slightly underweight duration (4.77 vs benchmark 4.92 years). Cash levels fell to 2.87% at end-June from 3.63% at end-May. Considering that fund managers had generally reduced bond and currency exposures in June, we suspect the drop in cash levels was due to liquidity needs from client redemptions.
On an individual market level, we find it notable that fund managers significantly increased the size of their underweight China duration position from 0.3% UW in May to 1.0% UW in June. This is likely in recognition that the worst of China slowdown fears are likely behind us, and a 2H recovery means that China bond yields are likely to trend moderately higher. We find it slightly surprising that fund managers maintained their large underweight CNY positioning (2.5% UW) despite recent news around possible tariff rollback from the Biden administration.
Fund managers remain quite bearish Thai duration (1.8% UW) and the THB (1.2% UW). We think this is unlikely to change anytime soon, until we see Thai bond yields reprice to more EM-competitive levels and the tourism recovery gains much more momentum (correction in oil prices could help too).
We also note that fund managers seemed to have sharply downgraded their expectations for South Africa’s local markets, likely a result of the country's rapidly deteriorating economic outlook. They had significantly reduced their overweight duration position from 0.9% OW in May to 0.3% OW in June. On the ZAR, they sharply increased the size of underweight from 0.5% UW in May to 1.5% UW in June.
10Y Asia Bond Yield Valuations – Richening trend in 1H could reverse; expect cheaper Asia bonds in 2H
Based on our Yield Decomposition Approach (YDA), excess risk premia (valuation buffer) embedded in 10Y Asia bonds have halted their persistent declines over the last seven months (December 2021 to June 2022). In July, excess risk premia have instead modestly risen across the board (i.e., 10Y Asia bonds have slightly cheapened). In terms of global risk factors, a lower 10Y US real yield (25bps lower vs June) was supportive. In terms of regional risk factors, modestly lower forward inflation expectations and sovereign credit spread helped to boost excess risk premia. However, much higher Asia currency volatilities in July was a negative offset, the move underpinned by persistent and broad-based strength in the US dollar. Our YDA approach suggests that 10Y China bonds do not offer a positive excess risk premium and valuations remain the richest in Asia. 10Y South Korea, Thailand and India bonds screen as slightly rich. On the other hand, 10Y Malaysia and Indonesia bonds are still slightly cheap and offer some value.
Our ARVI metric also shows, in July, the same broad-based cheapening in 10Y Asia bond valuations.
Though 10Y Asia bond valuations are no longer richening and have modestly cheapened in July, they are still clearly far from very cheap levels that could warrant turning bullish based solely on valuation considerations. Considering the global stagflationary outlook and subdued appetite for EM assets in 2H, we are likely to see further cheapening of Asia bond valuations in 2H, likely via lower US real yields and/or higher Asia nominal yields. Closer to the end of 4Q or early next year, forward Asia inflation expectations could peak and help to boost valuation buffers.
Equity Flows - Asia ex China outflows ease in July; China outflows resume on renewed lockdown worries
Asia ex China equity outflows were historically large in June. Fortunately, outflow pressures appear to be easing in July. So far in July, the biggest flow improvement has been in India where foreign investors have net bought USD0.2bn of Indian equities. This compares favourably to the consistently large outflows seen in the January-June period (cumulative USD28.6bn of net sales). For Korean equities, foreign investors net bought USD0.8bn in July, after June's outsized net sale of USD4.8bn. Amongst Asia equities markets, both India and Korea saw much larger outflows in 1H, to the extent that those equity outflows weighed heavily on their respective balance of payments.
In ASEAN, the net change in foreign ownership of both Thai and Malaysian equities is close to flat in July. Considering that June was the only month of 2022 that registered foreign net sale, the flows outlook for both Thai and Malaysian equities appear to be relatively more resilient. For Indonesian equities, foreign net purchases in January-April period have reversed into net selling since then. Foreign investors net sold USD0.3bn in July, a third straight month of net sales.
In Chinese equities, offshore investors net sold USD3.3bn via Northbound Stock Connect, a partial reversal from June's outsized net purchases of USD10.9bn. As lockdown worries return and stability risks in the property sector have grown in July, the outlook for further price outperformance of Chinese equities is likely judged to have weakened.
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