Investing in Asia Pacific: Focus on carry

A monthly guide to investing in Asia Pacific financial markets

The truce between Presidents Xi Jinping and Donald Trump at the G20 summit was expected, though President Trump’s recent trade threats are a reminder that the conflict remains far from resolved and that investors need to stay alert. Central bank easing has also gained pace globally, with Federal Reserve Chair Mr. Jerome Powell recently relaying that the Fed stands ready to ease policy in order to prolong the current growth cycle.

Financial markets have responded favorably – the S&P 500 (+19% YTD) has hit new highs and the MSCI Asia ex-Japan Index (+9% YTD) has rebounded from May lows. The correlation between equities and bonds has also turned positive in recent weeks, underscoring the Fed’s role in steering sentiment. We expect the Fed to cut rates by 50bps in July, but if it disappoints expectations, Treasury yields could bounce. Also, it remains to be seen whether looser monetary policies would reinvigorate growth or just stabilize it.

Against this backdrop of an even lower-for-longer rate environment, we focus our attention on carry trades and income-enhancement strategies.

Against this backdrop of an even lower-for-longer rate environment, we focus our attention on carry trades and income-enhancement strategies. Furthermore, given central banks’ differing capacities to ease, we emphasize relative value trades and diversification. In our Asia TAA, we add an overweight position on JACI high yield (HY) versus US government bonds for carry. Thematically, we prefer high-yielding stocks given the gap between regional dividend and bond yields – which is now close to levels last seen in late 2015, when high-yield Asian stocks started to significantly outperform their peers.

Can central banks extend the cycle?

Whether the cycle gets extended depends not just on how central banks move from here, but if markets are expecting too much.

Indeed, central banks’ capacity to boost global growth may be limited, as a quarter of global bonds are already yielding negative returns. Alongside the Fed, we now expect the European Central Bank to cut rates in September and December and Australia and New Zealand’s central banks to cut again later this year. The Bank of Japan, on the other hand, faces clear constraints to further easing (lowering rates further could cause unintended harm on the banking sector, for instance).

Asia’s central banks will likely follow suit but to varying degrees - India, Indonesia and the Philippines are likely to reduce the most (by 75bps) in 2H19. We also expect Singapore’s central bank to ease policy after weak 2Q growth numbers. Elsewhere, lingering macro-prudential concerns have made officials in China, Korea, and Thailand reluctant to ease aggressively.

In China, while domestic interest rates should be held steady, we anticipate an additional 100–200bps of cuts to the reserve requirement ratio and, if needed, targeted liquidity operations to lift funding for certain sectors. Also, as leverage is elevated, fiscal policy – via additional tax cuts and infrastructure spending – will likely assume a more prominent role in 2H. Beijing has already cut the VAT by 3ppt for manufacturing industries (to 13%), relaxed pension contributions, and might increase the annual local government credit quota further to support local government projects.

Macro indicators still mixed

Weakness in industrial production (IP), caused by weak capex and new orders, has been more persistent in Asia and globally than expected – the June global manufacturing PMI fell to its lowest level since 2012. But the latest activity readings from the US beat expectations, and we anticipate a modest seasonal pick-up in global tech earnings, which is critical for industrial and trade cycles in Asia, into 4Q.

In China, 2Q GDP growth, as anticipated, slowed to 6.2% y/y from 6.4% y/y in 1Q. However, June activity data surprised positively – IP and fixed-asset investment both jumped to 6.3% from 5.0% and 4.3%, respectively – and the weakness in IP has not led to recessionary outcomes in service-related sectors; service sector growth is running about 100bps faster than headline GDP growth in China as well as in India, Indonesia, and the Philippines. Retail sales also bounced, though much of this was related to autos and discounting ahead of changes to emission standards. While this momentum probably won’t last, policy easing and favorable base effects should kick in by 4Q.

Asia TAA: Adding risk via credit

After staying defensive for two months, we add risk via our new overweight position on JACI HY (vs. US government bonds). JACI HY offers around 500bps of extra carry over US government bonds per year at the moment, versus the 10-year average of 436bps, and is 2.5 years shorter in duration, making the trade somewhat defensive if the Fed disappoints. For equities, we remain overweight China versus Hong Kong and overweight Malaysia versus Thailand. We also hold an out-of-the-money call option on the Taiwan stock market. In FX, we maintain our long IDRPHP, which offers 300bps of carry, but close our long SGDTHB. We remain overweight Japan versus Eurozone stocks in our global tactical asset allocation.

Asset classes

Equities

Asia ex-Japan valuations look fair at 1.5x P/B. But given the elevated dividend-to-bond yield spread, low gearing, and subdued capex, we expect stocks with strong balance sheets and a track record of reliable payouts to do well. We prefer stocks with a yield of 3% or better. By market, Taiwan, Singapore, Hong Kong, and Thailand look the most attractive.

Bottom-up, we prefer defensive industries with predictable cash flows like telecom operators in Hong Kong, Thailand, Korea, Malaysia, and Indonesia, as well as select utility companies in Hong Kong and Thailand. Two exceptions are Singapore, where we favor banks over more expensive REITs, and Taiwan, where we prefer select petrochemicals and some technology names (see our AxJ Focus 20).

Credit

Lower US rates have offset the drag from trade tensions, but given the strong performance in Asia this year, returns in 2H will likely be limited to carry – for 2H19, we forecast total returns of 2–3% for HY and 0–1% for IG. Hence, in HY, we suggest good quality Chinese property names and perpetuals with strong coupon step-up features, and avoid idiosyncratic risks of single B rated issues. In IG, given the stable fundamentals, we trade quality for yield, focusing on BBB rated bonds and some perpetuals, like Chinese government-related issuers.

FX

APAC currencies have been generally stable since the G20 ceasefire. In the short term, we see the asset class taking its cues from the Fed and Mr. Powell’s comments. USDCNY should be largely range-bound between 6.7 and 7.1 over the next 12 months. We close our underweight AUDUSD in our global TAA, and expect USDJPY to fall further towards 105 over the next six months.

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Written with Mark Haefele, our Chief Investment Officer.

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