From inflation to growth concerns: A view of Asian markets
Global supply chain bottlenecks, energy shocks, squeezed real incomes, tighter financial conditions, a fresh Covid wave – the ship that is the global economy is probably too loaded down to hope for calm sailing.
New manufacturing orders have plunged and we have rapidly shifted from input scarcity to excess inventories in several sectors. After the sharp post-Covid rebound, industrial activity and international trade are likely to suffer in the second half of the year.
As a result, the ‘R’ word is on people’s lips again. Leading indicators are pointing towards a heightened risk of recession in the US, beginning in early 2023 based on economists’ consensus.
At the same time, the war in Ukraine continues to impact commodity prices. Gas and petrol prices are likely to keep fuelling inflation in the months ahead. Finding the right balance between tighter monetary policy to fight inflation and avoiding a recession will be challenging for central banks.
Chinese economy’s mild recovery
The Chinese economy is recovering from the April-May lockdowns as mobility restrictions are gradually lifted in major cities, including Shanghai. While further city-wide lockdowns may be avoided going forward, certain restrictive measures (such as a requirement to take frequent Covid tests) remain and will likely continue to constrain domestic demand in the near term. China’s second-quarter gross domestic product (GDP) disappoints with 0.4 per cent year-onyear expansion in Q2, but sequentially the economy contracted by 2.3 per cent quarter on quarter (seasonally adjusted). We have revised down our 2022 full-year GDP forecast for China to 3.2 per cent from 4 per cent previously.
The housing sector is showing initial signs of stabilisation on increasing policy support from local governments, although a strong rebound is unlikely given softening income and employment conditions.
Credit growth picked up noticeably in May, mainly driven by government bond issuance, while private credit demand, particularly mortgages and long-term corporate credit, has remained subdued so far.
Showing a clear sense of urgency, the government has announced more policy measures to stabilise growth. However, reduced tax receipts and falling land sales revenue have hit government coffers. We believe further stimulus will require more debt financing.
Jury still out on equities
A look at the equity risk premium (the premium for holding stocks over safe-haven government bonds) suggests stocks are strongly priced, despite recent drops in valuations. With central banks intent on curbing demand to rein in inflation, there is also a rising risk of an earnings recession. But investor sentiment has turned sufficiently negative to convince us to remain neutral on global stocks overall, and positive on individual defensive markets such as Switzerland.
We maintain our interest in quality growth stocks with good cash flow in areas such as pharmaceuticals. The challenges facing equities mean our focus also remains on sectors with robust income streams and dividend payouts.
So far, our Asian equity exposure has been focused on undervalued Asean equities. But we are switching to Chinese equities as Covid lockdowns in China are eased and fiscal stimulus to rekindle economic momentum kicks in. Policy pressure on certain sectors may also ease to help the Chinese economy’s recovery, and the downward trend in earnings forecasts has recently been halted.
Playing ongoing volatility and protecting portfolios remain the order of the day. We are still overweight liquidity and while yield opportunities are rising, we still see scope for low-duration, cash-enhancement solutions. Tactical options trades on all traditional asset classes remain pertinent, and can also be used tactically to deal with strong variations in commodity prices.
Asian corporate bonds: Avoiding the storm
Asian credits (ex Japan) have followed the sharp spread widening seen in the US market this year but, while still attractive, the premium Asian investment-grade (IG) bonds offer over their US counterparts has narrowed.
As the Chinese authorities have not yet softened the tough ‘3 red lines’ criteria they demand property companies respect, we remain generally wary of Asia high-yield (HY), despite the attractive carry. In fact, the elevated yields Asian HY bonds offer are a clear sign of funding stress, which could lead to insolvency.
We remain positive on Asian IG corporate bonds as the yield premium over their US counterpart is still attractive despite recent narrowing. We thus aim to keep ‘clipping coupons’.
We expect Asian IG spreads to tighten slightly from 230 basis points (bps) on Jun 24 towards 210 bps by year-end, supported by a fiscal stimulus-induced rebound in the Chinese economy.
EM equities: Red phoenix or red herring
While emerging-market (EM) equities corrected along with global markets generally in June, they actually outperformed developedmarket (DM) equities overall, in spite of another bout of US dollar strength. Asia stood out for its good relative performance, with China the only major EM market to post positive returns over the month.
Several factors have helped improve previously depressed investor sentiment towards Chinese equities.
A progressive economic reopening coupled with signs of easing regulatory pressure on Internet giants, additional stimulus measures and hopes of a partial lifting of Trump-era tariffs have all helped compress China’s risk premium, thus supporting equity prices.
The compression of Chinese stocks’ risk premium is a positive early signal, although earnings prospects remain grim due to the impact of Beijing’s zero-Covid policy. Nonetheless, the possibility that Chinese equities continue to diverge could make them an attractive play for the rest of this year, especially if global markets remain depressed.
Asia EM currencies: A reversal in the medium term
The increasing concerns over the global growth outlook and high commodity prices have weighed on Asian EM currencies (ex Japan), as Asian countries are especially sensitive to global trade and are mostly net importers of commodities. Deteriorating rate differentials with the US have not helped either.
The sharp depreciation of the Chinese yuan added to the headwinds facing Asian EM currencies in Q2.
Still, declining global risk appetite had less of a negative impact on Asian currencies than on their EM peers, as the former are seen as relatively less vulnerable to surges in global risk aversion.
Looking forward, our central scenario that the US Federal Reserve will not raise rates next year could limit the deteriorating rate differentials with the US.
Furthermore, thanks to fiscal stimulus, growth differentials should favour China over developed markets in the next few quarters, supporting Asian EM currencies.
Asian EM currencies have broadly weakened against the US dollar in recent months. While energy import costs may remain a challenge for Asian EM currencies in the short term, a peak in global rates and an improving growth outlook in China relative to the US could lead to a reversal of fortunes for these currencies in the medium term.