Fixed Income Investment Outlook 3Q 2023

The latest quarterly Fixed Income Investment Outlook from Value Partners, by Fixed Income Co-CIO Gordon IP.

The Outlook summarises ongoing developments in both US and China monetary policy, and factors influencing credit markets in both jurisdictions.

The environment requires caution, urges Gordon IP:

 “We remain cautious given ongoing challenges on the macro front, including periods of volatility, US recession risks, tightening liquidity, continuing geopolitical concerns, and China’s patchy growth recovery.”

US: Retaining A Tightening Bias Post Rate Skip In June

The US Fed paused its interest rate hikes in June, ending a series of 10 consecutive rate increases since March 2022. This should allow the central bank to consider the cumulative effect of monetary tightening on the economy. However, a slowing but still elevated inflation will unlikely derail the Fed’s tightening tone and does not preclude the Fed from resuming rate hikes later.

While US job and inflation data remain stubbornly high, we are mindful that they have started showing some signs of weakness. This may mean the path and timing of near-term rate hikes would be more unpredictable. In any case, we believe the massive monetary tightening, tighter credit conditions, and a softening labor market will weigh on the US economy and its growth outlook. Against this backdrop, we expect the US treasury yield to trend lower in the medium term.

China: Refocusing On Policy Fine-Tuning After A Transitory Rebound Faded

While the removal of Covid-related lockdowns and pent-up demand supported GDP growth in the first quarter of this year, economic momentum has moderated, and the property market remains sluggish. In addition, the financial health of local governments has attracted the attention of investors, given the sizeable year-on-year contraction in land sales, which is the biggest revenue source for many local governments. Deflation risks may heighten if economic activities and confidence fail to pick up. The slower growth trajectory has raised the possibility of further policy easing before and during the July Politburo meeting.

We expect the policy tone to remain supportive, but will be more targeted toward consumption. Monetary policies should stay accommodative to maintain a broadly stable liquidity environment. Other than the deposit rate cut and LPR cut in June, there could be further RRR and policy rate cuts. While the breadth and magnitude of rate cuts are developing, the government must balance their unwanted impacts on capital outflows, currency depreciation and banks’ financial health. Policy banks may also be called upon to support infrastructure investment and local governments. On the property front, further mobilization of the existing policies is likely, including the relaxation of home purchase restrictions and down payments or fine-tuning of financing rules introduced in late 2022. These might boost sentiment in the short term, but a major massive shift in the current economic and property policy remains unlikely.

Credit Strategy

We remain cautious given ongoing challenges on the macro front, including periods of volatility, US recession risks, tightening liquidity, continuing geopolitical concerns, and China’s patchy growth recovery.

After the rally in Asian US dollar bonds during the first quarter following China’s reopening and policy pivot towards the property sector, sentiment waned due to weakening economic data in China. That said, looking beyond the second quarter, we expect Asia’s overall economic recovery to remain on an improving path, given the region’s resilient domestic demand. China’s recovery trajectory should be on track, led by consumption, despite the short-to-medium-term economic uncertainties. Moreover, inflation in Asia continues to ease, which is an encouraging sign and may create room for policy easing in certain markets, such as Korea and India. On the other hand, we remain mindful of various risks, including the global economic slowdown, which could pose headwinds to the region’s export outlook, as well as China’s lagging growth – especially in the property sector – which may take some time to recover.

Sector Views  – Onshore China

The 10-year China Government Bond (CGB) yield dropped by 30 bps to 2.6% since March (as of mid-June, -18bps since the beginning of 2023) due to the country’s weaker growth momentum. Meanwhile, the 25% decline in local government land sales since the start of the year suggests stress has been building up. Local government financing vehicle (LGFV) debt roughly accounted for 13% of Chinese banks’ total assets as of Dec’22. However, we believe this should not pose systemic risks to banks as the central government will likely channel more support, though some loan restructuring cannot be ruled out with the banks’ non-performing loan (NPL) risks to be spread out in future years. Property and consumption activities also lack strength. Given this backdrop, we expect CGB yields will moderate and maintain at current levels. The yield level may move higher towards the fourth quarter, but that is also a function of reaction to policies and a sustainable demand recovery.

The lowered deposit rates and the policy rate cut in June suggested the government is concerned about an economic slowdown and deflationary pressures. Further easing will likely push the local currency weaker. For most of the first half this year, yields of the 5-year CGB (-68 to -166 bps) or the 10-year CGB (-44 to -118 bps) were inside that of US treasury yield, given the Fed’s hawkish stance. Depending on China’s policy response, a further rate cut may see the possibility of the 10-year CGB yield testing the 2020 lows at 2.4%. This could prolong the trend of a wider yield gap against the US.

 
The full report is available here.