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Opportunities in the midst of crises

John Woods
John Woods10/21/2021 09:32 AM GMT+08  • 9 min read
Opportunities in the midst of crises
John Woods, CIO Asia Pacific at Credit Suisse, sees investment opportunities amidst the volatile environment.
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While we recognise that some near-term risks remain, we retain the view that the global economy is likely to continue to expand, fuelled by an acceleration in global industrial production. We believe that September’s nonfarm payrolls number — albeit disappointing — will be sufficient to keep the US Federal Reserve (Fed) on track to announce the start of a tapering of their asset purchases at the November meeting. The recent deceleration in US Covid-19 contagion and a pickup in high-frequency activity indicators suggest that payrolls should reaccelerate in coming months.

With supply-side bottlenecks proving more enduring than initially thought, the Fed and the European Central Bank are likely to keep liquidity conditions accommodative, helping to keep the growth environment favourable. We have thus tactically increased our portfolio allocation to developed market equities, implying a mild overweight in equities overall in a portfolio context. We keep emerging market equities at neutral even though the year-to-date decline in China’s equity market hints at an attractive recovery potential in the medium term.

For now, though, the confluence of China’s property sector jitters, power supply disruptions, regulatory regime uncertainty and sluggish consumption recovery constitutes meaningful downside risk to Chinese growth. In this environment, China’s policymakers could well resist meaningful appreciation in the yuan (CNY) to support the external growth engine.

Asian equities: Remain constructive

A cluster of negative news-flow has led to falls in global and Asian equities over the past one month, with rising energy prices and higher bond yields taking centre stage at the global level. In China, recent power shortages and manufacturing production shutdowns have added to regulatory changes to cloud earnings prospects. Consequently, earnings revisions for the broader region have turned negative over the past month.

Meanwhile, moderation in new Covid-19 cases has allowed signs of economic recovery to emerge and made equity markets relatively resilient. We maintain the view that the global economy will continue to grow at an above-trend rate in 2022. Asia’s industrial production is also expected to rebound in the coming months as supply-side constraints abate, aiding investor risk appetite. Our economic outlook combines with Asian equities trading at a 12-month forward price-to-earnings ratio discount to global equities of about one standard deviation to their history, leading us to continue to expect positive returns for regional equities over the next 3–6 months.

South Korean equities expected to outperform

South Korea remains our preferred market in Asia as it stands to benefit the most from a rebound in industrial production. The last month witnessed increased volatility due to a spike in US yields — leading to a repricing of growth stocks — and new regulations targeting FinTech activities of Internet platforms. We believe the latter is idiosyncratic and already priced in given a 25% reduction in 12-month forward EPS since early September for the communications sector.

We remain constructive on the semiconductor sector, which accounts for over 40% of the MSCI Korea. Key chipmakers have been providing guidance of stable DRAM prices, citing strong demand from server and mobile customers, lean inventories and limited production growth. Furthermore, relative to other emerging markets, South Korea trades below its 10-year historical average across a range of valuation metrics, offering a good risk-reward for investors.

Hong Kong no longer expected to underperform

The recent 6% fall in Hong Kong equities — an underperformance of 3.2% against developed markets — over the past one month provides us with a good opportunity to return to a neutral allocation in Hong Kong equities in a portfolio context. The main sources of weakness were fears of spillover onto Hong Kong’s insurance and property sector from property tightening policies in mainland China and regulatory risks for Macau casinos. We believe, however, that the risks of a tightening in property sector policies in Hong Kong are limited. In fact, the local property sector is also likely to benefit from the recently unveiled urban development plan. In addition, we expect limited contagion impact from the Evergrande issue on Hong Kong corporates.

Asia fixed income: Discerningly constructive over the medium term

We remain constructive — but also highly selective — on Asian fixed income over the medium term, with a preference for CNY government bonds and Asian investment grade (IG) credits. Both asset classes offer robust fundamentals, a healthy yield premium over developed market peers and have been relatively resilient to the recent market volatility. Over the next 12 months, we forecast CNY government bonds and Asian IG to deliver (in USD terms) returns of 3% and 2%, respectively.

We have turned more cautious on Chinese and Asia high yield (HY), as we believe the current market volatility is likely to persist in the near term. The Chinese authorities’ current deleveraging stance is unlikely to ease over the next 3–6 months and idiosyncratic risk events may episodically recur. Thus, we believe investors should derisk their Chinese HY portfolios and consider reinvesting the proceeds in global senior loans, which offer a better risk-reward tradeoff.

Asia investment grade: Expect 2% return over next 12 months

Asia investment grade has remained resilient through the recent bout of volatility in the high yield space, mainly on account of its robust fundamentals. Asia investment grade’s net-debt/ ebitda remained stable at 2.1x even as other regions experienced increases.

We believe that the risk of extreme volatility will be contained by the Chinese authorities’ likely support of systemically important entities in order to minimise contagion risks. Furthermore, Asia investment grade’s low duration of 4.6 years, versus US investment grade’s 8.8 years, should limit the downside from a potential rise in US Treasury yields in the coming months. We maintain our 12-month total return forecast at a modest 2%.

Asian high yield bonds: De-risk Chinese high yield bonds

Asian and Chinese HY bonds came under pressure in the last few months on growing concerns over the Chinese real estate sector, and we believe this is likely to persist in the near term. The Chinese authorities’ current deleveraging stance is unlikely to ease soon and idiosyncratic risks may persist for longer than initially thought. Thus the elevated level of concern in financial markets — about higher default rates — might now prove more enduring.

As such, Chinese authorities are unlikely to countenance any meaningful contagion risks to the economy, and we therefore see risks as more idiosyncratic than systemic in nature. Property prices are likely to be managed such that they are stable or trend modestly lower in an orderly fashion. This implies that consolidation of the sector is likely to continue, with further defaults of smaller companies and a managed intervention by authorities of larger companies — if the spillover risks or threatens local stability.

Nevertheless, the market reaction clearly suggests that China’s property sector has been fundamentally downgraded, re-priced and de-rated. The message seems to be that China’s 30- year property boom is finally over as defaults rise and property developers do not enjoy the same level of government support that they once had. Thus, we prefer to de-risk Chinese HY portfolios, with the proceeds reinvested in global senior loans, which offer a better risk-reward tradeoff.

Chinese HC sovereigns: Expected to outperform EM

We expect Chinese hard currency (HC) sovereign bonds to outperform their emerging market (EM) peers and project a 3% return over the next 12 months. Chinese bonds have a lower duration than the EM benchmark. Moreover, spreads are still relatively generous considering that China’s sovereign debt metrics remain robust — China has large foreign exchange reserves, low external debt and a strong growth outlook. Investor sentiment is likely to improve on the back of continued government support for strategically important entities.

Chinese local currency sovereign bonds: Expect 3% returns over next 12 months

The People’s Bank of China (PBoC) is likely to maintain a moderate loosening bias in its monetary policy stance after a surprise 50 basis point cut to the reserve requirement ratio. That said, we reduce our total return forecast to 3% in USD terms over the next 12 months and recently neutralised our previously positive view on the CNY. In line with these expectations, we maintain a neutral view on all Asia ex-China sovereign bonds.

Asia FX: Weighed down in the near term

The USD’s resilience looks like it might persist for a while as risk aversion seems likely to remain slightly elevated in the near term. Higher energy prices and the uncertainty emanating from China are likely to impose twin drags on most Asian currencies, albeit to different degrees. A key differentiator will also be the potential for disruptions to the economy and exports from Covid-19. We have thus raised most of our USD/Asia currency forecasts. Nevertheless, healthy current account balances are likely to limit broad foreign exchange (FX) weakness in Asia, though some individual currencies might be somewhat more vulnerable.

Turn neutral on CNY on policy risk

The potential for a preemptive response to the slew of growth risks — jitters in the property sector, disruptive regulatory change and power supply constraints — has led us to move from positive to neutral on the CNY, and shift our forecasts of 6.46 and 6.45 over three months and 12 months China’s resilient trade and current account still support the CNY, but a preemptive policy shift from the PBoC would likely serve to prevent meaningful appreciation.

To be clear, we do not expect the authorities to cause a sharp depreciation in the CNY, given that it might spark panic in financial markets. The strength of the basic balance (current account plus net foreign direct investment) means engineering outright depreciation against the USD would require larger amounts of reserve accumulation. More likely, the USD/CNY trajectory might be flattened out, allowing for the trade weighted CNY to gradually fall if the USD loses ground against G10 FX in the medium term.

MYR expected to underperform

We remain negative on the Malaysian ringgit (MYR) and adjust our USD/MYR 3M and 12M targets to 4.21 and 4.18, respectively. We remain concerned that the MYR might underperform its Asian counterparts in the near term due to the drag on both the current account and portfolio flows from the lingering disruptions to exports, and concerns about fiscal slippage. We note that the rebound in the August trade balance was mostly due to a falloff in imports, with exports remaining weak.

John Woods is chief investment officer Asia Pacific at Credit Suisse

Photo: Bloomberg

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