SUMMARY
- In 2018, we expect a continuation of the gradual, deliberate and controlled slowdown of China’s economy as new policymakers continue to focus on systemic risk control and deleveraging rather than growth.
- Indonesia has been a strong credit recovery story. While we believe the fundamentals continue to support a core duration and foreign exchange position in Indonesia, we are closely monitoring some longer-term risks.
- Global investors will likely continue to be attracted to India’s high growth. In the coming year, we expect more volatile trading conditions, so investors will likely be sizing their positions more carefully.
Emerging Asia’s bond markets sprang to life in 2017, and new issuance helped draw more investment flows to the region. Despite a likely slowdown in China’s economy in the year ahead, we expect strong issuance again in 2018 and see attractive opportunities for investors in Asia, particularly in India and Indonesia.
About US$103 billion flowed into emerging Asia in 2017 by our estimate, up sharply from US$50 billion in 2016, with fixed income inflows outweighing equity by more than two to one. Asian corporate bonds, in particular, were a strong draw: Gross supply climbed to around US$290 billion, far exceeding 2016 new issuance of US$169 billion. According to J.P. Morgan research, 2018 should see similar healthy supply. Asian bonds also continued to perform well, with the J.P. Morgan Asia Credit Index (JACI) delivering a healthy 5.78% in 2017, down slightly from the 5.81% seen in 2016.
Nominal growth in Asia is likely to pick up in 2018, reflecting some recovery in real GDP and a gradual rise in inflation.
China’s controlled deceleration
China’s political story over the past three months has revolved around continued centralization of power under President Xi Jinping following the 19th National Communist Party Congress in October 2017. In 2018, we expect a continuation of the gradual, deliberate and controlled slowdown of China’s economy as new policymakers continue to focus on systemic risk control and deleveraging rather than growth. In fact, we think GDP growth may well slow to a below-consensus 6.25% this year from 6.7% in 2017.
China’s government is likely to maintain its hawkish stance on monetary policy and financial regulation, with further regulatory curbs on shadow banking and property. We also expect inflation to accelerate to 2.5% on stronger core inflation and higher oil prices, which should induce the People’s Bank of China (PBOC) to continue tightening policy by raising official interest rates. (The consensus expectation is no hikes in 2018.)
For all these reasons, we remain neutral on China’s currency and rates even though duration may look undervalued based on various metrics. Over the medium term, China’s net-flow backdrop will likely remain challenging amid the longer-term, structural trend of local investors diversifying into foreign assets. This implies higher currency depreciation risk going forward.
Following China’s first sovereign bond issuance in 13 years in October 2017, the National Development and Reform Commission (NDRC) loosened the approval process for Chinese issuers to sell bonds offshore. With onshore rates increasing, we now expect onshore issuers will prefer to issue offshore to access cheaper funding costs. Given this dynamic, onshore bonds are likely to be more attractively priced than offshore U.S. dollar-denominated Chinese bonds.
While our base case is that China’s slowdown will continue to be gradual, there are risks to this outlook. Newer policymakers appointed at the recent Party Congress may be less experienced, leading to the potential for policy errors or miscalculations. Liquidity events in the somewhat opaque renminbi (RMB) 50-trillion shadow banking system and RMB 70-trillion bond markets cannot be ruled out. Geopolitical concerns, particularly surrounding North Korea, U.S.-China tensions and uncertainty relating to U.S. President Donald Trump’s trade policy intentions all have the potential to be disruptive for the region.
Indonesia: attractive for now
Indonesia has been a strong credit recovery story. While we believe the fundamentals continue to support a core duration and foreign exchange position in Indonesia, we are closely monitoring some longer-term risks.
Following a recent research trip to the country, we believe the fundamentals continue to be broadly positive. Bank Indonesia (BI) has been building significant foreign exchange reserves, and the current account deficit has narrowed to a more sustainable level. Stable external debt dynamics and fiscal discipline supported Indonesia’s upgrade to investment grade by S&P in May.
Headline inflation, as measured by the consumer price index (CPI), has slowed from 8% to 4% and is now safely within BI’s target range. The cyclical drivers of this inflation drop were lower oil and food prices combined with a negative output gap (actual GDP is less than the estimated potential level). GDP is growing at 5.0%–5.5%, below the 6% goal that President Joko Widodo has been promising in the lead-up to provincial elections in Q2 2018.
With slower-than-desired growth and inflation currently contained, we expect BI to maintain a dovish bias. The bank could squeeze in a rate cut in Q1 2018 if inflation falls further, as we expect, although waiting until Q2 would allow the bank to see if CPI is starting to pick up.
Looking further ahead, however, we note some uncertainties surrounding the provincial elections in the first half of 2018 and the presidential election in 2019. A strong populist agenda could lead to looser monetary policy and dilution in structural tax reform. In addition, foreign participation in the capital markets, now at 40%, remains a technical concern, and any drop in oil prices could pose a risk to the government’s fiscal projections for 2017/2018.
India: Abundant opportunities but higher volatility expected
India has been a significant beneficiary of emerging market (EM) debt and equity flows for the past few years, but 2017 has been a tough transition year for the economy. Prime Minister Narendra Modi’s government is making some hard-hitting but necessary structural reforms, such as demonetization and the new national sales tax (GST), and the country is experiencing some short-term pain as a result. Indians are skeptical about the implementation and effectiveness of both reforms; private capital expenditure (capex) has largely stalled, with poor sentiment contributing to the deferral; and the terms-of-trade benefits of low oil prices are fading somewhat.
However, we believe India is marching in the right direction, as does Moody’s. The rating agency upgraded India’s sovereign rating a notch to Baa2 in November 2017, citing continued progress on economic and institutional reforms. The government’s bank recapitalization scheme should help reignite the credit cycle and lead to more confidence, as long as it is targeted well and implemented with rigor. We expect growth to bounce back above 7% in 2018, although broad-based job creation is needed. The currency is much more stable than in the past, and inflation at 4%–5% has been reasonably contained under the new monetary policy framework.
Global investors will likely continue to be attracted to India’s high growth, although foreign participation in fixed income is close to the maximum permitted level. In the coming year, we expect more volatile trading conditions, so investors will likely be sizing their positions more carefully. In our view, Indian credits continue to offer attractive relative value opportunities compared with many of their Asian counterparts. High interest rates (after adjusting for inflation) and low realized volatility are also supportive of a long currency position in the Indian rupee.
Caution on South Korea and the Philippines
South Korea, rated investment grade, has a sound fiscal position and a recent improvement in short-term borrowing relative to total debt. However, geopolitical tensions in the Korean Peninsula and high levels of household debt are concerning. Although military conflict is not in our base case, we expect tensions to linger, and we remain underweight Korean duration. In addition, we do not expect Korean duration to outperform U.S. dollar duration. Based on market pricing, the Bank of Korea is expected to hike rates three times in the next 12 months. Our expectation is for a more gradual rate hike cycle, with one to two rises in 2018, thanks to a stronger currency and muted core inflation.
Improving growth prospects, strong external liquidity and the ongoing expansion of the service sector should make the Philippines an attractive place to invest. Valuations, however, have been high, and we view the policy orientation of President Rodrigo Duterte as a significant risk. The central bank of the Philippines does not appear as concerned about recent volatility in the currency (and some bouts of weakness) as we would expect; as Philippine central bank Governor Nestor Espenilla said in October, “Currency traders will do what they do.”
Investment implications
Although China’s economy is likely to slow in 2018, we expect that the government will succeed in controlling the pace, and Asia’s emerging economies should continue to offer some attractive investment opportunities in the year ahead.
© PIMCO
© PIMCO
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