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Asian Bonds – Resilience Despite the Challenges

2022 was a difficult year for fixed income investors as they contended with inflation, rate hikes, lingering lockdowns in China, and geopolitical tensions.

Asia Pacific Head of Fixed Income, Head of SSGA Singapore

As 2023 approaches, we look at some of the influential economic events of the past 12 months and where opportunities may lie.

In the early stages of the year, it was hoped that a war between Russia and Ukraine would be avoided. Sadly, this wasn’t the case. While the human cost was severe, the increase in energy prices witnessed in the first six months is a significant factor explaining the performance of the fixed-income market.

Rising energy and, to some extent, food prices quickly fed through to inflation, given energy is a large component in the cost of many goods and services. This spurred the US Federal Reserve (Fed) to become more aggressive with its rate hikes.

This shift in the Fed’s perception of the interest rate required to meet its inflationary objectives was reflected in the ‘dot plot’, which is released every quarter by the Federal Open Market Committee (FOMC) – the body that decides the cost of borrowing in the US. The upward swing in the dot plot was considerable and swift and by mid-June 2022, short-term interest-rate expectations had risen to 3.4%1. Longer-run expectations remained almost unaltered, showing the Fed’s belief this was a transitory situation rather than a structural change to the American economy.

The knock-on effects of Fed tightening were reflected in the subsequent strength of the US dollar and interest rate increases in almost all markets except China2.

How Did This Perception Shift Affect Asian Fixed Income?

There was a distinct pattern in currency and bond prices in 2022 across Asia and the US, with a measured decline in Asia from January through to October. At that point, we saw a relatively healthy recovery in most markets. The possible trigger for this shift in sentiment was lower-than-expected inflation in the United States, partly caused by the steady decline in energy prices from July onwards. These are now around the same levels as at the beginning of the year3. Perceptions of how aggressive the Fed would need to be with its rate hikes shifted downwards, boosting investor sentiment. Whether this belief continues into 2023 is uncertain. Still, there are encouraging signs of inflation having peaked, reducing the pressure on the Fed to continue fast and steep rate increases – it may yet be able to achieve the always hoped-for economic soft landing.

While fixed-income performance was negative across nearly all Asian economies, this resulted from external macroeconomic factors rather than market-specific weakness. It’s true that foreign investors have trimmed their Asian bond holdings, but there hasn’t been a rush for the exit – as we have seen in the past. This pattern was mirrored in currency markets as they moved in lockstep. In recent years Asian central banks have become more effective in managing their interest rates. Perhaps this is because they know too well the economic pain caused by allowing their currencies to collapse, with most Asian territories having experienced a sharp currency devaluation at some point in their history.

China Follows its Own Path, But COVID Lingers

Rather than mirror the Fed, China did the opposite and reduced interest rates and allowed its currency to devalue slightly against the US dollar. China also had to manage challenges in its property sector. Government support for the segment, perceived by some as somewhat tentative, has actually led to a healthy shakeout. Viable companies should remain relatively robust and potentially discounted in price. On the positive side, one outcome is that less money may flow into speculative housing purchases, and middle-class consumer income could be redirected into consumer goods and experiences, benefiting the broader economy.

What Can We Expect in 2023?

A pessimistic scenario would see an overly aggressive Fed crashing the US economy and triggering a broader global recession. Escalating European conflict could also lead to higher energy prices and investor uncertainty.

A more likely and optimistic scenario sees inflation reined in as supply bottlenecks continue to ease and the potential for a resolution to the conflict in Europe. This would lead to a decline in the US dollar and gains for Asian currencies – benefiting investors in the region’s local-currency bonds.

Another positive development would be China successfully navigating its way through COVID, thereby unleashing economic growth as consumers satisfy pent-up demand, particularly for travel and entertainment services. China also plans to support its technology and innovation sectors, presenting further opportunities for investors. Strong economic growth in China will benefit other Asian markets owing to the interlinked nature of their economies. When combined, these factors present an appealing backdrop for the Asian fixed-income universe.

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