IFR Asia Outlook for Asian credit Roundtable 2018: Part 1

IFR ASIA: Welcome everyone. Michael, perhaps you can kick us off with your sense of what’s changed since we sat down 12 months ago. What’s different this time around?

MICHAEL TAYLOR, MOODY’S: That’s an interesting question, because not a lot has changed.

We’re now in the eighth or ninth year of economic expansion across the G20. I suppose the biggest change is that last year that expansion was synchronised across the world’s major economies. It’s the first time since the global financial crisis that we’ve seen all parts of the global economy growing in tandem.

For this year, we’re expecting that synchronised expansion to continue, although – in line with the title of this session – 2018 probably will be as good as it gets. We will see a slight slowdown in growth in 2019, but we think this year is going to be quite a strong year.

In fact, we’ve been on the more optimistic side of the market and we recently raised our forecast for the G20 economies as a whole. We started off the year with a forecast of 3.2%, and when we polled the participants in our outlook conferences at the start of the year, we were already slightly more optimistic than our audience. But since then, we’ve actually upgraded our forecast to 3.4% for the G20 economies in 2018. We see a very robust growth story for this year.

IFR ASIA: It did feel at the beginning of the year as though things were going extremely well. We started off with just huge amounts of risk appetite, and everybody seemed to be doing deals. Avinash, what it’s like now in the primary markets? That has changed a little bit, hasn’t it?

AVINASH THAKUR, BARCLAYS: It has. In fact, January was the best month the markets have had in probably the last 10 years since the financial crisis. And the markets seemed to be on a roll. It was a very good issuance window for all the issuers that we were talking to. Things changed in February, and it’s been a bit of a surprise from the market’s perspective because, as Michael said, nothing had changed fundamentally.

To my mind, the only significant change was the leadership of the US Federal Reserve. There was no change to the policy, but I think the market took the change in leadership as an indicator of further tightening after the easy monetary policy under Janet Yellen. And the US has, frankly, seen a long, sustained period of economic growth, which again people took as an indicator of a change in the rate outlook. That’s what made the market nervous.

The nervousness has continued for longer than I thought it would. We continue to see volatility. US rates have been moving around a fair bit, which makes it difficult for primary issuances. I think that will definitely settle down as we see investors getting more comfortable with the new leadership and the fact that the new Fed chair has not really indicated any significant changes in policy.

CLIFF TAN, MUFG: We’re not sure that things have stayed completely the same with the Fed. I was pretty blown away by (Fed chair Jerome) Powell’s first testimony, because he came in and gave a testimony that sounded like the Fed that I worked at 20 years ago. It sounded very much like a Greenspan Fed.

I’ve told our guys to look at whether the other members of the FOMC start to line up behind him. Because the Fed is not a democracy; the Chair has 85% of the votes. So, if this new Chair wants to go in a different direction than the young, Bernanke Fed, than he has every right to do so.

Governor (Lael) Brainard gave a talk to the New York Money Marketeers last week and I didn’t think much about it, because Fed people often do that. But I found out aftewards that she actually called the New York Money Marketeers and asked for an opportunity to speak. So it seems to me that the Federal Reserve is very clearly trying to send a pretty straight forward signal to the market.

And what’s the signal? My own feeling is that Powell is trying to prepare the markets for the possibility of four hikes and not three. In the Greenspan Fed days, if the staff felt that the economy was on track, then a normalisation would be a hike every quarter. Now, that got completely side-tracked by the financial crisis and by the unorthodox policies under Bernanke and then under Yellen. So it’s a surprise to me to hear Powell sound so much like the old Fed.

IFR ASIA: In the rates world, the 10-year US Treasury is at around 2.8%, versus 2.6% a year ago. Obviously, the last few months have been quite a severe correction. But, on a long-term trend, it’s still relatively benign, isn’t it?

PAUL AU, CMBI: The 10-year hasn’t really moved that much, but the short end of the curve has spiked quite a bit, and it’s the expectation of what’s going to happen. That matters. Three or four hikes this year makes a difference.

It’s interesting that Cliff mentioned Greenspan. I think the difference is this time around, while there could be three or four hikes, people have been expecting it to be quite orderly. During the Greenspan days, hikes were 25bp or 50bp, and people were shocked to a certain extent. Right now, compared to last year, there is a little more uncertainty, and that is partly why the new issue market and the secondary market have been more sluggish compared to the end of last year.

DESMOND HOW, GAOTENG: The fact that we’re debating whether it’s three or four hikes is really a success for the Fed, in terms of telegraphy and signalling. Volatility going forward will not be as drastic as we would have seen back in the tapering in 2013, because the direction of the cycle is known. It’s just a matter of the magnitude and the timing.

The return to orthodox policy by the Fed is actually very welcome. Following Greenspan’s legacy, Bernanke and Yellen have been pretty accommodative. If you go by Taylor’s rule, equilibrium should probably be at 4% or more, given today’s inflation, growth and employment.

And it’s now more of trying to signal to the market how we get there. I think it’s a matter of time, and the Fed wants the shock to be as minimal as possible.

MICHAEL TAYLOR, MOODY’S: To echo that, the fact that we’re having this conversation is an indication of the way in which the Fed – along with the other major central banks – has been trying to communicate quite clearly what their intention is. Our view is that any change is going to be well communicated to the market. And inflation is going to remain pretty well contained. There will be some uptick in inflation next year, but it’s not going to be sufficient to really move the dial in terms of how the central bank is approaching this. We’re expecting this gradual normalisation process to continue.

IFR ASIA: Paul, how do you play this scenario? How do you decide whether fixed income is still attractive versus equities or other asset classes?

PAUL CARRETT, FWD: That remains an open question for now. The other dynamic that matters to us is what’s going on at the long end of the curve. What’s interesting, as an insurance company and a more long-term investor than most others, is seeing the dynamic with the shape of the yield curve. Some of the technical factors and the way the ‘plumbing’ works in the financial markets matters a whole lot more in a volatile environment.

I’ll give two examples. One, if you look at what’s happening with the short end of the curve, it’s not just expectations of Fed rate rises, but also Libor-OIS suddenly increasing a lot. That’s flattened the yield curve. That leads to my second point: it is now hard for a lot of foreign buyers that used to buy, say, 10-year bonds and hedge them back to, say, yen. With hedging getting more expensive, dollar assets become less attractive and some selling at the long end will be inevitable.

We’re watching those dynamics closely. It’s complicated to try and figure out how all the different participants will behave.

AVINASH THAKUR, BARCLAYS: I agree that the Fed has changed course on interest rates. But that, again, is something which is already known. In fact, our research view is that there will be four rate hikes this year, and we’ve maintained that view for a few months now. But the forecast on the long end is not very different from where we are today.

While the Fed will change course gradually, I don’t see that having too much of an impact on the rate environment. And that’s what I meant when I said that things will settle down. The 10-year treasury had to move up. It was going to happen at some point. The move up happened much faster than the market expected, and now we’re seeing some corrections. But I do think things will settle down.

What gives me comfort when I speak with investors and the market is that they’re all still sitting on a good amount of liquidity. And that’s what will bring the market back to more normalcy.

2017 was an extraordinarily good year. Michael talked about how it was one of the years when economies have done well across geographies, but it was also very good from a primary market perspective, because we didn’t see any of this volatility in 2017. We did have some volatile periods in 2016 and 2015, but what keeps the market going is the strong liquidity out there. Frankly, there’s nothing which leads me to believe that there will any big tightening of liquidity any time soon.

PAUL AU, CMBI: I agree with Avinash. The liquidity point is critical, and Asia is in a very unique and positive spot. To a certain extent, the liquidity in this region is why Asian credits have been outperforming other parts of the world over the last 12 to 24 months. It’s becoming more technical.

You have new liquidity coming from new investors, from China, coming in to buy Asian credits. That has supported the secondary market in the last 12 months. While volatility has become more obvious in the last two or three months, we’re still outperforming. It’s a trend: Asian accounts are buying Asian credits; Chinese accounts are buying Chinese credits. They’re also starting to buy non-Asian credits.

MICHAEL TAYLOR, MOODY’S: They say that “This time it’s different” are the four most expensive words in the English language. There are, I think, good reasons for thinking that this time it really is different from an Asian perspective, because even if we do see some tightening in global liquidity, there are structural factors around Asian credit, which will support demand for Asian assets going forward. And one of them is the growth of these pools of investment capital, which are sourced and managed within the region.

If you compare the situation now to 10 years ago – and, certainly, to 20 years ago in the Asian financial crisis, when Asia was very heavily dependent on capital inflows from the rest of the world – that’s something that really has changed. We are seeing a lot more demand for Asian financial assets coming from Asian pools of capital.

CLIFF TAN, MUFG: I’m a little cautious, just because we all know that liquidity can disappear in times of stress. What seems like really ample liquidity one day can just go. What’s a good example? When GM got into trouble around 2005, that wasn’t a crisis, but liquidity disappeared. So, I’m a little wary of putting all my hopes on liquidity; I’ll just say that.

IFR ASIA: We’ve got some people at this table who manage Asian assets. Paul how sticky do you think that Asian bid is, really, when you’re looking at global currencies or Asian credit?

PAUL CARRETT, FWD: I think it’s one of the great unanswered questions. We referred to the fact that there’s a lot of liquidity coming from new sources and we’ve not seen how they behave over a cycle or two. The thing I always look for – probably obsess about actually – is the degree to which some of that new money might be levered in ways that we don’t yet perceive. Until it’s tested, you don’t know where it might crack.

The other dynamic, which I think you’re alluding to as well, is that many Asian issuers have access to local currency and dollar markets. The high-quality work that’s been done to develop South-East Asian local currency bond markets has probably added some stability to both the buyer and issuer side for those markets.

Like Cliff, I’m quite wary of some of this liquidity in the market, because if it’s levered, it can disappear, very, very quickly. I honestly do believe it’s yet to be tested in a strong way.

IFR ASIA: Desmond, what do you think? Is the Chinese money coming into the international markets going to be there for the long term? Or is a short-term currency play, a rates arbitrage? What’s driving it?

DESMOND HOW, GAOTENG: Maybe I’ll mention a bit of the history of the Asian bid. It has been around since the Asian currency crisis in 1998 where banks, instead of lending to corporates, decided it’s more efficient to deploy their capital to buy bonds. What we saw in 1998 through late 2000s was more capital coming from the Singapore, Malaysia and Hong Kong banks. Post-Lehman crisis, we saw Philippine banks and Taiwanese banks adding to the pool. It’s only in the last three or four years that we have seen Chinese banks joining the fray. And my God, they really come in herds!

And to your point, a big reason for them to come offshore is the desire to diversify their portfolio beyond the CNY. This is a structural change. It’s not seasonal or cyclical; it’s structural. And the money coming into this space is enormous. Some of the sell-side research we’ve seen is talking about new US$10bn deposits trapped offshore every year.

Last year we had gross US dollar supply of about US$300bn from Asia, which is about US$150bn net of redemptions. For the market to be performing so well, there must be significant new players there to absorb this supply.

A lot of it is coming from Chinese money. And if you look at the trend for new issuance, the traditional asset managers are getting less significant allocations compared to the Chinese banks and Taiwanese banks. Maybe traditional funds five years ago would be taking around 40%, and banks 30%: last year it’s the reverse.

For sure, some of that money is levered. Two years ago, levered income as a strategy was very attractive. You could borrow at 1% and buy investment-grade bonds at 4.5%! Now we are testing almost 3% in financing costs and then we only can get 4%–4.5% yields, and that’s a less attractive proposition. The potential unwinding of these portfolio - it’s something to look out for. But, in general, I’m still pretty constructive about the flows coming from onshore.

IFR ASIA: We’ve seen some big deals easily absorbed this year. We had some in euros this week, where Chinese banks were still the biggest bidders. I don’t get the sense that there’s any real stress in this picture yet.

AVINASH THAKUR, BARCLAYS: What gives me optimism is the fact that there’s no real stress in the system. Except for the change in Fed leadership, which I understand is a signal for the market, frankly, there is nothing different on the fundamental side from where we were last year.

What is different, certainly, for this part of the world, is the emergence of China. You have the world’s second-largest economy now driving Asian markets. That gives me confidence, and, as you rightly said, whenever we’ve gone out with a transaction at the right pricing we’ve seen a lot of demand for the paper.

The largest Asian Reg S-only transaction was done a few weeks ago for, again, a Chinese issuer, with US$6.5bn across dollars and euros. I think that’s thanks also to the emergence of Chinese investors. However, just to clarify, most of the demand for the euro tranche of that deal was from Europe.

It’s not entirely true that investors sitting outside Asia don’t see relative value here anymore. The investors who did participate were some of the highest quality investors in Europe.

That all gives me the confidence to say that this is a temporary period and things will come back to normal over time, once we have more clarity on the Fed and once some of the uncertainty goes away.

The Asian markets still have a long way to go. China will keep growing, even if you’re talking about slowing down to 6% on that GDP base it’s still a huge number, and that’s going to make sure that we continue to see growth in Asian economies.

MICHAEL TAYLOR, MOODY’S: That’s an important point, because demand for Asian assets is going to be supported by a growth story across Asia. China is, obviously, a very important part of that, but we see quite a good growth story for other major Asian economies for the rest of this year and into next year.

Asia has outperformed the rest of the world in terms of growth for quite a number of years now and there doesn’t seem to be any reason to expect that to change. So, I think demand for Asian assets from outside the region is going to remain strong.

CLIFF TAN, MUFG: One reason the China bid is going to remain is that, as far as I know, most of these guys who have an allocation of offshore assets don’t have any mark-to-market considerations. I’m not sure that that’s the best way to manage market risk if you were a regulator, but that’s the state of play right now. And I think that is important.

IFR ASIA: Cliff, let me ask you about the currency picture. Chinese investors have done well in dollars as the RMB has been depreciating, but it’s not quite that simple now, is it?

CLIFF TAN, MUFG: No, it’s not. The Chinese authorities have moved to a basket management policy, we think since about the beginning of April last year. There’s a very interesting chart you can do very easily for yourself, which is to look at the USD/SGD versus USD/CNY from about April 1 last year. The two are trading incredibly closely together. Now, we know Singapore uses a basket, and we know that the MAS’s current policy is no appreciation with the same band. And China looks a lot like Singapore right now.

A basket peg filters out all the fluctuations of the major currencies and gives you a path that’s supposed to be appropriate for the local currency. So, yes, it depends the direction of the big US dollar, and I want to congratulate all of us that we’ve gone on for about half an hour without mentioning Trump.

IFR ASIA: I wondered who would bring him up!

CLIFF TAN, MUFG: We wrote a note in January 2017 just before the inauguration suggesting that Trump may become, in our words, a ‘dollar wimp’ because his economic philosophy is essentially mercantilism.

Mercantilism dates from the 17th century. Right now economists are mostly still in the age of neoclassical economics. Before that, there was classical economics and before classical economics there was mercantilism. In evolutionary terms we’re homo sapiens now, but before that we had Cro-Magnon man and before then we had Neanderthals. So, Trump’s economic philosophy is like a Neanderthal philosophy!

Now, Mercantilists always love a weak domestic currency. If that’s his view, that’s what he’s going to be leaning towards. And I think the markets have fully taken that on board.

The second thing to say is that I keep reading how people wish that would Trump would suddenly click his heals and become somebody else. And I’m here to tell you, that is not going to happen. That’s completely farfetched. He is a protectionist. You can put that in permanent capital letters. That’s who he is. Now, the problem with the weak dollar trade, though, is that it’s very crowded.

I don’t think what Trump is doing, actually, may be that great for the US economy, but it’s very, very difficult to tell how much further we can go. I wrote a note earlier this year reminding people that the percentage move between Plaza and Louvre (1985-1987) would put the DXY Dollar Index at 79, which is a long way from where it is right now.

That’s not a forecast. I’m just trying to figure out how much Trump can really disrupt this market. On the FX front, this is an important piece of the puzzle.

MICHAEL TAYLOR, MOODY’S: That’s quite an interesting point, because earlier we were talking about four Fed rate hikes this year, which normally – everything else being equal – would be a point of dollar strength. But we’re seeing the opposite. I agree. I think US policy is playing a big role in the market here.

IFR ASIA: It strikes me that Asia – and emerging markets more broadly – often runs into trouble when the dollar is strong. But if the dollar is going to stay weak, that’s good here, isn’t it?

AVINASH THAKUR, BARCLAYS: I agree with the assessment, but if Trump were to be dollar bearish that would also help the rates environment, because the Fed will take signals from the direction of the US economy. Rate hikes will be more difficult if you want to keep the dollar weak. Overall, a weaker dollar policy will probably help Asian economies and flows into Asian markets.

CLIFF TAN, MUFG: Over the last couple of years, the weak dollar, strong euro story has been very helpful for flows into emerging markets, including Asia. The reason I’m a little uncertain right now is because what Trump is starting to do now could actually undo some of the underpinnings of the global economy.

There is no doubt that Asia, as a region, is by far the primary beneficiary of the open, global, trading and investing system that we’ve had in place for most of our careers. So far, we’re still looking at rates and FX staying around the same neighbourhood where we’ve been. But we’re not looking yet at the bigger neighbourhood of where you could take this. That’s what I’m concerned about.

MICHAEL TAYLOR, MOODY’S: We started out the year with our outlooks, as we always do, and we listed three downside risks to the fairly benign story we’ve been talking about so far. One of them is the rise in protectionism. I agree very much with what Cliff said: Asia has grown wealthy over the last generation on the back of an open trading environment. And an unravelling of that open trading environment is going to be negative for Asian economies.

Asia is not as export-oriented as it was – that’s certainly the case with China, where net exports have played a smaller role in terms of GDP growth than they did in the past. But Asia’s economies are more export dependent than is typical of other major economies around the world. So, the risks of Trump moving in a more protectionist direction are particularly acute for Asia.

IFR ASIA: So, how does this fit into the credit picture then? So far, it seems that people are still investing.

PAUL AU, CMBI: Well, my biggest concern is actually politics rather than technicals and liquidity. Obviously, protectionism is one risk. You also have China’s leadership becoming more hierarchical with changes around the tenure of its leaders. You have the Russian debacle over the last couple of days with Britain. All of these could bring volatility to the market. We haven’t seen those kind of high-level political headlines for the last two or three years.

IFR ASIA: When you talk about Chinese politics, some individual credits have been clearly affected. There’s a fair amount of policy risk here.

PAUL AU, CMBI: Yes, there’s policy risk. And to a certain extent the direction of liquidity could also be dependent on politics. Investors with an offshore investment quota would try their utmost to keep it offshore. And a corporate issuer raising money offshore would want to keep those dollars offshore, unless there’s a specific requirement. But I think political risk is global; it’s not just China. The kind of global headlines we have today we haven’t seen for a long period of time.

IFR ASIA: How do you factor it in, Desmond, when you look at what assets you’re going to buy?

DESMOND HOW, GAOTENG: Actually, I agree with Paul’s assessment. In China, this year we have already had a significant event and I think down the road we should expect more. China has been pretty successful economically. They’ve been able to maintain above 6% growth. The policy shift since last year has been from growth to stability, and this year we would expect to see some reforms at different agency levels. These changes are going to create uncertainty and even the banks could be more conservative than in previous years, where they were pretty aggressively taking down deals. So, this is a concern that is going to be pretty prevalent this year.

CLIFF TAN, MUFG: I think this is worth tagging on to the discussion on liquidity. Another way to describe the inflows into Asia in recent years is as a reflection of the global quantitative easing. And the reason I’m a little cautious on credit in general this year, not just on Asian credit, is because of where we are on the macro side. The macro picture may be as good as it gets, so the probability of further downside outweighs the upside.

Secondly, the flow story has been really dependent on quantitative easing. But it’s very apparent that we are shifting away from these unorthodox policies, whether the central banks want to admit it or not. And then in China, we’ve got regulations on wealth management products that are supposed to go into play mid-2019. That changes the amount of savings that the banks can transform into other products, and the amount the can take out of the country may be under some question. We know China is doing some stress tests on wealth management products, and it’s a domestic problem first. However they choose to address it, logically, it has to affect the offshore flow as well.

IFR ASIA: At the same time, China is opening up its domestic markets to international investors. Is there an opportunity here? The international community hasn’t really looked at RMB onshore so far.

PAUL AU, CMBI: You’re seeing more and more focus on China credits over the past year. Well, I take that back. It’s really China rates products where you are starting to see allocations from global emerging market bond funds. That will increase over time, but the speed of it is unknown. There are still some concerns. If I were sitting in London managing a global EM book, I’d be worried about currency convertibility. Can I get my money out at the time I want it? Obviously, there needs to be more understanding of the local corporate and securities laws. Ratings are another hurdle: why are 90% of the credits all rated Triple A? How do I differentiate between a AAA and a AA+? There are issues that global investors would like to understand better before they get involved in China’s domestic market.

IFR ASIA: That’s a cue for you, Michael. Are all credits equal in China?

MICHAEL TAYLOR, MOODY’S: Certainly not! I think, if you look at what the global funds are doing with their investment decisions at the moment, they’re cleaving pretty close to the state. Investors are comfortable with quasi-sovereign risk. So there’s demand for paper issued by the policy banks, by the large state-owned banks, by some large state-owned enterprises, but once you get beyond that group of credits, many of the global investors are still very cautious.

How you assess credit quality is, certainly, a major issue. Obviously, there is huge demand for credit ratings that give greater differentiation, and they’re not seeing it in the domestic market at the moment. There’s greater demand for credit research and an understanding of how to do credit analysis on Chinese names. And policy also plays a big role in this, because in the past there’s been a tendency to assume that all China credit is equal – that everyone is equally supported, and that the probability of default is low across the whole portfolio.

As policy in China evolves, particularly with the current emphasis on financial stability, our expectation is that we will see greater differentiation in China credit going forward. All credits are not going to be equal. There will be a greater tolerance of default. The question is not whether there will be more defaults, but the government’s tolerance level. How many defaults are they prepared to see, and in which sectors?

In contrast to a Western economy, it’s policy driven. So, understanding the policy process and understanding what’s driving the government’s approach to these kinds of decisions is really key in terms of assessing credit policy.