Find strength and balance in Asian credit

China’s reopening and recovering economy are a major driver for Asian credit in a volatile global market environment, but there are many reasons for our high conviction in the asset class. Asia is at the start of an upswing and is in stronger economic shape than the US and Europe. Yields on Asian credit are higher relative to global credit, which make generating income an easier task. Asian credit also historically offers better risk-adjusted returns compared to US high yield, Asian and US stocks.

We believe the disconnect between the positive fundamentals and the muted sentiment for the asset class creates opportunities for investors. And the changing and improving landscape holds particular appeal to those looking for a more balanced mix of allocations to China and the real estate sector.

Asian credit markets, as represented by JPMorgan Asia Credit Index (JACI), were up 2.53% at the end of the first quarter, starting the year strongly. All underlying sectors contributed to the index’s return profile, with consumer, energy and real estate as standouts.

The composition of the JACI has changed over time. While China continues to be the largest country component, it has dropped from a more than 50% weighting in early 2020 to just under 40% of the index today. Real estate exposure has also gone down to under 7% from over 15% in the same period. Concentration risks to a single country or sector have been reduced, leaving a more balanced index to represent this debt segment.

In addition, the JACI has been re-rating upwards over the past decade and currently has just under 15% of high yield exposure. When taken together with the country and sector shift, the JACI now provides a more diversified exposure across Asia with a higher quality tilt. More importantly, it is a reflection of the improvement in Asian credit fundamentals and the overall asset class throughout the years.

Asia is where growth is. The region continues to outpace the rest of the world, making it more likely to be insulated from any potential slowdown or recession in the developed world. This relative economic strength is supported by robust balance sheets of most of the countries and companies, which in turn is keeping overall earnings growth positive this year.

Manufacturing PMIs across the region continue to be in expansionary mode, and headline consumer price inflation seem manageable so far (see charts below).

China is a big part of Asia. Recent data confirms China’s early cycle economic recovery is on track and that the rebound trajectory potentially could be faster and stronger than expected.

The headline first quarter GDP growth number surprised on the upside, rising 4.5% year-on-year, paving the way for earning revisions to stabilize and improve from the second quarter. Domestic consumption on reopening demand was up strongly with clothing, cosmetics, jewelry, and catering sales all rising by double digits. Industrial production has also improved with demand recovery in the domestic and export markets. High frequency data such as traffic congestion, tourism data and movie box office receipts have been strong as well. Consumption strength is expected to continue, supporting the ongoing recovery as consumer sentiment bounces back.

The property market improvement is also beating expectations. Overall March property sales jumped 31% year-on-year, partly driven by a low base in 2022 and increased momentum from pent-up demand (see chart below). The divergence in sales continues with state owned enterprise (SOE) developers benefitting the most from the sales recovery, while weaker privately owned enterprise (POE) names are lagging. Although the numbers are still below pre-COVID levels, the sequential improvement highlights the potential of a meaningful rebound in property sales this year. This should bode well for investor confidence and sector performance, and measures to stimulate housing demand rolled out by local governments should help as well. We believe that the property market is unlikely to be an economic drag going forward.

China residential property sales improve on pent-up demand

Source: Bloomberg. As of 14 April 2023.

As the banking crisis sent shockwaves through the US and Europe in March, Chinese banks stood out as a relative bastion of stability. Spreads on Chinese bank credit have also been spared from the same degree of widening found elsewhere. Bottom-up and top-down factors underpin this resilient performance. For the most part, Chinese banks are supported by sound balance sheets and fundamentals. Lenders are well capitalized above regulatory requirements, and deposit growth is actually accelerating. While additional Tier 1 bonds (AT1s) make up a significant portion of the capital structure at state-backed lenders, the vast majority has been issued onshore where the government is likely to provide greater support if needed.

Looking ahead, we continue to see China’s economic recovery driving the performance of Asian credits and Chinese credits outperforming the rest of Asia. Recession risks in Europe and the US might bring more volatility in credit spreads, but in a deep recession scenario, a rally in US Treasuries could help to partially mitigate credit spreads widening, especially for investment grade credits. There is a strong potential for Asian credit to achieve positive total returns this year.

For non-Chinese Asian credits, the positive growth and less inflationary pressure in Asia will provide a good buffer to the volatility from Europe and the US, which have been partially correlated on a historical basis. In the US, the dilemma for the Federal Reserve is that a soft landing might not be enough to bring core inflation below the 2% long-term target. We think the central bank might have to keep interest rates in restrictive territory for longer, which of course increases recession risks and could further pressure risk markets.

We are also constructive on onshore China bonds. We view the around 5% annual GDP growth target as conservative given the post-reopening growth momentum so far, reducing the need for any large-scale stimulus. Policy direction and coordination is expected to be more focused and targeted on sustainable growth driven by domestic consumption. With the policy targets, we do not expect the Chinese yuan denominated rates to sell off sharply and should remain at an attractive level from an income perspective. As long as China’s economic and monetary cycles remain divergent from developed markets, its lower correlation should bring greater diversification benefits.

Given all this, we believe there are attractive opportunities in Asian credit. Yields are higher relative to global credit, and shorter duration implies lower interest rate sensitivity. The yield pick-up can make a real difference for investors in search of income.

Despite the market volatility of the past few years, investors are compensated for the underlying credit risks. Asian credit historically offers a better risk-reward ratio compared to US high yield, MSCI Asia and the S&P 500 (see chart below).

Asian credit’s compelling risk/reward tradeoff

While we hold a favorable view of the asset class, picking the right investments and avoiding defaults still require dynamic portfolio positioning and in-depth, on-the-ground credit research.