September 28, 2017 1:00 pm JST
Nicholas Spiro

Emerging Asia investors may finally be turning more cautious

Korean tensions and US monetary policy recognized as prime 'tail risks'

Despite the dramatic escalation of tensions on the Korean peninsula and the resolve of the U.S. Federal Reserve to withdraw monetary stimulus, Asian government debt is still benefitting from hefty inflows. This year's cumulative inflows are already more than five times higher than for the whole of 2016, JPMorgan data show. But a tempering of investor enthusiasm for emerging Asian markets would be no bad thing, especially for the region's frothy corporate debt.

Since April, foreign investors have purchased nearly $50 billion of domestic bonds in emerging Asian markets, including more than $4 billion in August, when U.S. President Donald Trump vowed to meet the threat posed by North Korea's nuclear program with "fire and fury." Pyongyang responded by launching a ballistic missile that flew over Japan, for the first time since 1998.

Even South Korean assets have proved fairly resilient over the past several weeks. The KOSPI, the country's main equity index, fell more than 5% between July 24 and Aug. 11, but is up nearly 4% since Sept. 6. The won has strengthened nearly 1% against the dollar since Aug. 11.

The positive sentiment toward emerging markets in Asia reflects international investors' desperate search for higher returns amid persistently low -- and in some cases negative -- yields on government bonds in advanced economies.

Inflows into emerging market bond and equity mutual funds since the start of this year have surged to $152 billion, the highest year-to-date level since 2012, according to JPMorgan. The MSCI Emerging Market Index, the leading equity gauge for developing economies, has shot up nearly 30% in dollar terms so far this year, with Asian stocks posting the strongest gains.

It may be time for investors to rein in their enthusiasm.

Cracks are showing

The spread, or risk premium, over U.S. Treasury bonds for the Asian component of JPMorgan's benchmark Corporate Emerging Market Bond Index has tumbled to just 187 basis points, down from more than 300 at the beginning of last year and nearly 500 in mid-2011, according to JPMorgan. Asian corporate bond spreads are currently 40 basis points below their post-2008 lows reached in mid-2014 and only 40 basis points above the spreads on investment-grade U.S. corporate debt.

Moreover, Asia's large weight in the CEMBI -- currently 44%, up from 35% in 2012 -- has pushed down the average spread for the index as a whole, as well as the average spreads for both investment grade and high-yield (or "junk") emerging market corporate bonds, to within a few basis points of their historic lows.

Indonesia is one of the developing economies that has witnessed the sharpest compression in spreads. The risk premium on Indonesian corporate bonds included in the CEMBI has fallen by a staggering 200 basis points this year, handing investors a juicy return of nearly 12%, more than double the return on the entire Asian component of the index, according to JPMorgan.

Yet the average credit rating of Indonesian companies in the CEMBI is a speculative grade one, in contrast to the investment grade ratings of South Korean, Malaysian and Thai borrowers.

When junk-rated Indonesian corporate debt is leading a rally in emerging market bonds as North Korea threatens to detonate a hydrogen bomb in the Pacific Ocean and the Fed plans to begin its exit from quantitative easing, there are good reasons to be concerned about the risk of a sharp sell-off.

While Indonesia's fundamentals have improved markedly since the so-called "taper tantrum" in 2013, foreigners still hold nearly 40% of the country's local bonds, increasing Indonesia's vulnerability to an external shock.

There has already been a marked increase in volatility in markets, partly stemming from geopolitical tensions. On Sept. 22, global investors were once again seeking "haven" assets, such as gold and the Japanese yen, in response to the deepening standoff between Washington and Pyongyang.

Reassessed risks

According to the latest Global Fund Manager Survey published by Bank of America Merrill Lynch on Sept. 12, a conflict on the Korean Peninsula has suddenly risen to the top of the list of the most important "tail risks" in markets.

The second most important tail risk, moreover, is the possibility of a "policy mistake" by the Fed. On Sept. 20, the U.S. central bank decided to begin reducing its $4.5 trillion balance sheet by $10 billion per month, starting in October. More controversially, it is sticking to its plans for four more rate hikes by the end of 2018 despite the persistence of low inflation. This is fueling concerns that the Fed is more concerned about keeping rates too low for too long than tightening policy prematurely, increasing the scope for a policy blunder.

The good news is that there are signs that investors in emerging Asian markets may be turning more cautious.

August's inflows into the region's local bond markets were significantly lower than in previous months, with South Korea, Malaysia and the Philippines suffering outflows. More tellingly, spreads on the region's corporate bonds have risen over the past month, pushed up by a rise of 16 basis points in high-yield spreads, according to JPMorgan.

Still, sentiment remains fairly bullish. In the week ending Sept. 20, inflows into emerging market bond and equity funds increased by another $3.3 billion, while emerging Asian stocks have risen an additional 2.5% this month.

The segment of the market to keep a close eye on in the coming weeks is corporate debt. This is where the rally has been fiercest, and where the scope for a sharp and disorderly correction is the greatest. The dollar, whose dramatic fall this year has buoyed emerging market assets, has strengthened by nearly 2% since early September, partly because of the Fed's more hawkish stance. A sustained rally in the greenback would put corporate bonds under significantly more strain, particularly high-yield debt.

Nicholas Spiro is a partner at Lauressa Advisory, a specialist macroeconomic and property consultancy in London.

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