fixed income strategy - uobam.com.sg · fixed income strategy. fixed income asset allocation – n...

FIXED INCOMESTRATEGY

Fixed Income Asset Allocation

– N +

FIxed INcome

DevelopeD

dm Govt

dm credit

eMeRGING

em Govt

em corp

em Lc

duration^

Yield curve*

Asia

Latin America

cIS/ee

middle east/Africa

GLOBAL FIXED INCOME

Notes:‘-’ denotes maximum underweight, ‘N’ denotes neutral, ‘+’ denotes maximum overweight. Arrows show change from last quarter. ^ 3-6 month horizon * + denotes Steepener and - denotes Flattener

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In the developed markets, we remain underweight on government debts and maintain a slight underweight on investment grade corporate credits due to the potential steepening of the UST yield curve while keeping duration relatively short to the benchmark. We are neutral on high yield credits as they are less sensitive to interest rate increases.

In the emerging markets (EM), we maintain a neutral weight, but are slight underweight on EM sovereign credits and neutral in corporate credits. We are neutral on all the regions, but are focused on countries that are carrying out reforms and offer higher carry. We continue to favour the USD and are selective towards local currency EM credits over the next three to six months.

38 QUARTERLY INVESTMENT STRATEGYThird Quarter 2014

Please refer to the last page for the important notice & disclaimer.

United StatesIn the first half of 2014, the market consensus was expecting a solid growth trajectory for the US economy but was disappointed due to a combination of factors including a drawdown of inventories and severe weather conditions. The US GDP dropped one per cent per cent in the first quarter, worse than the initial expectations, making 1Q 2014 the worst quarter in three years. The US Federal Reserve (Fed) continued to highlight the slack in the labour market slack with the long-term unemployment and the need to maintain an accommodative policy for a “considerable” amount of time. The UST rallied due to a combination of factors, including the “risk-off” trade with tensions in Ukraine and the ECB setting the stage for an accommodative policy stand at its May meeting.

The second quarter saw the 10-year UST yields tightening from 2.72 per cent per cent to 2.60 per cent per cent, touching 2.44 per cent per cent at the end of May. Several factors caused this outperformance. Along with the disappointment in growth, the safe haven trade due to the Russia-Ukraine tensions, ECB’s accommodative stance and continued dovish forward guidance, as well as the change in the Fed’s exit strategy all contributed to the lower yields. The Fed stated

that the normalisation of its balance sheet will no longer be the centrepiece of its exit strategy and that reinvestments would continue. Delaying changes in the balance sheet re-directs attention to expectations of the interest rate path as the determinant of UST rates. This in turn places more importance on its forward guidance. The Fed’s strategic change means that only the short-end rates will go through the term structure and the balance sheet will continue to anchor the long-end.

One of the key leading indicators for the forward rates is the labour market, which has been constantly underplayed by the Fed. Though the overall unemployment rate has been coming down, there is still slack in the long-term (structural) unemployment as shown in the chart. Also the demographics of the baby boomer generation will dominate the labour force participation patterns in the coming years. With the baby boomers retiring, the year 2017 to 2026 could see a contraction in labour force, unless immigrant population strengthens. This is one of the reasons a few key Fed members have been signalling a terminal Fed funds rate of below 4 per cent. On the other hand, inflation should continue to inch up as wages improve with tighter labour markets.

DEVELOPED MARKET FIXED INCOME

Source: MUFJ Research, US Economic & Market Developments and Outlook, 7 May 2014

Short-Term (cyclical & frictional) unemployment “normalising”

Source: MUFJ Research, US Economic & Market Developments and Outlook, 7 May 2014

But progress on Long-term (structural) unemployment still slow

39QUARTERLY INVESTMENT STRATEGYThird Quarter 2014

UOB Asset Management

With expectations of a lower long-term trend growth and no balance sheet normalisation, we believe the 10 to 30-year part of the curve will continue to flatten. Also as the technical factor fades, the five-year and 10-year treasuries should normalise to between 1.70 per cent and 1.85 per cent and 3 per cent and 3.25 per cent respectively in the coming quarter. As such, we are underweighting treasuries with a short on the five to 10-year curve while long on the 10 to 30-year curve. In terms of currency, we maintain our overweight position on USD as we foresee growth continuing to pick up, which will provide support for the greenback.

1.501.701.902.102.302.502.702.903.10

Source: Bloomberg, 30 May 2014

US Treasury 10 Year

eurozoneThe ECB in its June policy meeting announced a series of measures that aim to support credit growth in the Euro area. The ECB cut interest rates, along with a series of other stimulus measures designed to increase bank lending. It may take further unconventional measures if the combination of rate cuts and cheap funding for banks prove inadequate. As a result, the Bund-US Treasury divergence has widened even further and currently stands at 125 basis points (bps), making the UST attractive on a relative value basis. The ECB’s dovish actions are anchoring the short-end and hence we expect the spread between UST and Bunds to widen even further as the Central Banks decouple. We expect the 10-year Bunds to trade in the 1.40 per cent to 1.55 per cent range by the end of next quarter. We are neutral on Bunds with neutral duration and are short on Euro.

The growth in France has been stagnant with unemployment at an all-time high. Though investors still support France for a relative yield pick-up, we continue to be underweight on France and are short on duration based on weak fundamentals.

1.00

1.20

1.40

1.60

1.80

2.00

31/5/

13

30/6/

13

31/7/

13

31/8/

13

30/9/

13

31/10

/13

30/11

/13

31/12

/13

31/1/

14

28/2/

14

31/3/

14

30/4/

14

31/5/

14


German Bunds 10 Year

31/5

/14

30/4

/14

31/3

/14

28/2

/14

31/1

/14

31/1

2/13

30/1

1/13

31/1

0/13

30/9

/13

31/8

/13

31/7

/13

30/6

/13

31/5

/13



United KingdomGrowth in the United Kingdom has been surprising on the upside, led by the improvement in the housing sector and the labour market. Though we may see the Bank of England (BoE) getting ahead of its peers based on the data, the Central Bank Governor Carney has continued to maintain a dovish stand in his communications. We expect Gilts to get ahead of BoE with the curve steepening and 10-year yields rising to the range of 3.10 per cent to 3.25 per cent, being long on the Pound.

1.501.701.902.102.302.502.702.903.10

31/5/

13

30/6/

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31/7/

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31/10

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30/11

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31/12

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31/1/

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28/2/

14

31/3/

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30/4/

14

31/5/

14


UK Gilts 10 Year

1.60

1.80

2.00

2.20

2.40

2.60

31/5/

13

30/6/

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30/11

/13

31/12

/13

31/1/

14

28/2/

14

31/3/

14

30/4/

14

31/5/

14


French Bonds 10 Year



JapanIn Japan, we expect the Japanese Yen (JPY) to be weak considering the structural issues such as demographics and increased external energy dependency. We expect the JPY to hover in a narrow range near the current level in the coming months. The Bank of Japan (BOJ) is likely to keep its powder dry in the next few months and refrain from further mega stimulus measures judging from the confidence it expressed in its recent economic and inflation outlook. Also, the BOJ could be waiting for the Government Pension Investment Fund to make its asset allocation changes before taking further action. Domestically, wages will be an important driver for inflation to be sustained. If wages do not rise, inflation will not increase and the high real yield will mean the JPY can still strengthen against USD if US inflation picks up. Investment returns for corporates have been improving and corporates are encouraged to pass this on to workers in the form of higher wages. This year’s Shunto average monthly wage increase was 2.14 per cent as at 9 May. This is the highest level since the bankruptcy of Lehman Brothers during the 2008 GFC.

Given the high sovereign debt and potential shift in asset allocation from Japanese government bonds, we are underweight on Japanese government bonds and neutral on JPY given the potential push back of monetary easing.

AustraliaAustralia’s GDP for the first quarter of 2014 surprised on the upside at 3.5 per cent YoY supported by strong net exports and residential investments. Business investment contracted which is unsurprising considering the downturn in mining investment. Public demand was weak and is expected to remain so given the efforts towards fiscal consolidation. The Reserve Bank of Australia (RBA) has forecast 2014 GDP growth to be 2.75 per cent. There is expectation that growth is likely to dip in the coming quarters as growth in resource exports pulls back from the recent strong pace. So far, the Australian dollar has held up quite well despite the economic slowdown in China, which is an important export destination for Australia.

In its most recent monetary policy meeting in early June, the RBA has indicated that the most prudent course for monetary policy is likely a period of stability in interest rates. The policy rate has been maintained at 2.5 per cent since August 2013 when the central bank eased by 25 bps. The RBA viewed that monetary policy is to remain accommodative and should provide support to demand, with inflation expected to be within the target of 2 per cent to 3 per cent over the next two years.

Hence, we believe that the Australian dollar could move lower on expectations of a further decline in terms of trade and a decline in capital inflows funding mining investments while monetary policy remains accommodative. Against the backdrop of a period of stability in the policy rate, we are neutral on the government bonds.



EMERGING MARKET FIXED INCOME

ReviewEM bonds over the last three months (end February 2014 to end May 2014) have continued their strong performance from the previous quarter. The Emerging Markets Bond Index – Global Diversified (EMBI-GD) has rallied around 60 bps from 5.7 per cent to end the quarter at 5.1 per cent. Since the beginning of the year, the EMBI-GD has returned 8.3 per cent in USD terms. Much of the performance can be attributed to a more stable UST market which has been a catalyst for credit spreads tightening. This in turn has spurred a rally in EM bond yields, particularly over the last three months.

A few key term structures are worth mentioning. The 30-year sector which is particularly sensitive to interest

rates has been the outperformer, registering around 20 per cent return in USD terms since the start of the year. In terms of regions, Latin America performed the best while the Middle East returned the least year-to-date (YTD). Among the countries, High Yield (HY) sovereigns have performed strongly, with many registering returns of more than 10 per cent in USD terms this year.

EM USD bonds have also outperformed EM Local Currency (LC) bonds this year. YTD, EM LC bonds have only returned 5.7 per cent compared with USD EM bond returns of 8.3 per cent. EM USD bond yields have performed much stronger than EM LC bond yields.

4 5 6 7 8 9

10 11 12

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

JPMorgan GBI-EM Global Diversified Composite Yield to Maturity (Last Price) JPMorgan EMBI Global Diversified Blended Yield (Last Price)


Performance of em Indices

6.6305.106



outlookThe outlook for EM bonds remains hinged on UST volatility in our view. If UST remains stable, that is if yields rise in a gradual and orderly correction within a modest trading range, credit spreads will continue to be supported. The Fed will continue to reduce its buyback of bonds but at the same time, expectations of interest rate increases have been pushed further out. Barring any major changes to this view, and the unlikely event of a spike in inflation, EM bond yields will likely remain stable around current levels and even rise a little. This will provide investors with positive returns going forward.

It has been a year since the feared ‘EM crisis’ broke out. Since then, the ‘fragile five’ – Brazil, Indonesia, India, Turkey and South Africa have seen interest rate increases, slower economic growth and a recovery in their respective currencies. We think it is fair to say that the worst case scenario of an EM rout has been averted. However, the growth picture has not turned decisively positive as these economies are still undergoing a period of rebalancing. Slower growth is acceptable. In fact it is probably positive in order to avert more serious problems further down the road. We do not foresee any further interest rate increase in these economies, at least not in the near term.

EM foreign exchange (FX) continues to lag the performance of EM USD bonds. However, we think there is potential for some outperformance against USD bonds in the second half of this year, albeit with higher volatility. Again, this view assumes that US interest rates remain stable, which would entice yield hunters back into local bonds. As we can see from the chart below, the main outperformers over the past year have been European EM FX while the underperformers were mainly members of the ‘fragile-five’.

StrategyWe continue to like the EM fixed income, although we think that performance in the second half of 2014 will be weaker than the first half, which was very strong. We like EM LC bonds at this level and favour remaining overweight on HY bonds.


Best Spot Returns (over 1Y, versus USD, in percentage)

-2 0 2 4 6 8 10 12

10.73 8.27

4.91 4.82

2.81 0.81

0.28 0.13

-0.26 -0.38

South Korean Won (KRW) Polish Zloty (PLN)

Bulgarian Lev (BGN) Romanian Leu (RON)

Hungarian Forint (HUF) Singapore Dollar (SGD) Colombian Peso (COP)

Hong Kong Dollar (HKD) Taiwanese Dollar (TWD)

Mexican Peso (MXN)

Best Spot Returns (over 1Y, versus USD, in percentage)

-2 0 2 4 6 8 10 12

Worst Spot Returns (over 1Y, versus USD, in percentage)

-3.67 -4.39 -4.48 -4.55

-7.61 -8.65 -8.92

-10.54 -15.41

-34.58

0

Malaysian Ringgit (MYR) Indian Rupee (INR)

Brazilian Real (BRL) South African Rand (ZAR)

Thai Baht (THB) Russian Ruble (RUB)

Chilean Peso (CLP) Turkish Lira (TRY)

Indonesian Rupiah (IDR) Argentine Peso (ARS)


0-5-10-15-20-25-30-35-40



Review The Asian credit market enjoyed a strong rally in the 1H 2014 as it continued to recover steadily from the weakness seen in 2Q 2013. The Asian credit market rose 2.8 per cent in the first two months of 2Q 2014 from a rise of 2.7 per cent in 1Q 2014, 1.6 per cent in 4Q 2013, 1.3 per cent in 3Q 2013 and -4.3 per cent per cent in 2Q 2013. On a YTD basis, Asian credits have risen 5.6 per cent after falling 1.4 per cent in 2013.

Credit spreads have tightened by 6.5 bps in the first two months of 2Q 2014 from a tightening of 4.1 bps in 1Q 2014. YTD, Asian credit spreads have tightened by 10.6 bps.

Asian credits confounded expectations by rallying hard in the 1H 2014 as UST rose on the back of monetary easing by the BoJ, poor US macroeconomic data as well as expectations of the ECB implementing QE. The 10-year UST yield fell 55 bps to 2.5 per cent in May 2014 from 2.7 per cent at the end of 1Q 2014 and 3.0 per cent at the end of 2013.

ASIA FIXED INCOME


Asian credit spreads – JAcI IndexJACI spread tightened by 6.5 bps in the first 2 months of Q2 2013. Credit spread has tightened by 10.6 bps since the beginning of the year; current spread = 253

The strong performance of Asia credits was due mainly to the robust performance of the sovereign credits. Asian sovereign HY credits rose 9.3 per cent while Asian sovereign High Grade (HG) credits rose 9.0 per cent in the first five months of 2014. Both the Asian sovereign HY and Asian sovereign HG were the worst-performing sectors in 2013, falling 3.4 per cent and 8.2 per cent respectively. The three worst-performing sectors were Asian single B credits (+1.8 per cent), Asian financials (+3.9 per cent) and Asian double B credits (+4.4 per cent).

JAcI Total Return IndexAsia credit market has rose 2.80% during the first 2 months of Q2 2014 from a gain of 2.67% in Q1 2014; Asia credit market has gained 2.80% YTD

100103106109112115118b

ps 121

124 127 130


31-May-10 31-May-11 31-May-12 31-May-13 31-May-14

outlookOur in-house Asian leading indicators suggest that Asia’s economic growth probably recovered in 2Q 2014. Our three-factor Economic Leading Indicator rose 0.4 per cent YoY in May 2014 compared with 0.0 per cent in April 2014 and -0.4 per cent YoY in March 2014. Meanwhile, the six-factor leading indicator recovered to -0.2 per cent YoY in May 2014 compared with -0.5 per cent YoY in April 2014 and -1.2 per cent YoY in March. Both indices are also recovering on a sequential basis.



The Chinese economy continued to weaken in 2Q 2014. In April, railway freight volume continued to shrink (-2.7 per cent in April from -3.6 per cent in March), loans slowed (RMB774.5 billion in April from RMB1,049.7billion in March) and energy production declined (6.4 per cent YoY in April from 7.9 per cent YoY in March). The overall index, which combines railway volumes, loans and energy production, was at 0.7 per cent YoY in April, unchanged from 0.7 per cent YoY in March. However, the three-month moving average number dropped to -2.2 per cent YoY in April from -2.1 per cent YoY in March. Based on the macro data, we believe that the Chinese economy is probably growing at 6 per cent to 6.5 per cent in 2Q 2014 compared with 7.4 per cent YoY in 1Q 2014.

Source: CEIC, Bloomberg, 30 May 2014


6-factor cLI and 3 factor cLI now strengthening sequentially

Both 6 and 3-factor composite strengthened in Q2 2014


Railway freight carried fell 2.65% year-on-year in April from 3.61% year-on-year in march


energy production slowed to 6.4% year-on-year in April from 7.91% year-on-year in march


Loan growth has stayed resilient in recent months



While economic growth appears to be slowing, Chinese asset prices seem to have discounted most of the bad news. The chart below indicates that Chinese property equities are now trading at a 48 per cent discount to its net asset value (NAV). Meanwhile, HY property names give a yield of around 9.5 per cent as at end May 2014. This is significantly higher than most other Asian HY sectors.

china activity index weakened in the first 4 months of the year


chinese property is currently trading at 48% discount to NAV, which is more than 1 Sd from the mean

Source: Barclays, 30 May 2014

chinese HY property has the highest yield in Asia HY

Source: JP Morgan, 30 May 2014



Strategy

We are revising our recommendations slightly. Last quarter,

we recommended underweighting Chinese HY credits.

We are now recommending an increase in weights on

BB-rated Chinese HY to slight overweight but are continuing

to be heavily underweight on Chinese single B-rated credits.

Overall we will be slightly underweight on the Chinese

property sector.

We also continue to recommend overweight on Chinese

state-owned enterprises (SOEs) and Indonesian HY property

credits due to their stable credit fundamentals, as well as

Sri Lankan quasi sovereigns and Mongolian sovereigns and

quasi sovereigns as these are relatively resilient to higher US

interest rates and also offer decent yield.

Both Asian HG and HY are up 2.8 per cent in 2Q 2014. On

a YTD basis, Asian HG credits have risen 5.9 per cent while

Asian HY has returned 4.6 per cent. With 10-year UST yield

having fallen 55 bps to a mere 2.4 per cent at end May

2014, we think that interest rates are likely to rise towards

the three per cent handle in 2H 2014. We believe that HY

credits will outperform HG credits in 2H 2014 given that the

former are generally less sensitive to interest rate increases.

Source: JP Morgan, Bloomberg, 10 March 2014

Asia high grade is up 2.8% in Q2 2014 while high yield is also up 2.8% in Q2 2014; YTd investment grade credits have returned 5.9% while high yield credits have returned 4.55%



Singapore macro ReviewIn 1Q 2014, the Singapore economy expanded by 2.3 per cent quarter-on-quarter (QoQ), seasonally adjusted. This is lower than the 6.9 per cent QoQ seasonally adjusted in 4Q 2013, but higher than 0.1 per cent QoQ seasonally adjusted for the 1Q 2014 advanced estimates in April. The main drag in QoQ seasonally adjusted growth for 1Q 2014 was from the construction and services sectors. Construction slowed to 0.6 per cent QoQ seasonally adjusted in 1Q 2014 from 10.6 per cent QoQ seasonally adjusted in 4Q 2013. Services slowed to 0.4 per cent QoQ seasonally adjusted in 1Q 2014 from 7.1 per cent QoQ seasonally adjusted in 4Q 2013. In YoY terms, real GDP expanded 4.9 per cent in 1Q 2014, in line with that in 4Q 2013. However this is lower than the 1Q April advanced estimates of 5.1 per cent YoY. The disparity between QoQ seasonally adjusted and YoY revisions could be due partly to the rebasing of the GDP series. Singapore’s national accounts for reference year 2005 to 2010 have been rebased.

Non-oil domestic exports (NODX) expanded 0.9 per cent YoY in April, better than the 6.6 per cent YoY contraction in March. The expansion was due to the growth in non-electronic NODX that outweighed the decline in electronic NODX. Non-electronic NODX exports surged 5.5 per cent YoY in April from 2.4 per cent YoY contraction in March. It was led by strong performance from exports in petrol chemicals (+21.4 per cent YoY), printed matter (+39 per cent YoY) and specialised machinery (+26.6 per cent YoY). Electronic exports continued to decline, registering 8.7 per cent YoY in April after the 16.1 per cent contraction in March.

SINGAPORE FIXED INCOME

The Singapore IP growth moderated to 4.6 per cent YoY in April from 12.1 per cent YoY in March. Excluding the biomedical manufacturing cluster, IP fell 0.7 per cent YoY in April from 11 per cent YoY growth in March. Reversing the positive growth trend since May 2013, electronic manufacturing fell 8.8 per cent YoY in April with semiconductor output down a sharp 11 per cent YoY. Other manufacturing clusters registered positive growth in the month.

Headline inflation rose 2.5 per cent YoY in April from 1.2 per cent YoY in March. The key drivers for headline inflation are the cost of private road transport (+5.7 per cent YoY in April from -2.8 per cent YoY in March), rising overall food costs (+3.1 per cent YoY in April from 2.9 per cent YoY in March) and service-related segments (+2.7 per cent YoY in April from +2.4 per cent YoY in March). Core inflation, which excludes housing and private road transport, climbed higher to 2.3 per cent YoY in April from 2 per cent YoY in March, the highest since September 2012.

We think that the government remains concerned on the inflation data amid the tight labour market in Singapore. In April 2014, MAS maintained the modest and gradual appreciation path of the SGD NEER policy band, with no change to its slope, width and the level at which it was centred. This policy stance, which has been in place since April 2012, has helped to alleviate inflationary pressures and anchor inflation expectations, as well as facilitate the restructuring of the economy. However, with the Fed tapering the QE programme, Asian FX could come under selling pressure. Hence, we expect the Singapore Dollar (SGD) to weaken by the end of 2014.



Singapore credit ReviewThe SGD bond market has rallied with spreads tightening further on buying from private banking clients and institutions over the past five months. The HSBC SGD Non-Government Local Currency Bond Index increased by 1.1 per cent in the first two months of 2Q 2014 and the index was up by 2.6 per cent since the beginning of the year.

SGD corporate bonds rallied with long-end bonds outperforming in the secondary market as interest rates moved lower and institutional accounts continued to extend their duration. Indian bonds tightened five bps to 33 bps in April and May from the better-than-expected election results. Singapore’s corporate Goodpack bonds tightened five bps to 33 bps across the curve in May and June after news on a potential acquisition by a private equity firm.

Primary corporate bond issuances continued to be active. Apart from mid-capitalisation companies tapping the market with less than S$100 million issuance size, established names like United Overseas Bank issued S$500 million of Basel

III-compliant Tier 2 Subordinated Notes and the Housing and Development Board issued S$675 million of five-year bonds. More foreign issuers also tapped the SGD market with good support from Singapore investors. Far East Horizon issued S$400 million of three-year bonds, Yanlord Land Group issued S$400 million of three-year bonds, Central China Real Estate issued S$200 million of three-year bonds, Sun Hung Kai Properties issued S$320 million of seven-year bonds and G8 Education issued S$175 million of three-year bonds. Other notable issues include S$150 million of three-year bonds from Golden Agri-Resources Ltd and S$175 million of two-year bonds and S$150 million of three-year bonds from Gallant Venture, and S$150 million of five-year bonds from Overseas Education Limited.

Apart from foreign issuers tapping the SGD market for opportunistic funding, we continue to expect high-yield issuances by mid-capitalisation companies, subject to market conditions.



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