“The Chinese government announced historic steps to stabilize its crisis-hit property sector, the effects remain to be seen”

Fixed Income Marco

Over the past 2 weeks, bonds rallied on the back of US economic data. A small uptick in initial jobless claims showed the market’s asymmetric response to any signs of softer growth. Next, retail sales came below expectations, declining 0.3% in April, following downward revisions to prior months, implying softer momentum in consumer spending heading into the current quarter. April headline CPI rose 0.3% month-on-month (vs 0.4% forecast), with the year-on-year number edging down from 3.5% to 3.4% while core CPI rose 0.3% month-on-month, in line with expectations, and the year-on-year number declined from 3.8% to 3.6%. This has probably eased concerns that 1Q data foreshadowed a reaccelerating US economy.

The retightening of Asia USD credit spreads quarter-to-date is surprising some market participants. Relative to 2023, the cycle has aged, funding costs are higher for issuers, and elevated inflation is a drag on profit margins. Yet spreads remain near their tightest levels in two decades. This could be attributed to the higher all-in yield relative to the post-global financial crisis period acting as a dampener of volatility and placing a ceiling on how wide spreads can get. The narrative is generally: higher yields and lower dollar prices not only provide better support for total returns (via a higher carry and lower losses as a fraction of prices) but also cause investors to demand a lower default premium all else equal, therefore leading to tighter spreads. That said, and whilst refraining from being outright bearish, it is not the time to move down in quality, as riskier credits are likely to underperform in any market selloff.

In China, the authorities are reportedly mulling an ambitious plan for local governments to acquire millions of unsold homes at large discounts, with loans provided by state banks, and turn the properties into affordable housing. Details are to be determined and far from reaching final stage. Bonds of non-defaulted China developers have rallied sharply, driven by the aforementioned but also the fact that investor positioning has been extremely underweight the sector. Currently, housing inventory remains a big overhang, with estimates of ~RMB 30 trillion (US$4 trillion) in residential inventory as of end-2023. Purchasing inventory at large discounts may create downward pressure for already weak housing prices and risks the purchases turning unprofitable, which is a disincentive for local governments. The physical market remains weak, with April contracted sales for the top 100 developers down 45% year-on-year while daily average new home sales volume in the first week of May fell 47% year-on-year and April new home prices down 0.58% month-on-month while existing home prices fell 0.94% month-on-month.

China Home Sales and New Construction Have Fallen More Than Completions

Source: Bloomberg Finance L.P.

Fixed Income

Markets currently price the Fed’s first 25 bp rate cut in November and a total of 2 cuts by year-end. The primary concern is that market prices rate cuts despite the ongoing failure to meet the stated inflation target and the clear easing of financial conditions over the past few months. Recent comments from various FOMC members that the Fed will be patient and wait for evidence that inflation continues to cool, reinforcing the need to keep the policy rate elevated for longer, which at face value is hardly dovish. For the bond rally to continue likely requires growth data to further soften. Near term, yields could settle into a range in the absence of key data. We are inclined to maintain shortened duration of bond portfolios.

A resilient global economy, normalization of China demand, and production discipline should remain supportive of both oil and gas prices for the remainder of the year. This is expected to continue oil & gas credits’ balance sheet improvement, with strong cash flow generation underpinning fundamental resilience. Within the Asia oil & gas sector, most issuers have national strategic importance, with the region except for Malaysia and Indonesia being a net importer. To ensure energy security, most Asian countries have designated oil & gas national champions. A large part of the sector comprises quasi-sovereigns (100% owned by the government) or majority control by government agencies. Given expectation of government support, these issuers are mostly rated the same as the respective sovereigns. This provides cushion to any pressure on standalone ratings when the oil & gas industry goes through a downcycle. Credit spreads of the Asia oil & gas sector at z+158bp currently are well inside the past decade historical average but wider than the past decade low at z+126 bp, while all-in yields at ~5.6% are hovering at the upper end of the past decade range. We are inclined toposition in Asia oil & gas issuers.

In Hong Kong, new home sales surged to HKD42 billion in April, more than triple the value of transactions in March. The increase follows the removal of additional real estate taxes in February, which led Hong Kong developers to speed up new project launches and discount properties to clear inventory. Meanwhile, the office sector remains under pressure with the vacancy rate at 12.9% in February, and potential cap rate adjustments from property downward valuations may adversely impact developers’ credit profiles. Despite such risks, Hong Kong property developers are expected to have adequate cushion. S&P projects that a 30% fair value change to developers’ investment properties increases their average gearing to 30%, which would be pushing up against the bounds of the rating agency’s “modest” category and would still be on par with regional peers and well below global peers (at 40% average gearing). This suggests that developers on average have sufficient buffer against significant revaluation of their investment properties. We are inclined to increase positions in Hong Kong property developers.

Hong Kong New Home Sales Surge

Source: Bloomberg Finance L.P.