One word that will always send bond investors into a blind panic is “inflation”. Naturally with any fixed return asset, if the value of money declines, so too will the present value of future cash flows over the long term. Compounding this is the ever-present fear that central banks will aggressively tighten policies to contain inflation by raising benchmark interest rates and creating an immediate near term hit on bond price relative value.
Since the middle of 2020, such inflation fears have rapidly gathered momentum across the world. The combination of ultra-easy monetary policy from most of the world’s leading central banks, a virus induced suppression of global upstream production for much of the past 12 months and expectations of a rapid rebound in global consumer demand as countries emerge from their COVID lockdowns has created a perfect environment for prices to rise. Adding to this a US Federal Reserve that has clearly taken the view that an inflation overshoot should be encouraged, rather than feared, implies inflation pressure is not likely to go away any time soon.
As a result, global commodity prices are spiking. In the US, steel prices currently trade at three times their historical long run average. (Source: CNN) Copper prices on the London Metals Exchange have increased 30% since the start of 2021 crossing $10,000/tonne for the first time in 10 years and global food prices are surging with the CRB Food Index also up 42% ytd. (Source: Bloomberg) Even oil, a sector that should be negatively impacted by COVID induced travel restrictions is back to its 2019 levels. (Source: Bloomberg) This all spells a serious worry for global fixed income markets.
In Asia, Investment Grade (IG) bond prices have generally remained resilient in the face of this massive risk. The Markit Iboxx ADBI Index (which is 85% IG) is down -1.1% since the start of the year, but that only takes the Index back to where it was trading last November. (Source: Bloomberg) For the time being, Fed governor Powell’s comforting words of sustained easy monetary policy have clearly supported demand for Asian investment grade dollar bonds. However, one has to wonder how long this can last.
For fixed income investors there are two ways to avoid the ravages of inflation. One is to move to shorter duration where any future interest rate hikes would have a much lower impact on prices and secondly is to move down the credit curve into higher yielding assets that are less sensitive to risk free yields and potentially can even benefit from rising prices if their underlying businesses are exposed to commodity sectors. It would seem Asia’s high yield bond market is uniquely suited to such an environment. With an average maturity of 3.5 years, it is the shortest duration bond market in the world. (Source: Barclays Bloomberg Indices) Meanwhile average yields across B and BB rated bonds in Asia trade at a sustained premium to other developed markets. Against the US, the Asian High Yield (HY) bond premium has actually increased in the past year. (Source: HSBC)
In China, construction costs for real estate projects average at RMB3,500-4,000/sqm, of which building materials only represent approximately 55-60%. (Source: JKC research based on various company checks) Even within these raw materials, a large proportion is accounted for by cement which has not seen the same degree of price appreciation in China this year compared to other industrial commodities. Given the average selling price of property across the country is over RMB10,000/sqm, land prices still remain the main cost and therefore the main contributor to developers’ margins. (Source: China National Bureau of Statistics) In other words, it is still the government policy of price caps (both in terms of land sales and finished product prices) that largely dictates the financial health of property companies. As we have seen in recent years, the Chinese government has been extremely proactive in real estate policy, but the overarching motive has been to maintain stability in the sector and critically to force developers to strengthen their balance sheets. On this basis, we believe even if raw material prices did start to pressure the sector’s viability, we would expect a rapid policy response, either by relaxing price caps on properties or, more likely, forcing raw material producers to maintain adequate and fairly priced supply. It is also worth remembering that, in contrast to most of the world’s leading economies, China has continued to maintain a tight monetary policy for the past 12 months indicating they are ahead of the curve in dealing with the risk of rising inflation.
In summary, we do think inflation is a concern for Asian USD bond investors as commodity prices have reached a level where dollar interest rate policy intervention is only a matter of time. Nevertheless, the characteristics of the Asian HY market with its low duration and high carry provides a way to remain exposed to fixed income assets, particularly if one remains at the short end of the maturity curve.