Given the current low growth and low interest rate environment, most of the Asian region offers superior growth prospects than developed markets and better debt dynamics. The region is seeing an improving credit rating profile contrary to many of the movements in developed economies over the past few years. Asian credit fundamentals are stable and it is a growing asset class that offers attractive yields and diversification from developed markets. In addition, according to our analysis, detailed later in this paper, including an allocation to Asian fixed income alongside Australian fixed income can boost portfolio returns without increasing risk.

Asian debt markets continue to grow quickly

The Asia ex-Japan region comprises a diverse group of economies and bond markets at different stages of development. While the Asia ex-Japan bond market may represent only a fraction of developed world bond markets, it is growing rapidly, with about USD 8.7 trillion in outstanding bonds or 57% of the region’s GDP1 (see chart 1).

In addition, the Asian region offers better growth prospects than developed markets. According to Standard Chartered Research2, the forecast 2014-2030 GDP annual growth for China is 5.9%, India 6.7% and the rest of Asia ex-Japan 5.5%. Over the same time period, the average annual growth for the rest of the world is expected to be 3.0%, for the US 2.3% and for the European Union 2.0%. Led by China, Asia ex-Japan’s share of the global economy is rising, offering increasing opportunities for fixed income investors.

Asian local currency bonds grew significantly following the 1997 Asian financial crisis (see chart 2), with strong domestic support for the asset class as the economies expanded with high savings rates.

Foreign investor participation has also grown as Asian governments continue to reform their markets and improve foreign investor rules, making them more accessible and attractive. For example, as of December 2004, less than 5% of Indonesian, Korean, Thai and Malaysian bonds were held by offshore investors3. As of March 2014, offshore holdings had increased to 33.6% of Indonesian bonds, 10.5% of Korean bonds, 16.2% of Thai bonds and 30.8% of Malaysian bonds.

Asian economy fundamentals substantially improved

Since the Asian Financial Crisis, external debt in the region has fallen to more sustainable levels. Fiscal deficits in the region are now mostly below 4%, while some economies, such as Hong Kong and Singapore are in surplus. In addition, Asian economies have accumulated substantial foreign currency reserves, allowing governments the flexibility to manage currency volatilities, and their current accounts are largely in surplus.

As of mid-2014, most Asian sovereigns were rated as investment grade by Standard & Poor’s (S&P), Moody’s and Fitch. This is much higher quality than the broader emerging market countries, with Singapore and Hong Kong leading the pack with comparable ratings to the UK and US.

In the current environment, investors are on the hunt for yield. And yet many are overlooking the Asian market despite the fact that Asian bond yields are higher than developed markets. One of the most commonly used indices to represent the Asia local currency bond markets is the HSBC Asian Local Bond Index (ALBI), which tracks the total return performance of a portfolio consisting of local currency denominated, high quality and liquid bonds in Asia ex-Japan. The average return of the HSBC Asian Local Bond Index from 2002 to July 2014 was 7.27% pa.

In addition, from 2001-2013, the annual calendar returns of the HSBC ALBI have only been negative in one year – 2013. Even in 2008, at the height of the GFC, the index returned 1% (see chart 3).

Currency has contributed to the strong performance of Asian local currency bonds. However, as macro-economic fundamentals remain strong, with most countries’ current accounts in surplus, we still expect Asian currencies to appreciate in the long term. Although there is a potential risk in a broad strengthening of the US dollar as the US Federal Reserve starts to remove its easy monetary policy, the Eurozone and Japan are expected to maintain their current loose monetary policy. We believe that Asian currencies are in a better position relative to other regions with fewer geopolitical risks and volatility compared with other emerging countries. India and Indonesia, two of the worst affected Asian countries during the ‘taper tantrum’ in 2013, have implemented policies to address current account deficits and with their new elected governments are viewed positively from a reform perspective. This should reduce their vulnerability when US rates start to rise.

Asian bonds also offer relatively good historical returns with moderate volatility (see chart 4). Compared with the broader emerging markets, Asian credit and local currency bonds have demonstrated much lower volatility over the past 10 years.

Asian credit – attractive spreads with lower defaults than other EMs

Asian hard currency bonds (USD-denominated) have grown steadily as more issuers tap the offshore market and these are dominated by credit issuers (including corporate and quasi- sovereigns) at 85% of the market. The JP Morgan Asia Credit Index (JACI) tracks the total return performance of a portfolio consisting of USD-denominated bonds issued by Asia (ex Japan) sovereigns, quasi-sovereigns, banks, and corporates. The total market capitalisation of the JACI has increased from USD 143 billion in 2005 to USD 522 billion as of June 20144. In terms of credit quality, investment-grade issues dominate at USD 400 billion, with USD 122 billion of high yield issuance.

Although investors may be worried about ratings downgrade and default risk for Asian corporates, chart 5 shows that this is lower than for other regions where default rates are higher. Although Asian high yield default rates are expected to inch up in 2014, we expect them to remain below the emerging market average.

Asian credit spreads are also more attractive than for US and European credits, now for high yield as well as investment- grade. As of 31 July 2014, the approximate spread pick up for an A rated Asian credit was 35 bps over US and European credits, while a BBB rated Asian credit saw a spread pick up of about 55 bps over US and 65 bps over European credits. In terms of high yield credits, as of the same date, the approximate pick up for a BB rated Asian credit was 80 bps over the US and 112 bps over Europe, while a B rated credit achieved about 235 bps over the US and 210 bps over Europe. In our view, spreads are at attractive levels that can offset the impact of increasing risk-free rates.

Returns for the JACI Total Return Index have been largely positive over the past 12 years, with only two periods of negative return – in 2008 during the height of the GFC when credit globally suffered and in 2013 mainly due to the sharp rise US Treasury yields. Although JACI investment-grade credits suffered in 2013, JACI high yield actually offered a positive return (see chart 6). Higher yields were able to offset the impact of rising rates and wider spreads.

Including Asian fixed income in an Australian portfolio can boost returns without increasing risk

Asian fixed income doesn’t feature heavily in the average Australian investor’s portfolio. However, our analysis shows that including an allocation to Asian fixed income alongside Australian fixed income can boost returns without increasing risk.

We compared a range of Australian fixed income indices with Asian fixed income indices as part of our analysis. Chart 7 shows the risk/return for JACI, JACI high yield, JACI investment grade and JACI corporate compared with the risk/return for the UBS Australia Composite Bond Index, the UBS Australia Supranational/Sovereign Index and the UBS Australia Credit Index.

Although the JACI and its sub-indices offer higher returns over the period, the volatility is also much higher. JACI high yield returned 11.79% p.a. over the period, but with 8.98% annualised volatility. Over the same period, the UBS Australia Composite Bond Index delivered a return of only 6.43% p.a. but with a much lower annual volatility of 3.29%.

Using our efficient frontier analysis, we studied various combinations of Australian and Asian fixed income indices in an example portfolio. Based on historical data, this analysis aims to create a set of optimal portfolios that would have offered the highest expected return for the given level of risk.

First we looked at the UBS Australian Credit Index, which offered a slightly higher return (6.85%) with lower volatility (2.24%) than the UBS Australia Composite Bond Index over the period studied. The analysis focused on the combinations that would have offered the highest return while maintaining the 2.24% risk level. The key is the amount of each allocation – for example, we included a much smaller proportion of JACI high yield to maintain the 2.24% risk level, although this combination still offered the highest return with an 84 bp pick up over the UBS Credit Index.

We also analysed what would happen if we combined Asian fixed income with the UBS Australia Composite Bond Index while maintaining its historical risk level over the period of 3.29%. A similar picture emerged, with the optimal portfolio combination of the UBS Index and the JACI Total Return Index offering a substantial 177 bp pick up over the return of the UBS Index on its own.

Obivously, to achieve these results would require perfect foresight to implement, but it does show the potential upside of combining Asian and Australian fixed income within a portfolio.

Asian fixed income offers diversification benefits

Another advantage of Asian fixed income is the diversification benefits that it offers. The correlation between Asian and Australian bond markets is fairly low, which could help manage overall portfolio risk and reduce volatility (see table below).

Sector diversification is another consideration, with the JACI offering Australian investors exposure to sectors that aren’t or aren’t well represented in the Australian markets (see chart 8).

Conclusion

Favourable macroeconomic conditions, higher growth trends, enhanced corporate transparency and improvements in sovereign credit ratings indicate that Asian economies are likely to continue to experience robust growth. In the current ‘lower for longer’ interest rate environment, strong capital inflows into Asian bond markets due to the hunt for yield should continue for some time. In our view, Australian investors are missing out on the opportunities that Asian fixed income offers, particularly the attractive yields and diversification from the Australian market.

By Bertram Sarmago Investment Director – Fixed Income (Singapore), Nikko AM

————

1 Source: Bloomberg, IMF World Economic Database, AsianBondsOnline, SIFMA.org, HSBC, Deutsche Bundesbank. Bond market size as of June 2014 except for Taiwan and India (mid-2013 estimate by HSBC), US (as of March 2014).

2 Standard Chartered Research – The super-cycle lives: EM growth is key , 06 November 2013.

3 Source: AsianBondsOnline.

Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Westpac releases China Consumer Sentiment Survey

Westpac Institutional Bank (Westpac) has partnered with MNI Indicators to co-produce an independent monthly report on the Chinese consumer: The Westpac MNI China Consumer Sentiment Survey.

The key headline indicator from the survey is the Westpac MNI China Consumer Sentiment Indicator (Westpac MNI China CSI). MNI Indicators is part of MNI, a subsidiary of one of the world’s largest exchange organisations, Deutsche Börse AG.

To be launched on Wednesday, 28 May 2014, the Westpac MNI China CSI aims to become the primary reference point for key decision makers around the world seeking to better understand the current and future state of the Chinese economy, with special reference to the household sector.

Formally known as the MNI China Consumer Indicator, it has been calculated since 2007 and is disseminated by MNI Indicators on a subscription basis. Following the partnership with Westpac, the Westpac MNI China CSI will be available on a monthly basis through Westpac’s global research portal WIB IQ or by subscription from MNI Indicators. Westpac’s expert interpretation and analysis will significantly enhance global access to this information given the bank’s authority in tracking consumer sentiment in Australia for over 40 years and in-depth analysis of the Chinese economy.

The Westpac MNI China CSI also sits alongside MNI Indicators’ range of business and consumer indicators in China, India, Russia and the United States.

Westpac’s Senior International Economist Huw McKay said the Chinese household sector is already an important factor in the determination of global growth, and that importance will increase over time.

“The Westpac MNI China CSI will take the pulse of China’s consumer mega market on a monthly basis thereby gauging one of the most critical rhythms of the global economy in a timely fashion.  This survey will complement the official data, with an easy to interpret monthly report underpinned by a pre-existing and well understood research methodology,” McKay said.

Chief Economist of MNI Indicators Philip Uglow said, “We’re delighted that our co-operation with Westpac means that this deep mine of data on the Chinese consumer will now reach an even larger audience.”

“As well as key top level data to show how the Chinese economy is performing, our database of more than a hundred thousand data points over the past seven years allows professionals to analyse all aspects of Chinese households by major city, region, income, gender and age. It provides unique insights into the minds of Chinese consumers on a range of topics, including personal finances, spending, housing, autos, equity markets and employment,” Uglow added.

Westpac’s Head of Greater China Andrew Whitford said, “While there are a number of closely watched business surveys in China, this will be the only independent monthly insight into the psyche of the Chinese household sector.”

“Westpac’s expertise in this field makes us well placed to cover consumer sentiment in China and delivers on our strategy of connecting our global customers to the flow of trade, capital, investment and people through the China Corridor,” Whitford said.

The Westpac MNI China CSI is based on the methodology developed by the University of Michigan’s U.S. Consumer Sentiment Index, which has been in use since 1946. The Westpac-Melbourne Institute Australian Consumer Sentiment Survey, founded in 1973, was also modelled on the University of Michigan survey.

The use of a pre-existing and highly regarded framework for the survey should give confidence to users that the data that they have in their hands is a robust tool for both tracking the state of the Chinese household economy and the facilitation of international comparisons. The sample size for the Westpac MNI China Consumer Sentiment Survey is larger relative to the sample population that is used in the U.S., which leads to a smaller sampling error (3.5% versus 5%).

The Westpac MNI China Consumer Sentiment Survey will be launched on Wednesday, 28 May 2014. After the inaugural release, the Survey findings will be published on the final Wednesday of each calendar month at 09:45 Beijing time.

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Clifford Lau – Head of Fixed Income, Asia Pacific, Threadneedle Investments

Keep calm and carry on – a wise statement to inspire during war times, and for post-crisis investment in the financial markets. 

Keep calm when market turbulence sets in again; carry on, even when technical factors take markets in a direction that goes against your well-researched fundamental views. The aftermath of the 2008 global financial crisis has resulted in the Asian fixed income market gaining not only new status in terms of its risk-reward profile versus equities, but more importantly has led to a much higher core portfolio allocation in Asian bonds by international investors.

As a result, the Asian fixed income market has become sufficiently sizeable in terms of its capitalisation, and geographic and industry coverage, to become a distinctive asset class for global investors in its own right. 

2012 was a defining year for Asian fixed income, especially the hard currency market.  Not only did it record the highest amount of new issuances within a single year; the diversity of industry groups represented by new issues was also unprecedented. The significance of those new entrants in the bond market made 2012 a truly remarkable year for Asian hard currency bond trading.

In the Asian sovereign market, we saw Sri Lanka returning with a 10-year new issue, and Mongolia’s debut issuance of two USD-denominated benchmark bonds. These new sovereign issues, together with supply from their quasi-sovereign peers (Bank of Ceylon from Sri Lanka, Vietnam Joint Stock Commercial Bank, and Development Bank of Mongolia) opened up a new arena for Asian sovereign and quasi-sovereign bond trading. 

For Asian high-grade corporates, we saw a good number of both regionally and internationally well-known names, such as CNPC, Sinopec, Baidu and Tingyi from China, and Samsung from Korea, which took advantage of the exceptionally low interest rate environment to raise money for capex programmes and re-financing. 

In contrast, Asian high-yield corporates had a relatively subdued year from a supply stand point, with only a handful of benchmark bonds coming to the market last year. However, a very attractive relative valuation post the May/June market sell-off (due to increased European headline risk) enabled Asian high-yield corporates to deliver strong total returns for the year. Overall, the JPMorgan Asian Credit High-Yield Corporate Index returned 25.4% (Source: Bloomberg) in 2012 as event risks from developed markets subsided and credit fundamentals exhibited signs of bottoming out into the year end.

Certainly, 2012 was a year full of policy surprises. Consensus trading views on economic fundamentals and technical flows on the one hand and forward-looking opinions from rating agencies on the other were moving almost in opposite directions. With so much appreciation already priced into risk assets (the JPMorgan Asian Credit Broad Index tightened 123bps, returning 14.3% in 2012 – see Chart 1), thanks to rhetoric from policy makers in the developed world and high expectations that politicians will ultimately deliver what they have promised, financial markets are now set up for a make-or-break scenario in 2013.

JPMorgan Asian Credit Broad Index 2012 Spread Performance

Asian high-yield sovereigns
The love-hate relationship between investors and Asian benchmark high yield sovereigns (Philippines and Indonesia) has deepened further in 2012. These markets represent everything to love in terms of liquidity, but everything to hate in terms of valuation (especially the Philippines).

Tight valuation aside, we do however believe the Philippines earned a well-deserved upgrade from the rating agencies with its better public finances, sustained growth of overseas remittances, and disciplined government budgeting which allowed the central bank to exercise a buyback program last year and refinance maturing debt at attractive terms.

Rightly or wrongly, the Philippines has now comfortably secured its safe-haven status at a time when the developed world is still in trouble. Philippine sovereign debt will be the most preferred asset to accumulate during volatile times. However we believe the underperforming Indonesia and new bonds from frontier markets such as Sri Lanka, Mongolia, and Vietnam offer better upside during a risk-on market.

Regardless, it is important to highlight a number of near-term risks:

• Vietnam’s banking sector de-leveraging is currently underway, which will be headline negative over the coming months
• Sri Lanka has vulnerable external finances, a structural current account deficit, low FX reserves and disappointing FDI
• there is the high dependency of Mongolia’s economy on the mining sector
• Indonesia’s poor commodity pricing market leading to a widening out of the current account deficit and high inflationary pressure in anticipation of fuel subsidy reform.

Overall, we prefer to go flat Philippines and Indonesia using their respective quasi-sovereign bonds as proxies, and outright long Sri Lanka and Mongolia in anticipation of their stronger economic performance this year.  For a long-only, total return type of portfolio, partially or fully hedged, the treasury components will be important to protect downside risk given the probability of rising treasury yields in the New Year.

Asian high-grade corporates
The investment-grade corporates market was full of life last year. There was a big jump in high-grade corporate new issuance in 2012, up 189% on a year-on-year basis in terms of the total amount issued, representing 45% of all US dollar-denominated bonds issued. Investors seeking safer fixed income assets added to positions last year as the global backdrop remained gloomy.

This intensified demand and encouraged supply, helping Asian high-grade corporates to rally 85 basis points over 2012, according to the JPMorgan Asian Credit High-Grade Corporates Index.  We believe this will continue to be a core theme for investors this year.  Despite spreads having tightened a lot (the weighted average spread closed the year at +240 basis points), peer comparisons show that Asian high-grade spreads still offer a 50-90 basis points pick-up compared to similarly rated bonds in the US.

We think the Asian premium is too high in the investment-grade category. Our favorable outlook on Asian high-grade corporates is also an expression of our view that market volatility is going to be less detrimental to Asian high-grade compared to high yield, as people are still generally cautious about the heightened risk from the uncertain global growth outlook and political tensions in 2013.

The valuation of high yield also appears more expensive from a historical standpoint. While we are not suggesting the liquidation of any high-yield investments, we do however believe that the Asian high-grade market is more suited to a spread compression trade versus global peers in the medium term. 

We believe that  the best opportunities can be found in Singaporean, Malaysian and Thai bank subordinated debt, all Lower Tier II bank capital (except in India) due to cheap valuations relative to senior paper; Hong Kong properties for their stable rental incomes; issues from the consumer sectors which should benefit from the expectation of stronger consumer spending across the region; and systemically important Chinese state-owned enterprises where spreads have been oversold due to M&A concerns and high capex risk this year. Korean paper looks fairly valued after last year’s sovereign upgrade, so we would accumulate only when the market sells off.

Asian high-yield corporates
It would require investors to take a leap of faith to believe the Asian high-yield market can deliver the kind of exceptional returns seen in 2012.  Discussions about the high-yield market outlook have to move beyond the generic assumption that spreads will close the gap versus global peers. After all, the Asian high-yield market is a collection of bonds with very diverse backgrounds, with some as tight as 2.9% YTD (Citi Pacific 2014) to as wide as 55% YTD (Bakrie Telecom 2015).

The very strong performance of high quality high-yield credits last year has now made them as sensitive to treasury risk as investment grade credits. What we have also observed is that the strong outperformance of Asian high-yield corporates has resulted in the spread pick-up from Asian high-grade corporates compressing from 623 basis points to just 270 basis points throughout the course of 2012.

Is the current valuation of the high-yield market providing fair compensation for the perceived higher fundamental credit risk?  Should we be just content with the higher carry return we can obtain by investing in the high-yield market? Should we be worried that the market could have already reached its tipping point, or can we expect Asian high-yield corporates to rally non-stop like the sovereign market in the Philippines?

These are big questions and difficult to answer as we all know macroeconomic trends are as important a driver of high-yield market performance as credit fundamentals. To be clear, however, we think the market now has very little tolerance of high-quality high-yield credits underperforming given their expensive pricing. So long as they maintain their stable credit profiles, the inclination is to stay strategically invested in high yield credits while the global market backdrop remains conducive.

For a technical risk-on play we would engage in trading the high Single-B names such as those from the Chinese property markets. This year, the Chinese property sector should see a ‘tug of war’ between strong consumption growth and the increasing operating cost of raw material and land bank replenishment.

The potential call risk for 2013 callable bonds is also worthy of attention. Chinese industrials had a bad year in 2012 in terms of profitability, and represent an investment opportunity should market optimism about China’s infrastructure spending be well-founded while the return of the Chinese consumption story would also help to revive their businesses.
Finally, on Indonesian resources names, the near-term risk from disappointing results is high but we are also aware that the coal price has started to rebound since Q4 2012.

One credit which may benefit from this rebound is Bumi Resources (Bumi 2017). The market has partially priced in the downside due to its high leverage and heavy refinancing needs in late 2013 and early 2014. Management has been discussing the sale of non-core assets, and if the company makes good progress and manages to raise cash to improve liquidity, this should provide a catalyst for the bonds to rally.

Asian economies and inflation
Asian economic growth has entered into a transformational phase where the strong export-led model will be sidelined further while domestic demand should become the more dominant force driving GDP growth.

Given the competitiveness of the region’s economies has also been weaker due to the strong appreciation of Asian currencies in recent years, the rapid growth of GDP and fast accumulation of FX reserves could be a thing of the past. For 2012, Asian GDP growth was below average as the consolidation of trade balances between emerging markets and developed markets led to weaker emerging market exports, which hurt current account positioning. 

For 2013, we think the recovery in the US economy and the elimination of tail risk (thanks to aggressive central bank policies from the Eurozone) should help to lift export growth and hence we forecast GDP growth of around 5-6% (ex-China) for Asia in the New Year.

However, as mentioned earlier, the transformation of the growth model for the Asian economies would make the outlook for domestic demand as important as export trends in driving bottom-line GDP growth. China and India could see their hands tied with regard to further credit expansion to fuel domestic demand, due to the recent build-up of excess leverage and up-tick in inflationary risk.

The other developed and emerging Asian countries should see a steady recovery but the overall outlook is benign rather than anything too positively surprising. The Philippines appears to be the most resilient, while Indonesia is going to face more headwinds to resolve the current account deficit. Developed markets such as Hong Kong, Singapore, and Korea should benefit from a recovery in global trade. Finally, we think the frontier Asia economies such as Sri Lanka, Vietnam and Mongolia are going to attract a lot of attention from investors in 2013.

In terms of inflation, we expect the broad trend to be modestly higher in most Asian countries, given our anticipation of a recovery in global trade. The lagged effect of quantitative easing will also help to drive capital inflows. Asian inflation risk is mostly food related, but so far there are no signs indicating that food prices are under any inflationary pressure.

However, tensions in the Middle East would increase the risk of an oil price shock, and the potential rebound in coal prices during 2013 is also a wild card that could take inflationary trends in an undesirable direction, especially for those countries where retail fuel prices are still heavily subsidised by the state.

China and India
The Chinese government is now going through a period of leadership transition. While the process has completed at party level with the changeover to be completed by March 2013, new economic reforms have taken place before the political handover began. The senior leadership, be it the outgoing or incoming one, have consistently reiterated the priorities of sustainable economic growth with urbanisation, infrastructure investments (urban and railway transport, social housing) and accommodative monetary policies being the main pillars to achieve the GDP growth target of 7%.

Construction-related sectors will most likely benefit more from this policy direction. We will also be keen to see more progress made by the government in opening up the private sector (especially in the service sector), better regulation of the banking sector (trust financing and shadow banking pose a very high risk to the health of the Chinese banking sector), a reassessment of exchange rate policy, further development of domestic bond markets, and a further push towards consumption demand as a driver of sustainable of growth.

For India, what worried investors the most last year was its fiscal slippage. S&P revised India’s outlook of its BBB- rating from ‘stable’ to ‘negative’ in early 2012, highlighting lower GDP growth forecasts, the risk of external liquidity and eroding fiscal flexibility. The government has taken steps to address those weaknesses since then.

In particular, a series of measures were proposed in September last year to buy time and hopefully avert the potential ratings downgrade. There are now heavy economic and political pressures on the Indian government to deliver on the reform front, but the political reality in India means that it will be difficult for reform bills to be passed smoothly by both the lower and upper houses.

Separately, due to the inelastic demand for both gold and oil, the current account deficit would only be eased in the near term by the successful implementation of capital account liberalisation and reform measures. Recently, both the lower and upper houses passed a retail FDI bill, which is a step in the right direction. Overall, we think there will be more difficult times ahead for India and therefore we are not conducting’ risk on’ trades in both hard and local/FX markets until we see a clearer path towards external account improvement and commitment to reform implementation. 

Conclusion
Given the new era of high volatility in financial markets, we have limited our views on the outlook to an investment time frame of three months. Whether or not people like or dislike the deal struck in the US over the New Year, fiscal cliff concerns are now temporarily behind us. In the short term, the market should enjoy ‘risk on’ rally until oversupply of new issues starts to overwhelm investors.

We favour overweighting risk as the new year starts, but will stay vigilant while medium-term risks are unfolding. These risks include the economic impact following the last-minute US fiscal deal, ongoing banking reforms, the recessionary and unemployment outlook in the eurozone, the economic and fiscal prospects for India, and more updates from China as the leadership transition is finalised.

We think the Asian fixed income market has the potential to generate a mid-single digit positive return in 2013, but we will place the emphasis more on active portfolio management, and are wary of chasing carry returns (from high yield) at this stage.

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• Inflation still well contained. China’s annual inflation rate rose from a 30-month low of 1.8 per cent to 2.0 per cent in August, in line with forecasts. Over the month inflation rose by 0.6 per cent after a 0.1 per cent lift in July. Food prices rose by 1.5 per cent in August while non-food prices rose just 0.1 per cent.
• Business inflation (producer prices) fell by 0.5 per cent in August after falling by 0.8 per cent in July. Producer prices are 3.5 per cent lower than a year ago – a 34-month low.
• Data supports stimulus moves. The latest data supports the decision by Chinese authorities to approve infrastructure projects valued at US$157 billion.

What does it all mean?

• Effectively the latest economic data is ancient history. Recognising the economy needs a kick along, Chinese authorities have approved new infrastructure projects, such as highways, ports and airport runways, valued at US$157 billion. While positive for Chinese businesses and commodity producers in Australia, it won’t assist with the longer-term goal of shifting economy-wide spending away from the industrial sector to consumers.
• Inflation is under control with the only factor boosting prices in the latest month outside authorities’ control – namely food. So Chinese policymakers can afford to cut interest rates or reduce reserve requirements in coming months if growth continues to stagnate.
• The Chinese policymakers are adopting a softly, softly approach to economic stimulus. During the global financial crisis in 2008, China launched a 4 trillion yuan (US$630 billion) stimulus package. While that had the desired effect of insulating the Chinese economy (and to some extent Australia) from the crisis, the concern is that it may have been too much – leading to some over-heating of the property sector.

What do the figures show?

• The annual rate of consumer price inflation rose from 1.8 per cent to 2.0 in August, in line with expectations. Over the month inflation rose by 0.6 per cent, up from forecasts centred on a 0.5 per cent increase and up from a 0.1 per cent gain in July.
• Food prices rose by 3.4 per cent over the year to August (2.4 per cent in July) while non-food prices rose by just 1.4 per cent in the year to August (1.5 per cent in July).
• Producer prices (business inflation) fell by 0.5 per cent in August after falling by 0.8 per cent in July. Producer prices are 3.5 per cent lower than a year ago – a 34-month low. The annual rate of producer price inflation peaked in July 2011 at 7.5 per cent and has been declining since.
• Industrial output expanded at an 8.9 per cent annual pace in August, down from 9.2 per cent in July and below forecasts centred on a result near 9.1 per cent. Production is growing at the weakest pace in more than three years (May 2009) and well off the highs of 20.7 per cent annual growth in January/February 2010.
• China’s urban fixed asset investment, such as spending on roads and power plants, grew at a 20.2 per cent in 2012 to date (January – August), below forecasts (20.4 per cent) and down from 20.4 per cent in the seven months to July.
• Retail sales grew at a 13.2 per cent annual rate in August, up from 13.1 per cent in the year to July and in line with forecasts.

What is the importance of the economic data?

• China’s National Bureau of Statistics releases its monthly economic statistics around the 10th of each month. Quarterly GDP data is released around the 16th of January, April, July and October. China is Australia’s largest trading partner and changes in the Chinese economic have major implications for the Aussie economy.

What are the implications for interest rates and investors?

• Chinese policymakers are doing what they have to, to support their flagging economy. China can’t rely on a fast revival of European, Japanese or US economies, so effectively it has to provide the boost that the world needs.
• The slowdown of the Chinese economy doesn’t appear to be gathering pace, but there are only tentative signs of growth bottoming out. The new infrastructure program will go some way in ensuring that the economic slowdown is arrested and clearly it is positive for Australian mining and energy firms. The only negative is that the boost to the Chinese economy has boosted the Aussie dollar, making it more difficult for Aussie companies.
• The new infrastructure program should ensure that the Australian Reserve Bank stays on the sidelines for a longer period.

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