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Asia Outlook and Strategy 2014
‘The tide recedes’ As the Fed QE tide recedes the global economy will be faced with a new dynamic. Growth in the G3 will continue to recover, led by the US while the growth gap with EMs will narrow. G3 policy rates will remain ultra low helping to shore up recovery amid subdued inflation while the USD is set to rally broadly in the wake of higher US yields. Asian economies will continue on the path of reinvention, with growth gradually decelerating, narrowing Asia’s outperformance. USD rate gyrations will dominate the movement in Asian rates markets over 2014, with a general move higher expected. Asian sovereign yields will move higher attracting foreign investors. As the Fed tapers, the resulting competition for capital will be detrimental for many Asian currencies, with deficit currencies remaining the most vulnerable.
l G3 growth. Economic recovery is likely to strengthen over 2014 led by the US. We look for the US economy to grow by 2.7% YoY in 2014 compared to 1% for the Eurozone and 2% for Japan. Reduced deleveraging and stronger personal and corporate balance sheets will help to boost growth, although unemployment rates will remain relatively high despite some gradual decline.
l G3 interest rates. Markets will eventually become accustomed to an environment of Fed tapering while the message that tapering is not tightening will help soothe concerns. In any case policy rates will not go up in the US, Eurozone, Japan or UK in 2014. The ECB and BoJ will attempt to become more aggressive in terms of reinforcing forward guidance in the case of the former and increasing asset purchases for the latter.
l FX majors. Many currencies will suffer as the Fed tapers. Others such as JPY will fall due to expansionary monetary policy and adverse yield differentials with the USD. The hard-to-sell EUR will lose ground due to similar factors and relatively inferior growth compared to the US. Commodity and ‘turbo dollar’ currencies including AUD, NZD, MXN and CAD will do relatively well at the top end of our forecast grid while the INR, JPY and CHF will fall.
l Asia growth. EM Asia will grow 5.9% in 2014 and 2015, with China decelerating to 7.2% and 6.8%. Most other economies will pick up pace on improved growth in G3 markets. Asia’s outperformance vs. the rest of the world is diminishing. The region is in the process of reinventing itself towards a consumer-driven growth model; exports can no longer be the main driver given that external markets are growing too slowly and have become relatively small. We assume that Asia will gradually decelerate, but maintain its global growth leadership, during this restructuring process.
l Asia rates. It will continue to be a USD rates story in 2014. Given high correlations between USD IRS and most Asian IRS on a 12M horizon, we expect Asian IRS to move higher alongside USD IRS. There will be divergences in the near term as suggested by a break-down in some 3M correlations when local factors dominate. Moreover, there could be a delay for Asian markets to react. Curve moves may also differ between rate markets as some have steepened significantly already while some have lagged. Towards the latter part of 2014, whether Asian rates curves will re-flatten depends on market expectations on front-end rates, which in turn depends in part on the effectiveness of the Fed’s forward guidance.
l Asia sovereign credit. Yield pick-up from asset swap trades in sovereign bonds – from a USD funded investor’s perspective – is negative for most Asian markets. We would expect most Asian sovereign yields to move higher in order to become appealing again to foreign investors. If foreign investors choose to buy Asian bonds at current levels, it would be desirable for them to pick those with which they may be comfortable without taking full FX hedges. In this regard, CNY and KRW bonds are the obvious choices.
l Asia FX. The gradual decline in Asia’s growth advantage is likely to be a major factor for capital flows, especially direct investment, with relatively less going to the region. USD’s rise vs. majors will make it difficult for Asian FX to gain against it. The Fed’s taper will sustain the rising trend in UST yields, attracting capital to the US away from EMs. Strong correlation between UST yields and USD/Asia FX rates means most currencies will fall. C/A-deficit currencies (INR and IDR) will be the most vulnerable. Those with the strongest external balances - where external surpluses can absorb portfolio flows - should strengthen. We expect outperformance of the KRW and TWD.
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