Period ended 30 September 2019
For the quarter ending 30 September 2019, the Matthews Asia Strategic Income Fund returned 0.84%, while its benchmark, the Markit iBoxx Asian Local Bond Index, returned 0.71%.
The dog days of August brought tumult to financial markets. Declining global manufacturing indicators, geopolitical tensions in Iran and a re-escalation of the trade war all brought pain to global markets. September brought some recovery in market sentiment, although many of the same issues remained unresolved. In the third quarter, Asian markets generally followed global patterns. Less risky assets, such as government bonds and Investment-grade credit, outperformed riskier ones, such as high yield credit and equities.
Safe-haven currencies, notably the U.S. dollar and Japanese yen, outperformed other global currencies. Asian currencies, though down around 2% for the quarter on average, did outperform other emerging market regions, which saw sharp sell-offs, averaging -4% for the quarter.
We believe part of the September recovery can be attributed to global central banks, which turned more dovish throughout the quarter in response to worsening economic risks. The U.S. Federal Reserve cut rates twice in the quarter, seeing them as insurance against future deteriorations. In Asia, South Korea, Thailand, Indonesia, Philippines and India all cut rates. Following dovish central bank comments, Asian government bond yields decreased in the third quarter.
News in India was top of mind in the third quarter as the new Modi government focused on reviving the economy. On top of policy-rate cuts, it wants to bring down lending rates. $10 billion likely will be used to recapitalize the banks to address nonperforming loan issues. In addition, a $20 billion tax cut was passed. We believe both Indian equities and corporate bonds responded positively to these stimulus announcements.
Performance Contributors and Detractors:
The Strategy outperformed its benchmark in the third quarter. Returns were driven by allocations across credit, currencies and interest rates. U.S. dollar-denominated investment-grade credit performed the best, driven by the fall in U.S. rates, followed by local-currency government bonds, which in our opinion benefited from the fall in Asian government bond yields. High yield credit, while positive for the quarter, lagged higher-quality bonds as credit spreads widened in the quarter.
In rates, most of our exposures to Asian government bonds contributed to performance. The top contributors were Thai and Malaysian local government bonds. Our allocation to Indian five-year interest rate swaps also contributed as the Reserve Bank of India cut rates during the quarter.
In foreign exchange, the third quarter was characterized by weakness across Asian currencies versus the dollar. Therefore, our exposure to Asian currencies led to negative returns. Compared to the benchmark, we are underweight local foreign exchange and overweight the U.S. dollar. Therefore, currency allocations were a contributor to performance relative to the benchmark.
In credit, among the top performers were Inalum, PLN and Listrindo Capital in Indonesia. Inalum and PLN are both quasi-sovereigns, while Listrindo is a utility company. All three have relatively low credit risk. Allocation to riskier credits detracted, with top detractors coming from SoftBank perpetual bonds and Modernland, an Indonesian high yield property developer.
Notable Portfolio Changes:
We made a number of changes to the portfolio in the third quarter across credit, currencies and interest rates. In rates, we added duration in government bonds while marginally cutting spread duration in corporate bonds. Specifically, we added to Indonesian and Malaysian local government bonds and added to our overweight in Thailand rates through five-year interest rate swaps. We believe slowing growth and cuts from the Fed will allow Asian central banks to further ease rates. Rates in developed Asia should follow the falling yields in the U.S. and Europe.
In foreign exchange, we kept our overall split between dollar and local exposure, remaining overweight the U.S. dollar. Instead, we made switches within local currencies. We added to Indonesian rupiah and Malaysian ringgit. On the flip side, we reduced in Indian rupee, Chinese renminbi and Thai baht.
In credit, we exited our positions in the bonds of Sprint, CP Foods, and Shriram Transport Finance. Sprint and CP Foods bonds reached our price targets and we locked in our gains. While Shriram Transport continues to be a strong operator in the non-bank financial sector in India, many of its peers are coming under funding stress. We chose to take profits rather than risk downside from the industry. We added the convertible bonds of Luye Pharma, which we think were oversold due to concerns over increasing regulation in the industry. These are part of our focus on higher-quality companies that we think have strong balance sheets and can withstand cash-flow volatility.
The optimism of the first quarter seems distant, replaced by caution and conservatism. After successive negative surprises, first on the economic data front and then on expectations of trade war resolution, we believe investors have reduced their risk appetite. The rush for safety means that $15 trillion of debt is now negatively yielding.
Not everything is negative. First, the market has already priced in a lot of negative news. In August, 10-year U.S. Treasury yields reached a low of 1.45%, and the two-year to 10-year curve inverted, a possible sign of upcoming recession. We think the market may have been too gloomy and could be positively surprised if there is evidence that a recession is not imminent. Second, global central banks were quick to provide support and are focused on doing all they can to prolong the current cycle. For developed Asia, which is reliant on technology exports, the semiconductor cycle is showing signs of recovery. For emerging Asia, the trade war may provide a boost as manufacturers look to diversify away from China.
Some issues continue to make us concerned. First, despite lulls in the trade war, uncertainty will be negative for global corporate confidence and investments. In addition, as tariffs hit U.S. consumer prices, the Fed could face a stagflationary environment in 2020, where it is unclear whether it should act to support growth or fight inflation. Unlike in previous downturns, policymakers in China have been hesitant to provide support, given fears that monetary stimulus might destabilize the currency and further encourage financial excesses. Therefore, the willingness and ability of policymakers to support growth may be decreasing.
With the mixed global outlook, we think Asia high yield continues to look attractive for investors, as it offers significant yield as well as upside potential if the outlook brightens. Given how much global government bonds and high-quality credit have rallied, we believe they are fairly valued and unlikely to generate significant return from price appreciation. Although the U.S. dollar is strong, we need to see evidence of better global growth outlook before becoming more bullish on local currencies. Instead, we focus more on credit selection and look for bottom-up opportunities where the carry is attractive relative to the risk. Although the hope is that the worst is over, we continue to position the portfolio to potentially generate strong performance amid economic and geopolitical uncertainty.