A Divided U.S. Government Only Adds to Indonesian Bond Positives

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A Democratic blue wave in the U.S. election would have been a negative for Indonesia bonds. As it turns out, the divided government that appears the most likely outcome should add to the growing list of reasons to favor the Asian nation’s debt.

The tally of positives for the country’s government securities include light current positioning by global funds, a local currency that appears undervalued, relatively low hedging costs, and expectations that a split U.S. government will limit any surge in Treasury yields.

A Divided U.S. Government Only Adds to Indonesian Bond Positives

Indonesia’s bonds have returned almost 4% this quarter, outpacing all of their Asian counterparts over the period. Given the host of positives, there’s every reason to think they may maintain this position through year-end.

1. Fund Positioning

One of the main reasons to like Indonesian bonds is the current underweight positioning of global funds. This resulted from the unusually heavy outflows over the past 12 months, with the total outflow about 2.7 standard deviations away from the five-year average. The percentage of the nation’s sovereign debt held by overseas investors has declined to 26% from as much as 39% in January.

The current situation gives plenty of room for foreign funds to buy back in. Indeed, the move may have already started with net purchases climbing to $1.5 billion in October, the most this year.

2. Undervalued Rupiah

The rupiah also appears to have some potential upside. The currency’s real effective exchange rate is around 3% below its five-year average -- implying undervaluation, according to data compiled by Bloomberg. Contrast that with the Thai baht, which is about 3% above.

Indonesia’s currency is also likely to be one the biggest beneficiaries once foreign portfolio flows return to emerging markets, according to a Bloomberg study of z-scores by my colleague Simon Flint.

3. Attractive Hedging

The cost of hedging rupiah-bond holdings appears relatively inexpensive, a boon to investors who prefer to avoid currency risk. The one-month rupiah implied yield, a proxy for short-term hedging costs, has been mostly below the nation’s 10-year bond yield since October. This makes it enticing to asset managers who are looking to gain exposure to the region’s highest nominal yield without the accompanying currency risk.

4. Election Catalyst

A divided U.S. government -- with Democrat Joe Biden winning the presidency and Republicans retaining control of the Senate -- is expected to result in a smaller fiscal stimulus than would have been the case under a blue-wave scenario. That should limit any surge in U.S. Treasury yields and help preserve the yield premium offered by Indonesia’s bonds. Still, it’s important to bear in mind the outcome is not completely clear as yet, with a contested election a potential possibility.

...And On the Negatives

There is one key negative for Indonesian bond gains closer to home.

A government report Thursday showed the economy shrank a larger-than-expected 3.49% last quarter as the country suffered from the coronavirus pandemic. Part of the reason may be that the government hasn’t deployed its stimulus funds quickly enough, with only 53% of the 695 trillion rupiah ($48 billion) of planned money spent as of early this month. After the figures were released, Oversea-Chinese Banking Corp. downgraded its forecast for the nation’s GDP growth to minus 2%, below the government’s target of a contraction of between 0.6% and 1.7%.

While the impact of the virus is likely to hurt Indonesia for a while yet, in itself, this is unlikely to totally offset the many positives outlined above. On balance, the nation’s bonds appear likely to remain among the region’s best performers as the tumultuous year of 2020 draws to a close.

What to Watch

  • Malaysia will release industrial production numbers on Monday and third-quarter GDP data on Friday
  • The Philippines is scheduled to publish its third-quarter GDP figures on Tuesday
  • Thailand will sell 20 billion baht ($652 million) of 2024 bonds (LB246A) and 5 billion baht of 2049 securities (LB496A) on Wednesday

Note: Marcus Wong is an EM macro strategist who writes for Bloomberg. The observations he makes are his own and not intended as investment advice.

©2020 Bloomberg L.P.

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