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Figure 179: Macro Balance Sheet Risk Score vs 5y CDS spread

300	CDS spread
250								BZ
200								ZA
150	RU				ID MX		IN
				RO			SE
100	BG						CO
		LV	KZ	HR	HU
						PH
	IL		PE LT	PL	MY
50								CN
		TH	KR QA	CL
									Macro
								Balance Sheet
0								Risk score
6		7	8	9		10	11	12	13
Source:	Haver, Bloomberg, UBS

Figure 180: EM corporate credit fair value model suggests EM corporate credit may widen by 30-50bp

600							180
550			Spread (rhs)		Forecast		Actual
							130
500
450							80
400							30
350
300							-20
250							-70
200
150							-120
11	12	13	14	15	16	17	18

Source: Bloomberg, UBS

CNY volatility will mean greater pressure on EM corporates

The weakness in Asia will be particularly relevant for corporate spreads, which have widened with a much lower beta to sovereigns in this round of weakness than in the past (Figure 180). This is largely because energy prices have remained well contained, and the widening of sovereign spreads has not spread to Asia, the companies of which form a large part of the corporate benchmark.

But three factors are set to put incremental pressure on EM corporates in 2019.

First, USDCNY volatility, which along with the MBS score and energy prices, is an important input into our corporate spreads model, is likely to rise next year. China’s growth and current account have been positively correlated in the past, unlike most other countries, and with exports coming under further pressure owing to tariffs, and the possibility of capital outflows amid some weakness in the housing market, the CNY is likely to weaken to 7.3 at the end of each of 2019 and 2020.

Second, although redemption pressures for EM corporate debt are manageable with respect to reserves, they are rising. EM non-quasi corporate debt maturing in 2019–21 is 1.7x that maturing in 2016–18.

Third, onshore credit markets have come under strain for large issuers such as China (See Box 15) and India. In both cases, non-bank financing of recent years is being frowned upon by the authorities, causing tightening of liquidity, especially for smalland medium-sized private businesses. Although yields in onshore and offshore markets do not necessarily move in lock-step (one is priced off US zero coupon, the other off local government bond yields), the spreads do follow each other closely. As these rise in the local-currency bond market, US market spreads will also rise, partly influenced by companies having to issue in hard currency.

Higher USD/CNY volatility, higher redemptions and weaker onshore credit markets will combine to see EM corporates widening by 3050bp next year

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Box 15: Will onshore defaults continue in China?

Of the RMB27tn (USD3.9tn) bonds outstanding in China onshore debt, local government owned enterprises and LGFVs,

Central SOEs and non-government-related corporates account for 44%, 31% and 21% of total bonds outstanding, respectively (Figure 182).

Onshore spreads have been widening on the back of curbing shadow banking activities, and rising defaults have led to waning demand for domestic lower-rated bonds (Figure 184). The government’s changing stance on launching more supportive measures towards better-quality privately owned companies should alleviate the default concern. This should also limit the widening of onshore credit spreads.

Will China onshore credit defaults rise? We believe so. The refinancing needs of both LGFVs and properties sector could be the trigger point, as these sectors are more exposed to tightening in shadow credit funding. Moreover, easing measures and risk appetite may not cascade down to bond issuers with weak credit quality, as shown in reduced issuance from AA or below credits in the past year (Figure 181). Nevertheless, China’s onshore credit defaults, although rising, remain low at 0.5% on an annualised basis in 2018 YTD (Figure 183). The default rate is also at the lower end when compared with Asia’s default rate of 2–4% in 2015–18, and EM’s at 1–3.5%. The default cases so far appear to be more issuer-specific than during the last peak default period in 2016, when the government targeted segments with overcapacity. Therefore, system-wide default risks are unlikely.

Figure 181: Onshore credit bond issuance and redemption Figure 182: Onshore credit bond by segment

RMB tn												Others		Banks
12											25%	15%		16%
10											20%	Mining
8											15%	5%
6												Utilities		Construction
											10%
4												6%		14%
2											5%
												Developers
0											0%
					2018							8%
2014	2015	2016	2017	2018		2019	2020	2021	2022	2023	2024
					Rem						>			Non-bank
												Transport	Diversified	financials
	Issuance				Redemption					% of o/s				13%
												11%
													12%

Source: Wind, UBS Source: Wind, UBS

Figure 183: Onshore default rates higher, but low when		Figure 184: Onshore lower-rated bonds (AA or below)
compared with EM/Asia		harder to print on waning demand and default concerns

RMB tn

RMBbn, 12mma

20

2.0%

1000

15

1.6%

800

1.2%

10

600

0.8%

5

0.4%

400

0

0.0%

200

Outstanding2014H1 2014H2

Credit2015H1

Bond2015H2

(his)2016H1

2016H2

Default2017H1

2017H2

-Jan15

-May15

-Sep15

-Jan16

-May16

-Sep16

-Jan17

-May17

-Sep17

-Jan18

-May18

-Sep18

Rate (Annualized)2018H1 2018H2YTD

0

Commercial Bank NPL Ratio

AAA

AA+

AA

AAand below

Unrated

Source: Wind, UBS

Source: Wind, UBS

Anna Ho

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Figure 185: Onshore corporate spreads do not suggest a large easing of liquidity is imminent

180
160			Average spread between AA and AAA China bonds (bps)
			TSF growth (% y/y, 3mma, rhs)
140
120
100
80
60
40
20
Jan-12	Jan-13	Jan-14	Jan-15	Jan-16	Jan-17	Jan-18

24%

22%

20%

18%

16%

14%

12%

10%

Source: CEIC, UBS

With this backdrop, we expect EM corporate spreads to widen by a further 3050bp in 2019 compared with 119bp in 2018 YTD. In Asia, the major weight in the corporate index, we expect IG yields to widen 25bp (41bp 2018 YTD) and HY to widen a further 100bp (257bp 2018 YTD). These should drive total returns of 3.5% in EM corporates, 1.3% in Asia IG and 3.1% in Asia HY.

Figure 186: Asia HY to Asia IG ratio and Asia HY to US HY ratio

4.5		Asia HY to US HY			Asia HY to Asia IG
4.0							100%ile
3.5
3.0
2.5
2.0
1.5							96%ile
1.0
0.5
11	12	13	14	15	16	17	18

Source: Bloomberg, UBS

Despite the problems facing Asian HY, we acknowledge that the price has also moved (Figure 186). The HY/IG ratio is now at 3.9x, against an average of 3.5x during the 2014–15 selloff. It is also wide relative to US HY, and even though we expect a further widening in this spread next year (we expect US HY to widen by 70bp and Asia HY by 100bp), the much higher coupon in Asian HY suggests total returns close to 4% for Asian HY compared with 3.3% for US HY.

Within Asia, we prefer <10y Chinese BBB central SOEs because, unlike AA/A names, they offer sufficient spread cushion. Cheap valuations for Chinese HY properties reflect a more balanced risk profile, while taking note of bond supply overhang, rising funding costs and overall thin market liquidity. We prefer BB Chinese properties because of potential mean reversal in the high-yield space when supply concerns fade, and their better credit quality, supporting alternative funding channels. Default risks are likely to remain higher for Chinese industrials than for Chinese property, which has already seen a significant consolidation of issuers.

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Fundamental view on Chinese property: We believe nationwide property activities will soften in 2019 as policies maintaining a tightening bias and shantytown subsidies fade, but we are not close to the last downcycle in 2014, when inventory peaked (Figure 187). The low inventory level and land purchase by developers should still support new starts (which should support both the commodity and the infrastructure push) (Figure 188). For developers in our universe, we assume presales for HY names and IG names will grow at 41% y/y and 27% y/y, respectively, in 2018, compared with 50% and 36% in 2017. We believe developers’ sales growth will continue to outpace the nationwide level given the benefit of expanded scale and market share. Signposts for a more bearish view will be a material slowdown in presales growth, build-up of inventory and a liquidity squeeze from shutting down onshore funding channels, even for refinancing purposes. We believe these are not imminent in 2019, but smaller and weaker-rated developers will be at higher risk.

Figure 187: Healthy sales-to-inventory level compared	Figure 188: Property new starts accelerated
with last downcycle in 2014

(Months)															100%
40				Tier 1					Tier 2					Tier 3
															80%
32															60%
24															40%
16															20%
															0%
8															-20%
0				Feb-12 Jul-12	Dec-12	May-13	Oct-13	Mar-14						Feb-17 Jul-17 Dec-17	-40%
Jun-10	Nov-10	Apr-11	Sep-11						Aug-14 Jan-15	Jun-15	Nov-15	Apr-16	Sep-16		May-18

Sales

New starts

Jan-07

Sep-07

May-08

Jan-09

Sep-09

May-10

Jan-11

Sep-11

May-12

Jan-13 Sep-13

May-14

Jan-15

Sep-15 May-16 Jan-17

Sep-17

May-18

Source: CREIS, UBS. Sales to inventory = current inventory/average sales in past 6	Source: CEIC, UBS
months

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