Asia gearing up for further re-leveraging

The reversal of region-wide deleveraging will accelerate even more with cost of debt now at a record low.

According to Morgan Stanely in its new Asia Credit Strategy report, Asia corporates will also look to leveraging as their balance sheet positions sour.

Here's more from Morgan Stanley:

On our estimates 2011 marks the end of a decade-long deleveraging trend in Asia. This removes a tailwind for credit and, if sustained, suggests that performance ahead will be increasingly driven by carry, and that there is upside to our already high supply expectations.

Why the leverage cycle is so critical to credit markets. It’s rare that corporates, once they’ve
begun to leverage up economy-wide, deleverage significantly short of being forced to by a recession. It’s also rare that credit spreads tighten meaningfully, or indeed at all, once the leverage trend turns. There is now little reason to expect further balance sheet improvement. The first case for further re-leveraging is that the cost of debt is at two decade lows. The second case is that Asian corporate profitability ex-leverage is no longer as extraordinary as it used to be. We suspect that this skews the balance sheet risks to the downside.

Implication #1: We’re increasingly relying on carry for returns. It’s rare that spreads tighten meaningfully once the leverage cycle turns, but this time spreads are unusually wide globally and Asian spreads are wider still, suggesting that carry can still provide attractive returns.

Implication #2: There’s upside to our already high supply forecast. Our forecast for near-record supply has been based on a need for capital markets to supply credit previously provided by banks. If funding requirements rise from here, this creates further upside to supply.

Market view: moderately overweight. We remain moderately overweight Asian credit based on positive global credit trends and still compelling Asian valuations. Balance sheet trends and supply risk are now headwinds. Our key overweight remains China high yield and China property specifically.