Low inflation risks in developed markets; a very different scenario facing emerging markets.
“China has experienced a sharp acceleration in bank credit and money supply growth, as government economic stimulus efforts have been compounded by strong levels of private-sector lending.”
— Paul Kasriel
chief economist, Northern Trust
As the global economy continues to struggle to keep the tepid recovery on track, predictions about economic growth and inflation rates are mixed. Although developed economies face mild to non-existent inflation, consumer prices are soaring in emerging economies. Europe, excluding the United Kingdom, is expected to face very little inflationary pressure, as it is in an economically vulnerable state, with the potential for a double-dip recession according to several leading market forecasters. At the other end of the spectrum, China continues to post high gross domestic product (GDP) growth on an almost monthly basis. In this environment, investors must be prepared to encounter economies at dramatically different stages of inflationary cycles.
According to Northern Trust's chief economist Paul Kasriel, "You can't have sustained or accelerating inflation unless there are high rates of growth in the money supply. Currently, there is no indication of that happening in the United States, Japan or the Eurozone."
However, in China and other emerging markets countries, it is a very different scenario; robust economic growth and high inflation rates. According to the International Monetary Fund (IMF), the real per capita GDP growth rate for 2010 is projected to be 5.3% in emerging economies versus 1.7% in advanced economies.
Those growth rates are being accompanied by correlating inflationary rates.
As Table 1 shows, consumer prices are projected to rise 6.2% in emerging economies in 2010. In contrast, the projected inflation rate for 2010 for advanced (or developed) economies is 1.5%.
"We're seeing some nascent recovery growth, but that's not necessarily being translated into strong short-term to medium-term inflationary pressures," says Wayne Bowers, chief executive officer, Northern Trust Global Investments in London. "In a benign, fragile recovery, a reduction in government spending could lead to an increase in unemployment among public sector workers along with the delay or cancellation of large infrastructure projects that the government simply can't afford."
According to Bowers, that would affect private industry as well. "In turn, this pause in growth and economic demand may lower the price of goods," Bowers says, "and thus add to the softening of inflationary pressures in developed economies."
Although a casual observation of government economic stimulus efforts in many countries might lead one to assume that inflationary pressures will build eventually, there's no current sign of those pressures in the United States. "Unit labor costs are contracting along with private-sector credit creation," Kasriel says. The high unemployment rate of 9.7% (as of June 2010) also serves as an anti-inflationary force. "In general, labor won't be able to negotiate rapid increases in wages," he concludes.
In contrast, China has experienced a sharp acceleration in bank credit and money supply growth, as government economic stimulus efforts have been compounded by strong levels of private-sector lending. "The Chinese banking system was not impaired like the banking systems in the developed world were," Kasriel says. "Unlike the United States, where banks have been buying a relatively large amount of Treasury debt and cutting back on other types of credit creation, in China they've been doing both â€“â€“ financing the country's budget deficits as well as lending to the private sector. Rising inflation in China is generating the global inflationary impulse."
After prices declined 1.5% in China from April 2008 to April 2009, they rose 2.8% for the 12-month period ending April 2010, and the Chinese inflation rate is projected to be 3.1% for calendar 2010, according to the IMF. Although that is higher than the inflation rate in developed economies, and beyond what most central banks would find acceptable, it is low relative to other emerging economies. For example, India's projected inflation rate is 13.2% in 2010.
As Table 2 shows, across emerging market economies, 2010 inflation is projected at rates that are two to three times those of several major developed economies. With such divergent economic dynamics at play globally, what is the best course of action for institutional investors?
Inflationary forces can gather strength quite rapidly, and the latest released consumer price index (CPI) figures look backward rather than into the future. With that in mind, and taking into account the widely divergent scenarios playing out in developed and emerging markets, it is entirely possible that inflationary as well as deflationary trends could develop, depending on potential shifts in a variety of economic factors. For that reason, broad asset allocation across countries, across regions and across security types can help provide an ongoing element of inflation protection.
With some economies expanding significantly faster than others, one strategy is to try to capitalize on areas with stronger economic growth. The potential for more rapid growth and higher rates of inflation provides opportunities to earn potentially more substantial investment returns in more robust economic sectors and geographic regions. "Look for opportunities to take advantage of the growth dynamic in places where inflation is higher," Bowers says. "This includes investing in emerging market equities as well as in multinationals that have exposure to these high-growth economies. Increasing demand for their goods and services generally tends to lead to rising price pressures. Of course, such an approach may expose portfolios to additional risks given the potential volatility in these markets."
“There's a strong case for ensuring that you are diversified across different regions within fixed income. That will give you exposure, quite naturally, to different economic, monetary policy and inflationary cycles.”
— Wayne Bowers
chief executive officer, Northern Trust Global Investments, London
While being respectful of benchmark weightings for certain sectors and markets, a tactical asset allocation approach could lead to greater portfolio exposure to emerging markets versus developed markets. In addition, this approach could lead to increased exposure to high-growth sectors, such as technology and materials, which have benefited from long-term secular trends, such as robust growth in Brazil, Russia, India and China, as these emerging economic powerhouses extensively build their infrastructures. Tweaking or tilting a portfolio in a manner that embraces inflation as a potential opportunity instead of just protecting against it as a threat can be an important and effective tactic.
Commodities, including gold, other precious metals and raw materials, have traditionally been valued for their protective qualities versus inflation. The logic is that prices for commodities often rise as economic activity, and inflation, picks up. "As global demand for commodities rises â€“â€“ largely because of the massive infrastructure builds in China, India and other emerging economies," Bowers notes, "it is not uncommon to see new or increased allocations to commodity plays within portfolios."
When it comes to hedging against inflation, geographic diversification can present numerous advantages. "There's a strong case for ensuring that you are diversified across different regions within fixed income," Bowers says. "That will give you exposure, quite naturally, to different economic, monetary policy and inflationary cycles."
Bowers recently has strategized with investors in Japan and the Eurozone, where yield curves have been showing little growth dynamic and minimal inflation risk premium. To these investors, the U.S. yield curve may offer greater potential to capture higher growth and inflation risk premium. Exposure to currency, Bowers notes, can be treated as a separate decision, with currency risk either hedged or not, based on the investor's desire to manage this variable.
Investors also are moving into emerging market debt as a means of diversification. Yet, it is vital to keep in mind what a relatively small portion of global assets these markets comprise. Emerging markets debt accounts for less than 1% of global fixed-income issuance with regard to broad fixed-income indexes. As such, Bowers offers cautionary advice to investors considering this segment. "Separate from any inflation concerns, there may be significant technical demand-supply constraints that alter the price and yield dynamics," Bowers says. "Therefore, you have to be extremely careful when considering allocating into such a small market segment."
Investors looking to turn inflation expectations to their advantage often look to the yield spreads between fixed-income securities as a guide to adjusting a portfolio's allocation to government versus corporate bonds, but there are a number of variables to consider with this strategy. "When inflation expectations rise, it's pretty certain that this will cause government bond yields to rise," says Colin Robertson, managing director of fixed income at Northern Trust, "even if inflation is confined to a specific country."
"With corporate bonds, another important factor is the specific issuer and its sector," Robertson says. "If the company issuing the debt is expected to be less affected by inflation â€“â€“ based on its business model, for example â€“â€“ then these bonds could outperform the overall fixed-income market. However, changes in inflation expectations often affect the yields and prices of all bonds across the board." As a result, investors seeking incremental yield along with inflation protection need to look beyond traditional fixed-income instruments.
Robertson and Bowers note some exposure to inflation-linked bonds might effectively defray inflation risk. U.S. Treasury Inflation-Protected Securities (TIPS) generally protect against the potential threat that inflation might erode an investor's purchasing power. "The current inflation breakeven rates in the United States for 10-, 5- and 3-year TIPS are 2%, 1.7% and 1.22%, respectively," Robertson says. "These market breakeven rates tell us that investors are not anticipating much of an inflation shock any time soon." A passively managed TIPS fund in a collective or commingled vehicle often is seen as a convenient method for gaining this type of exposure.
“When inflation expectations rise, it's pretty certain that this will cause government bonds yields to rise.”
— Colin Robertson
managing director of fixed income, Northern Trust
Government inflation-linked bond funds also are increasingly being used by investors in Europe. Bowers notes that for a U.K. investor, a professionally managed global portfolio of inflation-linked bonds may offer a more cost-effective means to hedge against growing inflation risks than a portfolio of home market inflation-linked Gilts, for example. "These portfolios are designed to provide investors with an opportunity to diversify geographically amongst inflation-linked instruments while maintaining a low correlation to other asset classes."
Northern Trust has seen demand for global inflation-linked strategies that aim to provide institutional investors with a means to hedge inflation without taking on the credit risk association with exposure to lower-rated countries. "We are seeing the trend to indexed inflation-linked strategies gather momentum, along with heightened concerns over medium-term inflation and its impact on pension fund liabilities," Bowers says. "Investors are considering our inflation-linked strategy as a risk-efficient, cost-effective means to meet the challenges presented by economic uncertainty."
It was anticipated that the concerted stimulus efforts by developed economy governments in the post-financial crisis period would eventually produce a sustained recovery with gradually rising inflation. But based on the mixed results to date, it does not appear that inflation will be a pressing concern within most developed markets in the next year or two. Emerging markets, however, are a different story with inflation a consideration for those regions. Because many economic and monetary policy factors in the emerging markets region continue to be somewhat opaque, a combination of strategies and tactics is often recommended. Bowers notes, "We truly do find that diversification is a key component to managing portfolios through inflationary cycles."