Inflation hedge: Could Asian stocks be the answer?
Traditionally, higher inflation and higher rates in the United States have spelt trouble for stock markets in Asia, particularly when it comes to the emerging markets of the region.
But there’s a growing chorus of experts who now think this time could be different and Asian stocks could actually be a shrewd inflation hedge.
The inflation situation in the U.S.
First let’s look at inflation is in the U.S.
The most recent Government data shows consumer prices rose 7.5% in the 12 months to the end of January 2022. This was the largest annual spike in inflation since 1982.
There has been a divide between economists and politicians over whether this inflation is transient or sticky. Those in the ‘transient’ camp believe prices have been artificially inflated in the short-term by the impacts of COVID-19 – including pent-up demand, and the global supply chain problems.
Those who think inflation is ‘sticky’ argue there are more structural and cyclical economic forces, along with geopolitical issues at play that will lead to higher inflation for longer.
In recent months, the consensus has shifted towards the sticky camp.
Even Federal Reserve Chair, Jerome Powell – who had been arguing for much of 2021 that inflation was transient – has changed his tone.
He was asked about his persistent use of the word “transitory” when discussing inflation at a Senate Banking Committee in Washington in November. His response:
“I think it’s probably a good time to retire that word”Jerome Powell, Chair of the Federal Reserve at the Senate Banking Committee on November 30, 2021.
Powell, no doubt, is finding the data very hard to ignore.
Energy prices in the U.S. have risen around 25% over the last year, wages are growing at almost 6% annually (this is compared to the historic annual average of around 3%) and consecutive monthly inflation prints have shown rents have been rising at around 10% annually.
Because of this inflation pressure, the Fed has been forced to move to cool the economy down (or tightening monetary policy, as its referred to in finance and economics). Already the tapering program is seeing the purchase of Treasury securities reduce by $30 billion each month.
And it is a near-certainty that next month (March) Powell will announce a rate hike of at least 25 basis points. It’s widely expected that there will be at least another four rate hikes during the remainder of the year.
The impacts of rising inflation and the subsequent monetary policy tightening and rate rises on U.S. stocks could be profound. In fact, it already has been – large cap U.S. tech stocks have aggressively sold down over the past month.
This is because higher yields change the price investors are prepared to pay for growth stocks that are priced on aspiration future earnings and don’t generate much profit or cash flow today.
Higher inflation and higher rates will also mean investors re-assess the pricing power of the companies they own, the impacts of the rising cost of capital (interest rates) and whether or not they can withstand the inflationary cost pressures.
Furthermore, there is the added impact of less retail participation in the market, which can be argued as a force that has inflated the stock prices of many companies during the recent bull market.
COVID-19-induced fiscal stimulus saw an extraordinary amount of retail money flow into U.S. stocks, particularly passive ETFs. But now with the stimulus tap being turned off and higher cost pressures on households, the retail money is expected to slow.
All this comes as U.S. stock have been trading at a never-before-seen premium to the rest fo the world.
As inflation uncertainty surrounds U.S stocks, investors are looking for an inflation hedge
During these periods of heightened inflation volatility, many investors look to add assets to their portfolios that can act as an inflation hedge.
The most well-known hedges against inflation are gold, commodities (including agricultural commodities, metals and oil), infrastructure and certain REITs.
Digital currencies such as Bitcoin have also been referred to as an inflation hedge by some commentators, however there appears to be little basis to support this claim and Bitcoin has recently shown a close correlation with U.S. tech.
Asia stocks as an inflation hedge in 2022 and beyond
One of the more unconventional asset classes to be labelled an inflation hedge right now is Asian stocks.
Traditionally higher rates in the U.S. have led to a higher USD, and thus imported imported inflation to Asia.
However, this time the same inflationary pressures being experienced in the U.S. aren’t being seen across Asia, and monetary policy in major economies such as China, are on a clear path of divergence with the West – in short, while the U.S. in tightening, major economies in Asia have the fiscal firepower to loosen as they injected far less stimulus in the wake of COVID-19 and still have higher rates that can be lowered.
Robert Horrocks, CIO of Matthews Asia – one of the leading Asian investment firms in the U.S, says the low inflation seen so-far across Asia is a “silver lining” for investors.
“Core inflation rates may have increased dramatically in the U.S., Europe and Latin America but in much of Asia they have barely budged. It’s true that South Korea has raised interest rates, as much to cool the property market as anything. However, China is in a loosening cycle, Japan needs more inflation, and even India, for whom inflation has been an unwelcome speed limit for the economy in years past, has given itself a bit more room to grow by holding inflation down.,” says Horrocks.
“So, Asia is far less vulnerable to tightening than has historically been the case and may even be running monetary policy at odds to the U.S.”
Horrocks says while much uncertainly remains about the global impacts of inflation in the West, company fundamentals will be as important as ever for Asia investors.
“The best way of dealing with these rather opaque cycles in a portfolio context is to look through the macroeconomic issues and focus on those companies that are strong enough to navigate the environment. It is how we have always approached investment in emerging markets.”
Edward Colem, Managing Director at Man GLG, goes a step futher. He says inflation in the U.S. will act as a tailwind for emerging markets in Asia.
“As investors weigh up the likelihood of persistent inflation, one thing at least is clear: history indicates that inflationary outcomes benefit emerging market equities.
“From higher commodity prices to increased investment spending to improved trade balances, inflationary conditions are likely to act as a tailwind to emerging markets equities.”
Colem adds precedence to his argument, pointing out that the performance of emerging markets has historically been highly correlated with the performance of commodities (one of the more traditional hedges against inflation). This is illustrated below.
Valuations lower risk in Asian stocks
Further strengthening the case for Asian stocks as an inflation hedge is the historically low valuations relative to the U.S. This provides, not only room for growth, but also downside risk protection according to analysts.
As an example, the average forward price to earnings ratio in China’s Shanghai Composite Index is around 10%. This compared to just over 20% for the NASDAQ and the S&P 500.
Re-thinking conventional wisdom in bond markets
Senior Portfolio Manager at Manulife Investment Management in Hong Kong, Paula Chan, is another leading investor who believes the current inflationary pressures in the U.S. is positive for the outlook for Asian assets.
Chan notes an unusual patterns that has occurred in recent month with the Chinese yuan suggesting this time may well be different.
“According to conventional wisdom, there is a belief that US inflationary pressures can be negative for the Chinese yuan. This is because, historically, US inflationary pressures have led the Federal Reserve to tighten monetary policy, and US Treasury yields then to move higher as investors became concerned about inflation,” says Chan.
“Consequently, the yield advantage of China’s interest rates over US Treasury yields would narrow, as the latter rises while the former remains stable.
“Contrary to the above expectations, we have noticed that (recent) US inflationary pressures did not necessarily lead to an underperformance in the yuan. In fact… The yuan had tracked US inflationary pressures quite closely, as indicated by US 5-Year breakeven rates, which is a gauge of the market’s expectations for US inflation.
“Meanwhile, the CNY had also tracked the official annual US CPI rate on an ex-post basis. As US inflation ticked higher, the CNY appreciated against the US dollar during these periods.”
Chan says ultimately she believes, like Chinese equities, Chinese bonds can too be a positive-yielding inflation hedge.
“China bonds are already an attractive asset class, given their higher nominal and real yields and diversification benefits due to a lower correlation with other assets. However, the potential for China bonds to be a positive-yielding asset that also hedges against rising global inflation further enhances their appeal.”
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