Inflation: a challenge with many facets/

Inflation: a challenge with many facets

by Neal Underwood on Aug 26, 2011 at 15:43

Inflation: a challenge with many facets

Although most economists and commentators will happily express a global outlook for inflation, in truth there are a number of very specific regional and sectoral issues which are having an impact on economies and in turn, investors.

The surge in food and energy prices since last summer, for example, has contributed to rapid rises in emerging market inflation. This has been exacerbated by the strong economic growth in most of these countries and the uptick in wages, resulting in higher consumer prices.

As a result, emerging market governments and central bankers have been in tightening mode for some months now, trying to contain the inflationary dragon. Figures from Trading Economics show China’s current inflation rate stands at 5.5%.

Policy overshoot remains a major risk for Chinese equities as the government tries to rein in excess liquidity, although the measures it is employing appear to be necessary. Failure to tame inflation could slow corporate profit growth in 2011 and erode profit margins, as many companies may have problems passing all cost increases to customers.

Inflation could also hurt consumer confidence, and high house prices and rising interest rates may curb private consumption. These would all have a knock-on impact on those investing in the region.
Varied approach from emerging economies

Willem Sels, UK head of investment strategy at HSBC Private Bank, notes that emerging markets weathered the financial crisis fairly well and came through with healthier finances and stronger economies than the developed world.

However, he says, with strong economic growth, many were quickly faced with the prospect of rising inflation. ‘As a consequence, emerging markets were the first to start the tightening process, especially in Asia. But higher interest rates often mean a stronger currency and countries were concerned about losing their competitive advantage in exports. In order to protect their currencies from rising too much too quickly, many countries turned to unconventional measures to avoid hiking interest rates.’

China, for example, raised bank reserve requirements more aggressively than interest rates, although it did start hiking rates as well and has now started talking about allowing more currency appreciation to combat sticky inflation. ‘In Brazil, where the Selic rate [the Banco Central do Brasil’s overnight lending rate] is already one of the highest in the world, the government imposed taxes on foreign inflows to cool speculative inflows and slow currency appreciation,’ says Sels.

‘Turkish authorities took the unconventional experiment to the extreme, cutting interest rates while raising bank requirement ratios in an effort to cool domestic credit growth and stem Turkish lira appreciation. This appeared to work for a while as the lira depreciated and inflation appeared under control, but inflation has now started rising.’

Emerging market central bankers are faced with a difficult predicament as currency appreciation is a great tool to combat inflation but could hit competitiveness and future economic growth, notes Sels. ‘However, in our view, with inflation proving sticky, we believe that many countries are now more accepting of gradually appreciating currencies.’

While the end goal is to slow inflation, Sels points out that tightening measures are typically aimed at slowing economic growth as the means to achieve this. ‘In some countries, such as China, we are seeing the beginning of an impact of such tightening measures on economic activity. Growth has started to slow in China and other Asian economies and across Latin America. Further, we expect growth in the developed world to slow in the second part of the year, which could impact on the export components of emerging market GDP numbers.’

From a pure inflation perspective, Chinese inflation does now appear to be stabilising after a peak around the Chinese New Year. Sels also highlights the fact that inflation in countries like Mexico has started to come down in recent months.

Inflation: a challenge with many facets

by Neal Underwood on Aug 26, 2011 at 15:43
Unchecked inflation

‘Nevertheless, many countries continue to see rising inflation and tightening is set to continue, and may even accelerate,’ says Sels. ‘India recently hiked interest rates for the ninth time since March 2010.

In addition, tightening has become more aggressive as the Reserve Bank of India recently raised interest rates by 50 basis points versus the 25 basis points expected by markets. Central banks in the Philippines and Malaysia have also raised interest rates and we believe the trend is set to continue in Indonesia and Korea as well. We also expect Turkey to need to start tightening soon.’

Sels believes most emerging market central banks have actually been behind the curve in terms of tightening. ‘They have been worried about currency appreciation and a fragile economic recovery in the West and were reluctant to tighten. As such, tightening has been lacklustre. This trend appears to be ending and we believe tightening is set to become more significant in the coming months as growth remains robust and inflation remains high.

Many central banks have hiked more than expected recently or indicated that further tightening was coming. Some central bankers have agreed that currency appreciation was likely and helpful, which should imply a softer stance on currency appreciation.’
Falling commodities prices

One encouraging development for emerging markets, says Sels, has been the recent fall in oil prices and many other commodities. ‘If we start to see a stabilisation in commodity prices – a large component in Consumer Price Index [CPI] baskets in the emerging markets – this should help alleviate inflationary pressures in the second part of the year. In addition, with strong commodities demand coming from China, a slowdown in economic growth due to tightening could impact demand for commodities and then slow inflation.’

Further support to central bankers may be provided by the possible slowdown in growth in developed markets in the second half of the year, which could also mute commodity price appreciation, says Sels. ‘While tightening is set to continue to contain inflation, expectations appear to already be peaking – or at least be capped – as demonstrated by the recent good performance of the Emerging Markets Local Currency Bond index. Tightening measures have also been positive for currencies and further tightening should imply further appreciation for emerging market currencies.’
Food price inflation

Food price inflation has also been a major driver behind global inflation. Jim Leaviss, head of retail fixed interest at M&G, notes that UK food inflation is running at nearly two-and-a-half times that in Europe. ‘Why is UK inflation running at a much higher rate than European inflation?’ he asks. ‘The UK’s CPI is 4.5% compared with 2.7% in Europe. One answer might be food inflation, a major portion of the overall CPI baskets; 11% in the UK, 15% in the eurozone – add in alcohol and both are a little higher.’

The UK rate of food inflation is systematically higher than that in Europe, notes Leaviss. ‘At the moment the year-on-year increase is 4.7% compared with 2%, and at times the difference has been much higher. There are times when you might explain this through sterling weakness feeding into imported food prices, but there have been periods of both currency strength and weakness. What else might explain structurally higher food inflation in the UK?’

Earnings-per-share growth for UK and European food retailers might at least be part of the answer, say Leaviss. ‘When food price inflation started to moderate post the last shock in 2008, European food retailers cut prices. In the UK the supermarkets realised that they had pricing power and kept raising them; this resulted in the strong relative profitability that they enjoyed. There might be other factors involved – the UK supermarkets have massively diversified into non-food goods, everything from clothing to DVDs to insurance, but it does look like UK consumers are being hit by the lack of competition in the food retail sector.’
Agribusiness driven by inflation

Ralf Oberbannscheidt, portfolio manager, DWS Invest Global Agribusiness, notes that food price inflation is driving the agribusiness sector. ‘Changes in the US bond market are positively impacting the agribusiness sector. The recent decision by Standard and Poor’s to place the US government’s mounting debt on credit watch pushed the broad market down in April, as political divisions on deficit reductions were again laid bare. The S&P report questioned whether both sides of the political spectrum will be able to reach an agreement before the election in 2012.’

The downgrade to a negative outlook means that there is a one-in-three chance that US bonds could be downgraded from the current AAA rating, says Oberbannscheidt. ‘Bond prices initially fell, but later rebounded as investors viewed the report as a lever to move both sides closer together on a deal. Globally, markets quickly recovered as data indicated that manufacturing output for the US economy positively influenced the agribusiness sector, as output grew more than four times faster than the estimated rate.

‘Due to this, we are seeing strong demand for capital goods such as machinery and farming equipment following delayed purchases by customers who conserved cash during the recession,’ he says. ‘Food price inflation is boosting worldwide spending on agricultural equipment and the market continues to value companies with exposure to this trend, even those firms that have a secondary or tertiary place in the agribusiness value chain.’

Inflation: a challenge with many facets

by Neal Underwood on Aug 26, 2011 at 15:43

Oberbannscheidt says current promising sectors include food retailers, particularly USbased supermarkets, as overall retail grocery sales improved in April compared with March. UK food retailers also performed well, as companies were able to pass higher agricultural commodity prices on to consumers.

In the US, following a year of input cost deflation and declining prices, price inflation is taking hold with large multi-nationals responding with price increases. Companies with strong brands and private label products will benefit from the current environment, whilst those without price or innovation advantage will lose market share.

‘Other sectors which have performed well include supply chain managers, as tight conditions for soft commodities continue to benefit companies that grow and process farmers’ crops,’ says Oberbannscheidt.

‘European-based crop protection manufacturers have also seen positive sales. Excess inventories have been reduced, pushing consumer purchasing prices above analysts’ expectations.’

‘We are in a time period where the focus shifts to the planting decisions of US farmers as Brazil, Argentina, and South Africa are in the midst of harvesting crops,’ concludes Oberbannscheidt.

‘As we receive more definitive data on the quality and yield estimates for next year’s crops in the summer, performance of agribusiness stocks will be impacted by the level of exports to key countries like China and Japan as well as their current appetite for grain.’