Embed Size (px)
Citation preview
May 2011
For Professional Clients Only
Who let the Tigers Out?By Philip Poole, Global Head of Macro and Investment Strategy
Fighting the Fed
Inflation has reared its ugly head again and there’s a strong
sense of déjà vu. Sharply higher food and fuel prices have
been responsible for much of the initial shock and emerging
markets (EM) are again the main focus of concern.
But this time around there is also a key difference: EM central
banks are fighting the Federal Reserve (Fed). With Fed funds
at close to zero and additional quantitative easing the Fed
is effectively reflating much of the emerging world. For EM
central banks it’s ‘Catch 22.’ Tightening via rate increases
runs the risk of sucking in more of the Fed’s liquidity.
The result has been a resort to ‘quantatitive tightening’
measures including hikes in reserve requirements in an effort
to tighten without putting additional appreciation pressure
on currencies. But some EM central banks have not reacted
aggressively enough to guard against second round effects.
Many still have negative real policy rates. On balance, the
market also expects EM inflation to roll over later in the year
as base effects kick in. The risks to this view are biased to
the upside.
Too slack to worry
Commodity price pressures generated in EM are also feeding
through to developed markets (DM). Here the impact on
headline inflation is more muted because food and fuel are
a much smaller proportion of Consumer Price Index (CPI)
baskets than in emerging economies and because excess
capacity and slack labour markets are constraining second
round effects. For the most part, wages are not rising to
compensate for this terms-of-trade shock which, as a result,
is squeezing real incomes in the developed world. For now
developed world inflationary pressures are mostly imported
and pass through is likely to remain limited.
While the European Central Bank (ECB) is going its own way
and has started to raise rates, the Fed, the Bank of Japan and
most likely the Bank of England seem likely to keep policy
ultra loose through year end – erring on the side of caution
regarding the strength of the recovery, not incipient inflation
risks.
A good hedge is hard to find
Hedging investment portfolios against inflation is difficult.
If in cash, investors will suffer from currency debasement
as a result of inflation, particularly if central banks do not
raise rates sufficiently to deal with it. But the performance
of nominal government bonds, nominal corporate bonds
and equities – at least initially – are also likely to suffer from
inflation.
Overview
Seek out asset-intensive and cyclical equity markets
Stocks are in no sense a perfect inflation hedge but, subject
to valuations, investors should seek out asset-intensive
exposure and exposure to cyclical sectors. The former
should benefit from a valuation effect as a result of inflation
and the latter from increased pricing power. Asset intensive
businesses that potentially fit the bill include banks, real
estate companies and most conglomerates; cyclicals
include tech, energy, materials and industrials. While equity
markets normally initially suffer from inflation these are the
sectors that should ultimately provide the best protection.
These characteristics are most evident in markets that were
largely unloved in 2010 – in an Asian context, Korea, Taiwan
and China H, rather than the ASEAN markets. Because of
attractive valuations, Russia currently remains the preferred
equity market in BRIC countries (Brazil, Russia, India, China)
to play the energy theme.
Little value in DM nominal bonds but EM linkers offer protection
While inflation may not yet be a significant concern in
developed markets, at current yields it is difficult to see
value in developed market government bonds, including US
treasuries. In the US, the Fed will cease to be a net purchaser
of government debt once Quantitive Easing 2 (QE2) expires
at the end of June. We belive there is still no credible
structural fiscal adjustment package in sight in the US to
bring down excessive government deficits. And there is also
the key question of how the accumulated portfolios of central
bank holdings of government debt – including the Fed – will
be reduced over time.
Putting aside issues of whether inflation in the developed
world will eventually move higher, both effects suggest that
yields will need to rise to clear the market.
In EM, investors should get some protection via inflation-
linkers. Held to maturity, they are the only instruments that
are specifically designed to protect against inflation. EM
linkers appear fairly valued on current consensus inflation
forecasts but the consensus has lagged and likely upward
revisions increase their attraction.
2
“Inflation is like a tiger: once set free it is very
difficult to get back in its cage,”
Chinese Premier Wen Jiabao, March 2011
Inflation is a sustained increase in the level of prices that
reduces the real purchasing power of money. It effectively
taxes holders of money and, as a result, discourages saving.
The rate of inflation represents the speed at which the real
value of money is eroded. Of course, there are normally
two sides to a coin and this case is no different. While
being a tax on savers inflation is a subsidy for borrowers.
For heavily-indebted governments in the developed world
there are evident attractions of allowing the inflation tiger
out of its cage. It would cut the real burden of government
indebtedness and also erode the real burden on homeowners
A prowling tiger
with negative equity resulting from the fall in property prices
from pre-crisis highs. For this reason a greater tolerance
of inflation could ultimately end up being part of the exit
strategy to deal with leverage for DM governments assuming
that inflation can be generated in a developed world
where labour markets generally remain slack. Central bank
independence and explicit targeting of inflation has been the
traditional counterweight to such concerns. But central bank
independence and inflation credibility have been undermined
as a result of actions taken during the crisis. Quantitative
Easing (QE) has made central banks the marginal purchaser
of government debt in many developed economies,
something that was anathema to orthodox central bankers
prior to the financial crisis.
Inflation forecasts as of Oct 2010 Inflation forecasts as of March 2011
2009 2010 E 2011F 2009 2010 E 2011F 2012F
North America -0.2 1.6 1.4 -0.2 1.6 2.1 1.9
United States -0.3 1.6 1.4 -0.3 1.6 2.0 1.8
Canada 0.3 1.7 2.0 0.3 1.8 2.3 2.0
Western Europe 0.6 1.7 1.6 0.6 1.7 2.1 1.7
Euro zone 0.3 1.5 1.5 0.3 1.6 2.1 1.7
France 0.1 1.6 1.5 0.1 1.5 1.8 1.6
Germany 0.4 1.1 1.4 0.4 1.1 1.9 1.8
Spain -0.3 1.6 1.8 -0.3 1.8 2.2 1.4
UK 2.2 3.1 2.5 2.2 3.3 4.0 2.4
Switzerland -0.5 0.7 0.8 -0.5 0.7 0.8 1.3
Eastern Europe 6.3 5.9 5.7 6.3 6.4 6.0 5.4
Russia 8.8 7.1 7.4 8.8 8.8 8.4 7.1
Asia Pacific 0.8 2.4 2.3 0.8 2.4 2.8 2.4
Japan -1.4 -0.8 -0.3 -1.4 -0.7 0.1 0.2
Australia 1.8 2.9 3.0 1.8 2.8 3.1 2.9
China -0.7 2.9 2.9 -0.7 3.3 4.4 3.5
Hong-Kong 0.6 2.5 3.0 0.6 2.4 3.9 3.5
India (2) 11.7 10.4 6.7 11.7 10.3 8.9 6.6
Latin America 5.7 7.2 7.0 5.7 7.3 7.2 6.8
Brazil 4.3 5.2 4.8 4.3 5.9 5.7 4.8
World 1.3 3.0 2.8 1.3 2.7 3.2 2.8
3
Source: Consensus Forecasts, The Economist, OECD, IMF(2) Fiscal year, April to MarchE : estimateF : forecastAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Figure 1. Market inflation expectations
As the Figure 1 shows future inflation expectations have
moved higher over recent months as the consensus view
has reflected the reality of rising realised inflation pressures.
However, the profile has not changed, just the time horizon
over which it is expected to play out. The expectation
remains that the current inflation problem will roll over as
base effects kick in. Of course, this could happen but there
are also significant risks that it does not, particularly in the
emerging world. The key to the future progression of inflation
will be the extent to which there are second round effects
that result from the supply side inflationary shock coming
from commodity prices and in some cases the effects of
fiscal tightening on indirect taxes. The severity of these
second round risks will be determined by capacity constraints
in respect of both human and physical capital. The tightness
of the labour market and the degree of slack in the economy
– normally measured by the so-called ‘output gap’ – will
determine the extent to which an inflation shock from
commodity prices becomes an ingrained inflation process
as pricing power in labour and product markets passes
pressures through, in turn generating higher expectations
of future inflation. Below we consider this potential risk for
developed and emerging economies.
Over the last few weeks the market has started to worry
more about inflation in the developed world. Are expectations
of DM inflation overdone or does monetary policy in these
markets need to be reset tighter to deal with future inflation
pressures?
As a generic conclusion, it still appears to be the case that
for much of the developed world the inflation currently
in evidence is imported not home grown. It is partly the
reflected consequences of QE stimulus but, whatever its
causes, the domestic demand aggravating it is manufactured
more in emerging than developed markets. So far, there
appear to be few domestic inflation drivers in economies like
the US and UK and hence only a potentially low risk of pass
through, with countries like Germany and Sweden in Europe
being possible exceptions.
4
CPI weight (%) Food Energy
US 13.7 9.1
UK 10.3 8.7
Japan 25.9 7.4
Eurozone 14.4 10.3
Germany 9.0 9.5
France 13.2 8.1
Italy 15.1 7.9
Spain 17.1 10.6
Norway 10.4 7.7
Sweden 12.5 8.8
Switzerland 9.7 7.2
US Eurozone UK Japan
Q1 2011 -1.85 -1.4 -3.9 0.1
Q4 2010 -1.25 -1.2 -3.2 0.1
Q3 2010 -0.85 -0.8 -2.6 0.7
Q2 2010 -0.85 -0.4 -2.7 0.8
Q1 2010 -2.05 -0.4 -2.9 1.2
Q4 2009 -2.45 0.1 -2.4 1.8
Q3 2009 1.55 1.3 -0.6 2.3
Q2 2009 1.65 1.1 -1.3 1.9
Q1 2009 0.65 0.9 -2.4 0.4
Q4 2008 0.15 0.9 -1.1 -0.3
Q3 2008 -2.9 0.65 -0.2 -1.6
Q2 2008 -3 0 1.2 -1.5
Q1 2008 -1.75 0.4 2.75 -0.7
Q4 2007 0.15 0.9 3.4 -0.2
Q3 2007 1.95 1.9 3.95 0.7
Q2 2007 2.55 2.1 3.1 0.7
Source: Thomson financial datastreamNote: Calculated as policy rates minus CPI inflation
Source: Thomson financial datastream
Source: Eurostat, national statistics Offices and HSBC Global Research
Figure 4. DM real interest rates
Figure 2. Food and fuel CPI weights Figure 3. Developed market headline inflation
-1.5-1.0-0.50.00.51.01.52.02.53.03.54.0
Figure 3
2004 2005 2006 2007 2008 2009 2010
Japan EU US
Developed markets – is there really an inflation risk?
In our view, the key determinant of monetary policy tightening
should be the risk of second round effects via acceleration
in wage growth. When prices for food and fuel rise, and
wages do not rise to compensate, real spending power in
other areas is curbed. Tightening monetary policy in response
would further compromise the recovery in economic
activity. According to J.P Morgan, core inflation in developed
economies is determined mostly by the output gap and on
their own commodity price shocks have little effect. This
analysis supports our view that supply-induced inflation via
commodity price rises will be most problematic in economies
where capacity constraints exist as the resulting pricing power
generates the risk that supply-induced inflation shocks turn
into self-perpetuating inflation processes. In the next section,
we look at these questions for the US, the Eurozone, Japan
and the UK.
5
Figure 5
03/07 12/07 03/08 12/08 03/09 12/09 03/10 12/10
Germany UK US
90
92
94
96
98
100
102
104
Figure 5
03/07 12/07 03/08 12/08 03/09 12/09 03/10 12/10
Germany UK US
90
92
94
96
98
100
102
104
Source: Thomson financial datastream, Bloomberg, Index, Mar 2007 = 100
Figure 5. Developed market real wage growth (index)
6
Inflation has picked up in the US in recent months and cost
pressures that have been evident in producer price indices for
crude materials and intermediate goods have had an impact
on finished goods prices. What happens to wage inflation
could be key in determining the extent of second round
effects. So far there is little evidence of a problem. The level
of unionisation in the US is lower than it was in the past (for
example, after the oil price shocks in the 1970s.) In addition,
irrespective of unionisation globalisation of the production
chain has reduced the power of labour to push up wages to
compensate for increases in the cost of living. The data bears
this out. Over the last 3 months, consumer prices have risen
by a 6% annual rate while average weekly wages have hardly
responded, increasing at an annual rate of only 1.3%.
So what of policy? The Fed’s policy response to the crisis
is unprecedented in peacetime. The decision to launch a
second round of QE reflected on-going concern about the
low level of employment growth and the historically low level
of inflation with the transmission mechanism designed to be
via an effect on financial asset prices and a weaker dollar in
our view. While there has been speculation that QE2 could
be ended prematurely, in our opinion it is unlikely that the
Fed will take this gamble. In addition, we are of the view
that interest rates will be kept on hold through year end.
Indeed, the Fed could be inclined to use monetary policy to
partly offset tighter fiscal policy when it finally arrives. The
output gap remains large enough and headwinds to growth
problematic enough (the housing market included) that
commodity shocks are unlikely to lead to substantial second
round inflation effects in the near-term.
In recent comments Fed Chairman Bernanke seemed to
concur. He argued that the increase in US inflation is driven
primarily by rising global commodity prices and is unlikely to
persist: ‘I think the increase in inflation will be transitory,’ he
03/06
06/06
03/07
09/07
03/08
09/08
03/09
09/09
03/10
09/10
CPI ex food and energy
Food CPI
Figure 6
-2
-1
0
1
2
3
4
5
6
US
Figure 8
-4.0-3.5-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.52.02.53.03.54.0
01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11
Forecast
Source: OECD
03/09
03/92
03/94
03/96
03/98
03/00
03/02
03/04
03/06
03/08
03/10
03/12
Figure 7
-5
-4
-3
-2
-1
0
1
2
3
Figure 9
Forecast
08/07 12/07 04/08 08/08 12/08 04/09 08/09 12/09 04/10 08/10 12/10 04/11
500
1000
1500
2000
2500
3000
03/06
06/06
03/07
09/07
03/08
09/08
03/09
09/09
03/10
09/10
CPI ex food and energy
Food CPI
Figure 6
-2
-1
0
1
2
3
4
5
6
Source: Thomson financial datastream
Source: Thomson financial datastream Source: OECDAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Source: US Federal Reserve BankAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Figure 6. US CPI components (%)
Figure 8. US real interest rates (%)
Figure 7. US output gap
Figure 9. The FED’s balance sheet (US$ bn)
The US
Conventional (policy rate) Unconventional / Quantitative tightening
US - Asset purchase programme (QE2) of USD600bn announced in November 2010 to end in June 2011
Canada 75 bps increase since June 2010 -
Eurozone 25 bps increase in April 2011 -
UK - -
Norway 75 bps increase since October 2009 -
Sweden 150 bps increase since July 2010 -
Switzerland - -
Japan - Size of asset purchase programme increased by JPY5tn to JPY40tn and liquidity injection worth JPY15tn in March 2011 after earthquake
Australia 175 bps increase since October 2009 -
New Zealand 50 bps increase since June 2010 reversed in March 2011 after the Christchurch earthquake
-
Figure 10. Developed markets conventional and unconventional monetary policy measures
Source: Central banks and HSBC Global Research27 April 2011
said in answer to a question. ‘Our expectation at this point
is that in the medium-term inflation, if anything, will be a
bit low. We will monitor inflation and inflation expectations
very closely.’ In short, the Fed seems unlikely to ease ultra
loose policy until there is sustained evidence of employment
gains and is likely to err on the side of caution regarding the
strength of the recovery, not incipient inflation risks.
7
8
The Eurozone
The recent interest rate hike shows that rising headline
inflation has been a bigger concern for the European Central
Bank (ECB) than for other central banks in the developed
world. This reflects the ECB’s sole inflation-targeting mandate
and the fact that it has tended to put more weight on headline
than core inflation. The ECB has a mandate to keep inflation
‘below but close to 2%.’ This is a ‘harmonised’ average for the
Eurozone countries so, as with any average, in some countries
inflation will undershoot and in others it will overshoot. With
different member countries in very different parts of the cycle
this is a difficult juggling act. At the margin fiscal policy can
help to take the strain, one of the reasons why Germany is
currently tightening despite relatively favourable debt metrics.
Despite some moderation, Eurozone activity indicators remain
strong, suggesting growth in Q1 2011 is likely to at least match
Q4 2010. The manufacturing PMI and its components remain
above their long-term averages. So far, the impact of higher
oil prices on growth seems to have been limited but some
inflation pressure has built. Money supply growth has also
become moderately positive. Unemployment remains elevated
but, in contrast to the Fed, the ECB seems to have taken the
line that a sizeable slug of this is structural rather than cyclical
and so not easily influenced by monetary stimulus. In other
words, the negative output gap (spare capacity) is probably
smaller than first appears.
Germany’s inflation rate has been moving towards the average
for the Eurozone and this could create anxiety given the on-
going strength of activity and falling unemployment there.
By contrast, the periphery of the Eurozone remains under
pressure with activity depressed. You can argue that this has
always been a problem for a central bank that has to set policy
for such a diverse set of economies, but the dilemma for policy
makers seems particularly acute at the moment. Of course,
this has not stopped the ECB acting and the consensus has
now priced in another 3 hikes through year end with the
policy rate set to rise to 2%. This looks to be the correct
interpretation and, in our view, should continue to set the ECB
apart from the Fed, the Bank of Japan and the Bank of England
during the course of the rest of the year.
03/06
09/06
03/07
09/07
03/08
09/08
03/09
09/09
03/10
09/10
CPI ex food and energy Food CPI
Figure 11
-4
-2
0
2
4
6
8
10
01/00 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 01/11
EU
Figure 13
-1.5
-1.0
-0.5
0
0.5
1.0
1.5
2.0
2.5
3.0
03/90
03/92
03/94
03/96
03/98
03/00
03/02
09/04
03/06
09/08
09/10
09/12
EZGermany
Forecast
Figure 12
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
03/90
03/92
03/94
03/96
03/98
03/00
03/02
09/04
03/06
09/08
09/10
09/12
EZGermany
Forecast
Figure 12
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
03/06
06/06
03/07
09/07
03/08
09/08
03/09
09/09
03/10
09/10
CPI ex food and energy
Food CPI
Figure 6
-2
-1
0
1
2
3
4
5
6
Source: Thomson financial datastream
Source: Thomson financial datastream
Source: OECDAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Figure 11. German CPI components (%)
Figure 13. Eurozone real interest rates (%) Figure 14. ECB balance sheet (Euro bn)
Figure 12. Eurozone and German output gaps
09/9704/9811/9806/9901/0008/0003/0110/0105/0212/0207/0302/0409/0404/0511/0506/0601/0708/0703/0810/0805/0812/0907/10
EuroSystem-Total Assets (Eur bn)
500
1000
1500
2000
2500
3000
3500
4000
09/9704/9811/9806/9901/0008/0003/0110/0105/0212/0207/0302/0409/0404/0511/0506/0601/0708/0703/0810/0805/0812/0907/10
EuroSystem-Total Assets (Eur bn)
500
1000
1500
2000
2500
3000
3500
4000
9
The UK
CPI ex food and energy Food CPI
03/06
06/06
03/07
09/07
03/08
09/08
03/09
09/09
03/10
09/10
Figure 14
-3
0
3
6
9
12
15
03/00 03/02 03/04 03/06 03/08 03/10
UKGermany
Figure 16
4
6
8
7
10
11
9
5
12
03/00 03/02 03/04 03/06 03/08 03/10
UKGermany
Figure 16
4
6
8
7
10
11
9
5
12
03/90
03/92
03/94
03/96
03/98
03/00
03/02
03/04
03/06
03/08
03/10
03/12
Figure 15
-6
-5
-4
-3
-2
-1
0
1
2
3
4
Forecast
01/00
01/01
01/02
01/03
01/04
01/05
01/06
01/07
01/08
01/09
01/10
01/11
UK
Figure 17
-4
-3
-2
-1
0
1
2
3
4
5
6
03/06
06/06
03/07
09/07
03/08
09/08
03/09
09/09
03/10
09/10
CPI ex food and energy
Food CPI
Figure 6
-2
-1
0
1
2
3
4
5
6
Source: Thomson financial datastream
Source: Thomson financial datastream
Source: Bloomberg
Source: OECDAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Figure 15. UK CPI components (%)
Figure 17. German vs UK unemployment (%)
Figure 16. UK output gap
Figure 18. UK real interest rates (%)
The UK is currently in a more difficult situation than either the
US or the Eurozone. The UK’s problem verges on stagflation
– competing, uncomfortable pressures on policy from both
activity and inflation. It raises a problematic dilemma for
economic policy since attempts to curb inflation could further
constrain economic activity and the other way round. And
because the Bank of England does not have a unitary mandate
like the ECB it is forced to try to tackle both problems. The
key question over policy reduces to whether the UK’s high
inflation rate is simply the result of “one-off” factors or due to
monetary policy being ‘too loose for too long?’ This is at the
core of the current debate over UK monetary policy and the
question as to whether policy needs to be tightened to prevent
inflation expectations rising further.
One camp has it that inflation would be near target were it
not for one-off indirect tax increases and sterling weakness
which has exacerbated imported cost push pressures from
surging commodity prices. Certainly, such one off shocks
need not necessarily create inflation. In the absence of
second round effects and monetary accommodation they
could simply end up generating a shift in relative prices, not
starting an on-going acceleration in the overall price level.
These one-off factors act like a tax on consumption,
squeezing disposable income that is available to spend
elsewhere. On top of this there is the drag of fiscal
retrenchment. Unlike in the US, fiscal tightening is happening
and its effects on activity and employment have not yet been
fully felt, suggesting that monetary policy will have to take
more of the strain if the recovery is not to stall.
Others argue that inflation is above the Bank of England
target because monetary policy is too accommodative (see
the figure 18 showing how negative real interest rates have
become) and that the Bank needs to tighten. According to the
Monetary Policy Committee (MPC) hawk Andrew Sentence
(as reported in the FT) the MPC’s call on inflation has
been poor because it underestimated the effect of sterling
depreciation in mid-2007 and overestimated the degree of
10
spare capacity in the economy. Sentence notes that it is very
difficult to estimate the size of an output gap in real time and
that forecast errors can be extreme. This school of thought
has it that because employers held on to productive workers
there was far less spare capacity in the economy at the end
of the last recession than there had been in previous cycles.
We prefer the first line of argument: the only inflation likely
to come through in the UK any time soon is commodity-
related and manufactured in the emerging markets not
domestically. There can be little doubt that a sizeable part of
the recent uptick in inflation has been due to one-off factors;
in particular, the rise in VAT and the impact of higher energy
and food prices. The downward trend in wages over the last
12 months is an indication of spare capacity. Moreover, the
aggressive fiscal tightening plan will be a substantial drag on
activity that is not yet fully evident. In addition, banks are still
not ramping up lending. The market is pricing in a series of
rate hikes this year but, on balance, this looks to be overdone.
In our view, the Bank appears is right to sit tight and will
probably continue to do so for the rest of the year. If policy is
tightened it is more likely to be token move.
Official
rates
Last
change
Date
of change
Expected in
3 months
Expected in
12 months
US 0 / 0.25 -87.5 bp 16/12/08 0 / 0.25 0.25 / 0.5
Canada 1.00 25 bp 08/09/10 1.25 2.25
Euro zone 1.25 25 bp 07/04/11 1.25/1.5 2
UK 0.50 -50 bp 06/03/09 0.75 1.25 / 1.5
Switzerland 0.25 -25 bp 12/03/09 0.25 1
Norway 2.00 25 bp 06/05/10 2.25 3.00
Sweden 1.75 25 bp 20/04/11 1.75 2.75
Japan 0 / 0.10 -5 bp 05/10/10 0 / 0.10 0 / 0.10
Australia 4.75 25 bp 07/12/10 4.75 / 5 5.25/5.5
New Zealand 2.50 -50 bp 10/03/11 2.50 2.75 / 3
Figure 19. Consensus forecasts for DM central bank policy rates
Source analysts’ consensus expectation, Bloomberg, HSBC Global Asset Management 27 April 2011
11
Japan
When it comes to price pressures, Japan remains a case
apart. As things stand, the Japanese problem still appears to
be deflation not inflation. The economy is likely to contract by
an annualised rate of more than 2.5% in the second quarter
as a result of earthquake and tsunami damage, according to a
survey of private-sector economists compiled by the Nikkei.
For the year as a whole, the disruptions to electricity supplies
due to earthquake and tsunami damage could well lower real
GDP growth by 0.5 percentage point (pp) but reconstruction
and base effects should increase GDP growth in 2012 by
a similar amount. As a result, over the immediate future, a
continued negative output gap is likely to remain a source of
deflation. According to HSBC Global Research, the base-year
change in CPI from 2005 to 2010, scheduled for August 2011,
should add another 0.6pp of deflationary pressure on CPI and
core CPI will fall 0.2% in 2011 and 0.3% in 2012. Under such
circumstances, the Bank of Japan is unlikely to raise rates
until late 2012 or even 2013.
01/91 01/93 01/95 01/97 01/99 01/01 01/03 01/05 01/07 01/09
CPI (yoy)Nationwide Land Prices (yoy)
Figure 19
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
01/91 01/93 01/95 01/97 01/99 01/01 01/03 01/05 01/07 01/09
CPI (yoy)Nationwide Land Prices (yoy)
Figure 19
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
01/91 01/93 01/95 01/97 01/99 01/01 01/03 01/05 01/07 01/09
CPI (yoy)Nationwide Land Prices (yoy)
Figure 19
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
01/00 01/02 01/04 01/06 01/08 01/10
01/00
01/01
01/02
01/03
01/04
01/05
01/06
01/07
01/08
01/09
01/10
01/11UKUS EU Japan
Figure 20
-4
-3
-2
-1
0
1
2
3
4
5
6
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Source: Thomson financial datastreamSource: Bloomberg
Figure 20. Long-term deflationary pressures (%) Figure 21. Japan real interest rates (%)
12
Emerging markets inflation risks
Last release 2011F CB target rate
Figure 21
Brazil Chile Colombia Mexico Korea Poland Turkey SouthAfrica
0
1
2
3
4
5
6
7
8
Food Fuel & Utilites
0
10
20
30
40
50
60
70
80
UA
E
Israel
Mexico
Hungary
Singapore
South A
frica
Indonesia
Taiwan
HK
SAR
Brazil
Chile
Poland
Turkey
Argentina
Malaysia
China
Saudi A
rabia
Thailand
Russia
Egypt
Kazakhstan
Pakistan
Vietnam
India
Philippines
Ukraine
% in
CP
I bas
ket
EM food + fuel & utilites
EM food average
Figure 22
Average 2000–2007Diffusion type composite CPI index for Asian EMs
0%
25%
50%
75%
100%
Oct 10
Jul 10
Apr 10
Jan 10
Oct 09
Jul 09
Apr 09
Jan 09
Oct 08
Jul 08
Apr 08
Jan 08
Oct 07
Jul 07
Apr 07
Jan 07
Source: Thomson financial datastream, national sources, BloombergAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Source: Thomson financial datastream, CEIC, Bloomberg, national sources December 2010
Source: Thomson financial datastream, CEIC, HSBC Global research
Figure 22. Inflation vs. central bank target (%)
Figure 24. EM food and energy weights in CPI baskets (%)
Figure 23. Generalised inflation pressures in Asia
In our view, markets remain overly sanguine on EM inflation
prospects, believing the inflation risk is solely about food and
fuel price shocks with limited second round effects and that
inflation will roll-over later in the year as these shocks drop
out of the indices. However, the consensus has lagged reality
and forecasts continue to be revised higher. Indeed, this is
also the case for many central banks in EM. For example,
recently the central bank of Chile – an institution with strong
accumulated inflation fighting credentials – sharply raised its
inflation forecast for 2011.
Within the emerging world there are three key sources
of headline inflationary pressures. Rapidly rising food and
energy price inflation is the most obvious. As discussed
above, this concern is shared with developed markets but it
is more problematic for emerging economies because food
and energy dominate purchasing patterns and so have very
large weights in CPI baskets.
Second, unsterilised currency intervention is a contributory
factor. A period of global risk aversion has reduced the
pressure for much of 2011 so far but, in view of prospects
for relatively weak growth in the developed economies, the
challenge for EM is again likely to become how to absorb
substantial net capital inflows. There are structural and
cyclical drivers of such flows. Portfolio diversification is
leading to net capital inflows that reflect, with a lag, the shift
in the centre of gravity of the global economy towards the
emerging world. Combined with the recycling of QE-related
liquidity to these same markets, there remains a risk of
potentially disruptive asset price consequences as bubbles
inflate and then burst. In many emerging economies, recent
policy has focussed on trying to stem these inflows with
quantitative tightening (QT) measures.
13
The third contributory factor in many emerging economies is
tighter capacity constraints. Markets like India and China did
not suffer a decline in output during the ‘global’ recession,
just a slight moderation in growth. With a re-acceleration
of activity, where they did open, negative output gaps
have closed and turned positive in a number of emerging
economies. As a result, pricing power has returned to many
labour and product markets. The labour market could be
a particularly important transmission channel for inflation
pressures with the risk that, unlike in the developed world,
an inflation shock turns into an on-going inflation process.
With the figure 25, we examine these drivers of inflation and the
implications for policy and investment in emerging markets.
Figure 24
0
-5
5
10
15
20
25
30
Oct 10
Jan 11
Jul 10A
pr 10Jan 10O
ct 09Jul 09A
pr 09Jan 09O
ct 08Jul 08A
pr 08Jan 08O
ct 07Jul 07A
pr 07Jan 07O
ct 06Jul 06A
pr 06Jan 06
(% y
-o-y
)
Brazil China Russia
Figure 25. EM food price inflation has picked up again
Source: Thomson financial datastream
14
Commodities: more trend than cycle
After falling from their peak in mid-2008 commodity prices
bottomed at a much higher level than in previous recessions
and the rebound following the crisis was more robust.
Commodity prices have been supported by very loose
monetary conditions in the developed world. Commodities
have become more investable in nature and prices have
been forced higher in line with other risk assets. Moreover,
as argued above, monetary policy in most of the developed
world is likely to remain highly accommodative for some
time to come. In addition, loose monetary policy is debasing
developed world currencies, particularly the US dollar and
should continue to support gold and precious metals demand
more generally.
Rapid growth in populous EM economies like China, India,
Indonesia and Brazil (collectively some 3 billion people) will
generate powerful demand pressures. Figure 27 shows that
per capita energy consumption is very low in these and many
other emerging markets. As these economies continue to
grow – increasing their share in global demand – per capita
consumption levels will grow. In fact, this dynamic is not
restricted to energy and oil but applies to most commodities,
hard and soft.
In addition, the supply response to high prices is likely to be
constrained for a number of reasons. For hard commodities,
Political changes in the Middle East have additionally
probably added a long-lasting uncertainty price premium
to oil and broader energy prices and the impact of Japan’s
nuclear problems could do the same for fossil fuels more
generally, particularly natural gas. Most importantly, though,
the world has changed – including the demand drivers of
commodity prices. The US is no longer the marginal source
of demand for bulk commodities. In most cases, China and
other rapidly growing populous emerging economies in Asia
have surpassed the US as the world’s largest – and fastest
growing – source of hard and soft commodity off-take, both
hard and soft.
the short-term response to high prices is likely to be limited
by the impact of cancelations and postponements in
investment projects during the financial crisis. In the iron
ore, coal and copper sectors alone more than USD200 billion
of investment projects were either postponed or cancelled
during the financial crisis. This should continue to fuel M&A
activity in the coming months. On the soft commodity side,
the supply of agricultural commodities is likely to continue to
suffer from climatic disruptions. Whether or not you believe
in global warming it is hard to dispute the evidence that
climatic disruptions are increasingly negatively impacting the
global agricultural supply chain.
Figure 25
China9%
China24%
US12%
India 2%
India 10%
Asia ex CIJ 6%
Asia ex CIJ 8%
SSA 2%
SSA 5%
MENA 4%
MENA5%
Latam 7%
Latam9%
CIS 5%
China 9%
US 24%
EU-2727%
EU-2714%
Japan 9%Japan 3%
ROW 7%ROW5%
Figure 25
China9%
China24%
US12%
India 2%
India 10%
Asia ex CIJ 6%
Asia ex CIJ 8%
SSA 2%
SSA 5%
MENA 4%
MENA5%
Latam 7%
Latam9%
CIS 5%
China 9%
US 24%
EU-2727%
EU-2714%
Japan 9%Japan 3%
ROW 7%ROW5%
Source: IMF, Standard Chartered research November 2010
ROW: Rest of the world, SSA: Sub Saharan Africa, CIS: Commonwealth of Independent states, Asia ex CIJ Asia excluding China, India and JapanAny forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
Figure 26. Rapid growth in the emerging world
Nominal global GDP 2010, USD 62trn Nominal global GDP 2030, USD 308trn
15
To fight inflation, it is important to understand its nature.
Does it simply relate to supply-side shocks or is it
compounded by the effect of rising domestic demand
creating capacity constraints? Are central banks curbing or
accommodating it?
Unlike much of the developed world, in many emerging
countries, negative output gaps have narrowed and
skilled labour is again in short supply. An output gap is the
difference between what an economy can produce without
driving up prices and what it is actually producing. When
such gaps turn positive, other things being equal, it tends
to create inflation pressures. Most emerging economies in
Asia have now surpassed their pre-crisis output level. Falling
unemployment has increased the pricing power of labour
in many emerging economies. Brazil is a good example.
Unemployment has fallen to the lowest level on record (see
chart 29) and shortages of skilled labour are increasingly
evident in a number of other large emerging economies,
including India.
Our estimates of output gaps (see figure 30) bear out this
conclusion. In general, where they opened up during the
crisis, negative output gaps have closed and in many cases
become positive. And while corporate pricing power in EM
came under pressure during the crisis it has bounced back.
In such circumstances supply shocks that pressure costs
higher are more likely to force up headline inflation than
squeeze profit margins. This creates the risk that in emerging
economies inflation shocks turn into self-perpetuating
inflation processes as expectations adjust higher and become
embedded. For now this conclusion looks quite different
from most of the developed world.
10 2015 25 35 45 5530 40 50 60
0
1
2
3
4
5
6
7
8
USA
crude oil consumption (% of total energy consumption)
per
per
son
co
nsu
mp
tio
n o
f en
ergy
(to
e)
South Korea
Taiwan
Japan
Poland Hungary
ArgentinaTurkey
Colombia
PakistanChina 2004
China
IndiaIndonesia
Philippines
ChileMexico
ThailandBrazil
Venezuela
Russian Federation
South Africa
Figure 27
Brazil India Russia Indonesia Korea China
05/07
03/07
01/08
05/08
09/08
01/09
05/09
09/09
01/10
05/10
09/10
85
90
95
100
105
110
115
120
125
130
Figure 28
03/01
06/02
03/03
03/04
03/05
03/06
03/07
03/08
03/09
03/10
Brazil (LHB) Russia (LHB) Argentina (LHB) Taiwan (LHB)Thailand (4Q MA, RHS)
5
0
10
15
20
25
0.5
0
1
1.5
2
3.5
2.5
3
Brazil (LHB) Argentina (LHS) Thailand (4Q MA, RHS)
6
5
4
3
7
8
9
10
1.1
1
1.2
1.3
1.4
1.7
1.5
1.6
12/07 04/08 08/08 12/08 04/09 08/09 12/09 04/10 08/10 12/10
Figure 27. Coming off a low base – EM per capita energy consumption
Source: BP oil statistics December 2009
Source: BloombergDecember 2010Source: Bloomberg, HSBC Global Asset Management
December 2010
Figure 28. EM industrial production (%) Figure 29. EM labour markets tighten (unemployment, %)
Quantifying second round effects
16
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Brazil
Taiwan Phillippines Turkey Chile
China Korea Russia
-4
-2
0
4
2
-2
-1
0
2
1
-4
-6
-8
-2
0
4
2
-4
-6
-8
-2
0
4
8
6
2
-4
-6
-2
0
6
2
4
-2
-3
-1
0
3
2
1
-3
-5
-7
-1
3
5
1
-4
-6
-8
-2
0
4
6
2
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
2008
2010
2006
2004
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
2002
1997
1996
1995
1994
1993
1992
20092010
2008200720062005200420032002200120001999199819971996199519941993199219911990198919881987
2010
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
2009
2010
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Figure 30. EM output gaps
Brazil
Korea
Taiwan
Turkey
China
Russia
Philippines
Chile
Source: Bloomberg, Thomson financial datastream, HSBC Global Asset ManagementOutput gaps calculated using Hodrick-Prescott filterMarch 2011
The emerging markets policy response
Economic theory teaches that if money velocity remains
stable and output fluctuates around trend, inflation should
have a positive relationship with money supply growth.
Indeed, there has been a strong relationship between money
supply and the level of prices in EM. Unsterilised currency
intervention – one of the three sources of EM inflation
pressure highlighted above – turns external liquidity into
domestic liquidity. All of which implies that monetary policy
tightening and more complete currency sterilisation is likely
to be necessary to curb the rise in EM inflation pressures.
However, as also mentioned above, EM central banks are
fighting the Fed in this tightening cycle. As a result, central
banks are increasingly resorting to prudential and quantitative
tightening measures rather than taking the orthodox route
of raising rates: an attempt to tighten while limiting the
resulting appreciation pressures on their currencies. Fiscal
policy should be tightened in a number of these economies
to help take the strain but, so far, there has only been limited
progress on this front.
Brazil Russia India China
Q1 2011 5.7 -1.5 -1.6 1.2
Q4 2010 4.8 -1.9 -3.2 1.2
Q3 2010 6.1 -1.1 -2.9 1.7
Q2 2010 5.4 -0.4 -5.0 2.4
Q1 2010 3.6 0.8 -5.2 2.9
Q4 2009 4.4 1.8 -2.2 3.4
Q3 2009 4.4 3.9 3.7 6.1
Q2 2009 4.5 6.0 5.5 7.0
Q1 2009 5.6 7.2 3.5 6.5
Q4 2008 7.9 7.0 -0.1 4.1
Q3 2008 7.5 5.0 -1.8 2.6
Q2 2008 6.2 4.3 -2.4 0.4
Q1 2008 6.5 3.1 0.0 -0.8
Q4 2007 6.8 2.0 3.7 1.0
Q3 2007 7.1 1.2 4.2 1.1
Q2 2007 8.3 0.9 3.1 2.2
Source: Bloomberg, Thomson financial datastream
Figure 31. BRIC real policy rates (%)
17
18
Conventional (policy rate) Unconventional / Quantitative tightening
Brazil 300 bps increase since April 2010 RRR hikes aiming to contract liquidity by about BRL60 bn and higher capital adequacy requirements imposed on certain types of consumer loans. Banks required to deposit 60% of oversold FX positions in excess of USD3 bn in cash with the BCB or the difference between their oversold position and their capital base
Chile 400 bps increase since May 2010
Russia 25 bps increase in March 2011 RRR raised to 5.5% from 4.5% on liabilities to non-residents and to 4.0% from 3.5% on other liabilities (Mar)
Hungary 75 bps increase since November 2010 -
Poland 50 bps increase since January 2011 50 bps RRR increase in October to 3.5% effective January 2011
Turkey 75 bps of cuts since December 2010 Maturity weighted RRR hike of 840 bps since September 2010
Israel 250 bps increase since August 2009 10% RRR on FX derivative transactions with non-residents, effective January 2011
South Africa 650 bps cut since December 2008 Liberalisation of outflows via 5pp increase in off-shore investment cap for resident funds
China 100 bps increase since October 2010 10 differential RRR hikes since January 2010 totalling 450 bps
India 200 bps increase in repo rate, 250 bps increase in reverse repo rate since March 2010
100 bps increase in cash reserve ratio since February 2010
Indonesia 25 bps hike since February 2011 300 bps RRR hike, effective November 2010
Malaysia 75 bps increase since March 2010 100 bps increase in RRR in March 2011
Philippines 25 bps hike in March 2011 -
South Korea 100 bps increase since July 2010 -
Taiwan 50 bps increase since June 2010 Nov 2010: re-imposed a rule that foreign investors can place at most 30% of their funds in Taiwan in local government bonds of all tenures
Thailand 150 bps rate increase since July 2010 -
Vietnam 200 bps increase since December 2009 In March 2011, SBV asked banks to curb the proportion of loans for non-production activity to 22% by end June and 16% by year-end, with the penalty for non-compliance being a doubling of the RRR and operational restrictions
Figure 32. EM conventional and unconventional policy measures
Source: Central banks and HSBC Global Research (data as at 20/04/2011)RRR: Reserve Requirement RateBCB: Brazil Central BankSBV: State Bank of Vietnambps: basis pointsFX: Foreign Exchange
Will prudential measures work?
Fear of currency appreciation continues to constrain the EM
monetary policy response to inflation. In a number of emerging
economies rates are not now being used as the primary tool to
combat inflation and central banks have increasingly resorted
to quantitative tightening measures. These include controls on
inward capital flows and increases in reserve requirements.
Brazil has led the charge on inward capital controls and Turkey
is an extreme case of the use of reserve requirements. In
response to rising inflation pressures the Central Bank of
Turkey is actually cutting rates to curb the attraction of Turkish
Lira (TRY) while, simultaneously, tightening by aggressively
raising reserve requirements for banks to suck liquidity out of
the system. This is a novel approach but the jury is still out on
whether it will work. The more central banks shy away from
raising rates the bigger the risk they slip behind the curve in
combating inflation.
19
Figure 33. Consensus forecasts for Central Bank policy rates (%)
Official
rates
Last
change
Date
of change
Expected in
3 months
Expected in
12 months
Brazil 12.00 25 bp 20/04/2011 12.25 12.25 / 12.5
Chile 4.00 50 bp 17/3/2011 4.5 / 4.75 5.75
China 6.31 25 bp 6/4/2011 6.50 6.5 / 6.75
Colombia 3.50 25 bp 18/3/2011 4.00 5.00
Czech Republic 0.75 -25 bp 10/5/2010 1.00 1.5 / 1.75
Hungary 6.00 25 bp 24/1/2011 6.00 6.00
India 6.75 25 bp 17/3/2011 7 / 7.25 7.25 / 7.5
Indonesia 6.75 25 bp 4/2/2011 7 / 7.25 7.50
Malaysia 2.75 25 bp 9/7/2010 2.75 / 3 3.25
Mexico 4.00 -25 bp 17/7/2009 4.50 5.25
Peru 4.00 25 bp 7/4/2011 4.50 5.00
Philippines 4.00 -25 bp 9/7/2009 4.50 5.00
Poland 4.00 25 bp 6/4/2011 4.25 5.00
Russia 8.00 25 bp 25/2/2011 8.25 8.25
South Africa 5.50 -50 bp 19/11/2010 5.50 6.5 / 6.75
South Korea 3.00 25 bp 10/3/2011 3.25 / 3.5 3.75
Taiwan 1.75 13 bp 31/3/2011 1.75 / 2 2.25
Thailand 2.75 25 bp 20/4/2011 2.75 / 3 3.25
Turkey 6.25 -25 bp 20/1/2011 6.50 8.00
Currency appreciation could be an antidote
The other option to curb inflation would be to allow
currencies to appreciate where there is upward pressure.
This would have two potentially beneficial effects. It
would help control imported inflation and limit pressure
from unsterilised currency intervention. Concerns about
competitiveness have until recently discouraged the use
of exchange rate appreciation to tackle inflation but, in any
case, inflation is leading to real appreciation of many EM
currencies. If inflation pressures persist and G3 monetary
policy remains loose, currency appreciation will likely feature
more as a policy tool in the future although it will likely
continue to be constrained by the competing objective
of keeping tradable goods and services competitive. This
will likely act to cap such moves to the upside with China
remaining the key reference point.
Sources: Analysts’consensus, Bloomberg, HSBC Global Asset Management (data as of 20/04/2011)
Investing for inflation
Inflation generates uncertainty about future variables not just
prices but also interest rates, the shape of yield curves and the
nominal and real value of currencies. As such it can undermine
the real value of financial investments and complicate the
process of planning for the future, including investing for
retirement.
Despite recent angst, in the developed world there is still little
evidence of rising inflation expectations and wage pressures
remain mostly benign. In the US, the market has been pricing
continuing strong recovery but there are substantial headwinds,
including continued falls in residential real estate prices, residual
problems in the financial sector and the prospect – even if it not
immediate – of fiscal tightening. From a policy perspective, a
little more inflation would not be such an unattractive prospect,
especially for the US government where leverage continues to
mount but also for households struggling with negative housing
equity. But while the threat of deflation has been staved off –
with the exception of Japan – negative output gaps in much of
the developed world will likely prevent the inflation shocks from
food and fuel prices turning into an inflation process. The ECB
has gone its own way and started to raise rates but the Fed, the
Bank of Japan and most likely the Bank of England seem set to
remain ultra loose through year end.
For now, inflation risks are still mostly concentrated in EM.
This reflects the same commodity price pressures but, in
addition, the added complications of tighter labour markets/
capacity constraints and unsterilised currency intervention in
an effort to stave off appreciation pressure resulting from loose
monetary policy in the developed world. EM central banks
are responding with a combination of hikes in policy rates and
prudential measures designed to tighten without aggravating
upward pressure on currencies. It could be that they believe
growth is already slowing on the back of higher food and energy
prices which will squeeze spending in other areas but it is not
clear that this will be enough. On balance, the market expects
inflation to roll over later in the year as base effects kick in but
there are upside risks. Some EM central banks have not reacted
aggressively enough to guard against second round effects with
the result that real interest rates are still negative.
It is not easy
Hedging investment portfolios against inflation is difficult.
Being in cash investors will likely suffer from currency debase-
ment as a result of inflation, particularly if central banks do not
raise rates sufficiently to deal with it. But the performance
of nominal government bonds, nominal corporate bonds and
equities, are also likely to be hit. Bonds with fixed rate returns
will normally suffer a fall in their price and, in the short-term at
least, equities will also likely fail to provide much insurance, not
just stocks in interest-sensitive sectors. In fact an IMF study
(‘Inflation Hedging for Long-Term Investors,’ authored by Attie
and Roache) found that in the first 12 months following an
inflation shock on average equities underperformed both
20
government and corporate bonds. This is particularly likely to
be the case where the nature of the inflation shock is cost
push rather than demand pull because, if corporate pricing
power is weak, profit margins could tend to get squeezed.
The study showed that commodities, including gold, normally
provide the most effective short-term inflation hedge.
Equities
Despite this rather gloomy overall prognosis for equities in
terms of a short-term inflation hedge, investing in asset-
intensive companies and cyclical sectors in EM equity markets
hit by inflation should help to insulate portfolios from inflation
pressures. Other things being equal, inflation has the effect
of increasing the nominal replacement cost of a company’s
assets which, in turn, should support valuations of asset
intensive companies. Inflation should also increase pricing
power in cyclical sectors. Of course taking this view will
depend on whether or not this has already been priced into
markets.
Commodity producers that control energy or metals deposits
are a clear example of asset intensive companies and should
provide a decent form of inflation hedge. This commodities
theme can be played via exposure to EM currencies and
commodity-related stocks in the sector. In the latter case there
is also a powerful additional supportive factor for earnings.
As argued above, upward pressure on commodity prices is
a critical part of current inflation concerns. For the most part
such producers are price takers and the price is set in US
dollars. So long as the impact of higher commodity prices
more than offsets any inflation-linked rise in local currency
production costs, earnings should benefit. Because of
attractive valuations, we believe Russia currently remains the
preferred equity market in BRIC to play the energy and hard
commodity theme while stocks and currencies in Latam can
provide interesting exposure to the soft side of the story.
Beyond the commodity plays, Asia seems to stand out. In
our view, Markus Rosgen at Citibank has called this correctly.
He points out that changes in composition of Asian equity
markets during the last decade have increased the correlation
of Asian corporate profit margins with inflation. Asia has a
substantially higher ratio of assets to enterprise value than
developed markets (see figure 34.) Asset intensive businesses
that should fit the bill include banks, real estate and most
conglomerates while cyclical sectors include technology,
energy, materials and industrials. Citibank summarises this
succinctly for Asia – when inflation comes knocking ‘buy
low P/BV asset-intensive plays and low P/E or P/cash flow
cyclicals.’ While equity markets might suffer initially from
inflation these are the markets and sectors that should
ultimately provide the best protection. These characteristics
are most evident in markets that were largely unloved in
2010 – Korea, Taiwan and Hong Kong, rather than the ASEAN
markets that were the flavour for much of 2010.
21
Figure 35. Increasing weight of Asian cyclicals
Figure 34. Asian equity markets are more asset intensive
Asia ex Japan Sector
weights (%)
2000 2005 2010
Banks 21.0 20.4 19.6
Basic materials 5.6 8.1 8.6
Consumer goods 2.4 4.3 10.2
Consumer services 6.3 7.0 5.0
Health care 3.6 4.3 1.1
Industrials 16.9 8.6 13.9
Oil & Gas 1.9 7.0 9.1
Other financials 3.6 5.4 5.0
Real estate 7.6 4.8 6.4
Technology 9.8 14.5 9.1
Telecoms 16.0 10.5 7.7
Utilities 5.3 5.1 4.4
Source: Datastream Citi investment and Research AnalysisApril 2011
Source: Citi Investment and Research AnalysisApril 2011
15 25 35 45 55 650
0.5
1
2
2.5
3
3.5
4
4.5
5
Tangible assets/Enterprise value
Free
cas
h fl
ow Y
ield
USUK
Asia ex Japan
Government bonds
22
3-month spot rates
3 month forward rates 3 Month money market return
Expected annualised quarterly money market
return in
Term structure premium
1 Year 4 Years 9 Years 1 Year 4 Years 9 Years Today 1 Year 4 Years 9 Years
US 0.07 0.76 3.65 5.56 0.07 1.24 3.31 4.30 0.00 -0.49 0.34 1.26
Japan 0.14 0.22 0.82 2.57 0.14 0.76 2.34 3.29 0.00 -0.54 -1.52 -0.72
UK 0.81 1.37 3.56 5.72 0.81 2.74 4.17 4.09 0.00 -1.37 -0.60 1.63
Australia 4.86 4.85 5.59 6.01 4.86 4.39 4.27 4.45 0.00 0.46 1.32 1.57
Canada 1.29 1.78 3.24 4.59 1.29 2.12 3.38 3.90 0.00 -0.34 -0.14 0.68
Germany 1.17 1.82 3.43 4.19 1.17 2.26 3.56 3.94 0.00 -0.44 -0.12 0.25
Norway 2.62 2.78 4.31 4.63 2.62 2.35 3.29 4.26 0.00 0.43 1.03 0.37
Sweden 1.70 2.34 3.74 3.62 1.70 2.46 3.54 3.93 0.00 -0.12 0.21 -0.31
Switzerland 0.18 0.48 2.48 2.87 0.18 1.08 2.86 3.80 0.00 -0.60 -0.38 -0.92
1 Year break-evens Expected annual inflation Inflation term structure premium
Forward in in
Spot 1Year 4 Years 9 Years Today 1Year 4 Years 9 Years Today 1Year 4 Years 9 Years
US 2.70 2.38 2.66 2.73 1.79 1.95 2.27 2.46 0.91 0.43 0.39 0.27
Japan -0.30 -0.16 0.02 0.30 0.41 0.71 1.21 1.45 -0.71 -0.87 -1.19 -1.15
UK 3.97 3.54 3.06 3.82 4.21 3.54 2.74 2.53 -0.24 0.00 0.32 1.29
Australia 3.50 2.98 2.93 3.11 2.54 2.49 2.46 2.49 0.96 0.50 0.47 0.62
Eurozone 2.22 1.90 2.22 2.35 2.16 2.04 1.96 1.99 0.06 -0.14 0.25 0.37
Figure 36. Developed markets nominal term structure premium (%)
Figure 37. Developed markets inflation term structure premium (%)
Source: HSBC Global Asset Management, April 2011Any forecast, projection or target where provided is indicative only and it is not guaranteed in any way.
While inflation may not yet be a significant concern in
developed markets, it is difficult to see value in developed world
government bonds including treasuries at current levels. The
Fed will most likely cease to be a net purchaser of government
debt once QE2 expires at the end of June. Moreover, while the
discussion has now kicked off there is still no credible fiscal
adjustment package in sight in the US to bring down excessive
fiscal deficits that continue to add to the already bloated
government debt stock.
Over and above the flow issues – and more generally than
just for the Fed – there is also a key question of how the
accumulated portfolios of central bank holdings of government
debt will be reduced over time. The market’s base assumption
seems to be that they will simply erode through a process of
natural decay as government bond holding mature and roll off.
However, unless there is a fiscal cutting programme draconian
enough to reduce outstanding government indebtedness (highly
unlikely) the private sector will need to step up to refinance
these maturing bonds. Putting aside issues of whether inflation
in the developed world will eventually move higher, both effects
suggest that the price of treasuries will need to fall (yields
rise) to clear the market. In the case of US treasuries, S&P’s
announcement of a negative rating outlook for US sovereign
debt reinforces this conclusion in our view – unless it galvanises
the administration into cutting the fiscal deficit.
Inflation-linked bonds in EM
Investors should get some EM inflation protection via inflation-
linkers. These are financial instruments where the rate of
return is linked to the corresponding inflation rate to provide
protection from real returns being eroded by inflation. Linkers
have a number of potential advantages. Held to maturity, they
are the only instruments that are specifically designed to protect
against inflation. In contrast to nominal bonds the market price
of inflation-linked bonds responds to changes in real interest
rates and provides protection when both nominal interest
rates and inflation are rising. They also provide an element
of portfolio diversification for mixed equity and fixed income
portfolios because of their different return characteristics. On
fundamentals and consensus expectations EM inflation linkers
appear fairly priced relative to nominal bonds but the inflation
consensus has lagged and upward revisions increase their
attraction.
23
Figure 35
1600
1400
1200
1000
800
600
400
200
0
USD billions
GBI-EM Broad Traded Index Market value in USDBarclays EM Govt Inflation-Linked All Maturities
12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10
1600
1400
1200
1000
800
600
400
200
0
USD billions
GBI-EM Broad Traded Index Market value in USDBarclays EM Govt Inflation-Linked All Maturities
12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10
Figure 36
12
10
8
6
4
2
0
Brazil
Poland
Colombia
Turkey
Mexico
South Africa
09/01 02/03 06/04 11/05 03/07 08/08 12/09
Sources: Barclays, JP MorganFrom December 2003 to December 2010
Source: HSBC Global Asset ManagementSeptember 2001 to February 2010
Figure 38. Capitalisation of the main emerging nominal and inflation-linked local-currency bond markets
Figure 39. EM breakeven inflation levels
This document is intended for professional clients only and should not be distributed to or relied upon by Retail Clients. The views expressed above were held at end of April 2011 and are subject to change without notice. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (UK) Limited accepts no liability for any failure to meet such forecast, projection or target. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Where overseas investments are held the rate of currency exchange may cause the value of such investments to go down as well as up. Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in established markets. Markets in some countries are described as ‘emerging markets’. Some of these may involve a higher risk than where investment is within a more established market. These risks include the possibility of failed or delayed settlement, registration and custody of securities and the level of investor protection offered. Emerging markets are generally, but not exclusively, those that are not within the United States, Canada, Switzerland and members of the European Economic area, Japan, Australia and New Zealand. Stockmarket investments should be viewed as a medium to long term investment and should be held for at least five years. Any performance information shown refers to the past and should not be seen as an indication of future returns. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisers and their clients on the investment products and services of the HSBC Group, This document is approved for issue in the UK by HSBC Global Asset Management (UK) Limited who are authorised and regulated by the Financial Services Authority. Copyright © HSBC Global Asset Management (UK) Limited 2011. All rights reserved. 20301/052011/FP11-0659
Figure 36
12
10
8
6
4
2
0
Brazil
Poland
Colombia
Turkey
Mexico
South Africa
09/01 02/03 06/04 11/05 03/07 08/08 12/09
Figure 36
12
10
8
6
4
2
0
Brazil
Poland
Colombia
Turkey
Mexico
South Africa
09/01 02/03 06/04 11/05 03/07 08/08 12/09
Figure 36
12
10
8
6
4
2
0
Brazil
Poland
Colombia
Turkey
Mexico
South Africa
09/01 02/03 06/04 11/05 03/07 08/08 12/09
