25 March 2011

Investment Update

Inflation in Asia: A Temporary Problem

There has been a lot of media attention on the topic of inflation, e.g. It was recently reported that Singapore inflation numbers (measured as CPI or Consumer Price Index) came in at 5% for the month of Feb 2011. What does this mean and how will rising inflation affect your investments? Read on.

Inflation is like the wind. One does not see it but one can certainly feel its effects. Price increases, especially in food, are widely reported by the media around the world and keenly felt by our pockets. One then begins to wonder if this pervasive trend is permanent and how would it affect our investments?

To put it simply, inflation is defined as having too much money chasing too few goods. This typically results in a general rise in the price of goods and services, and consequently a loss in purchasing power of a currency.

We see the current inflationary trends as an adjustment process that is needed to correct imbalances in the demand and supply of goods as well as a signal that money growth may be too strong.

As a result of the gloom and doom caused by the Great Recession in 2008, production did not recover fast enough despite signs that the economy was convalescing. Generally, companies were cautious about the sustainability of the recovery, let alone expecting a strong rebound. At the same time, central banks flooded the economy with liquidity in an attempt to resuscitate the economy. Looking back, the recovery was rather quick and surprisingly strong, easing fears that the global economy would be stuck with low growth for many years.

The impact of inflation is more pronounced in Asia where the balance sheet of consumers and corporations were healthy to begin with. As Asia began to exit the recession, the ability to spend and invest was unhampered. That was why a quick and sharp rebound in growth was seen in Asia.

Supply disruption is also one of the causes of price increase. This is especially so in the agricultural sector. According to the Food and Agriculture Organisation (FAO), food prices have been rising significantly, hitting a record high last month.

The weather has been oft cited as a reason for the poor harvest, which resulted in tight supply all round. And when speculators and hoarders get thrown into the equation, the increase in prices can be stratospheric for some products.

As a result of food accounting for a higher portion of spending, any increase in food prices tends to raise the Consumer Price Index or CPIs (a widely used measure of inflation) significantly. According to The World Bank, the headline inflation of developing economies has accelerated in recent months. This is largely due to the increase in food inflation, which has risen at twice the rate of non-food inflation.

The other cause of inflation is due to the ample supply of credit in Asia. Monetary aggregates in the large Asian economies like China (20% over the past year) and India (24%) have been growing too fast for comfort, likely exceeding the real needs of the economy. This has also spilled over to property assets, which have seen some Asian countries experiencing mini-booms.

For investors, the main worry over inflation is that it hits the profit margins of companies and this in turn could trigger the next recession. When corporations find that their cost base becomes too high (whether from material prices, rental or wages) versus revenue, then spending and investments start to slow or cease as returns diminish.

In Asia, workers are likely to ask for higher wages to offset the increase in the cost of living. Unlike the West, the employment picture in Asia is bright with low unemployment rates. Wages may have declined during the recession but are now set to grow. However, rising wages eats into corporate profit margins and if it continues to rise unabated, this could trigger the next recession or economic slowdown in Asia.

The good news is that policy makers in Asia have been rather quick to address the inflation issue. Interest rates have been rising in Asia, translating to a higher cost of credit (effectively reducing demand for loans). Besides increasing the cost of money, central bankers have also instructed banks to set aside a larger amount of reserves to constrain credit growth. Monetary tightening has been an ongoing affair since last year and for some countries, interest rates are close to the previous peak.

On food price inflation, governments in Asia have taken measures to address shortages by releasing stockpiles to alleviate supply concerns. More crucial to food supply is the weather. While it is difficult to predict the weather, there are signs that the worst in weather patterns is over. The worst La Nina weather anomaly in a decade, which was blamed for Australia's crippling floods, should be gone by June, according to the U.S. Climate Prediction Center. If that is the case, then we should see agricultural prices easing in the months ahead. This should provide some relief to consumers.

The key issue regarding inflation is how long it will last. Prolonged inflationary trends may lead to a vicious inflationary spiral where fears of higher prices lead to irrational buying. We believe this is a low probability event as emerging market bonds, a good indicator of inflationary problems, appear to be bottoming out. They have been underperforming since November last year and appear to be building a base. When they start to turn around, this could be the signal that inflation has peaked for emerging economies.

The good economic fundamentals in Asia help policy makers to combat inflation. Large foreign reserves, trade surpluses, growing domestic economies and a largely competitive economy allow this region to withstand potential shocks like higher prices. Governments have the necessary means to buffer the economy from shortages while the economies are strong enough to withstand the higher cost of credit.

Finally, Asia's most important customer, the United States, is also growing at a healthy clip. This provides another pillar of support to Asian economies combating inflation. We are of the opinion that inflation will not be a lasting problem for Asia. Supply shortages are likely to be temporary while credit growth is being restrained by central banks. Interest rates are closer to the previous cycle peak while companies and consumers are in a healthy position to adapt to higher prices. The Asian economy is set to overcome this temporary setback and shine again.

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