Q2 CIO Review and Outlook
CIO Robert Horrocks, PhD, discusses the short and longer-term prospects for Asia and EM in a rising inflationary environment.
Along with the rest of the world, China has recently seen a spike in core inflation. Although, let us be honest, in the U.S. it is 3.8% year-on-year; in China, it is 0.9% year-on-year. One is a spike, the other is more like a soft fluffy cushion. I think it is in line with our previous view that China’s monetary policy was tight but not tightening. Now it appears that things may be loosening up a bit. As well they should!
China had the luxury of a more normal monetary policy because the effects of COVID have been much less severe on its economy. In all practicality, that meant that China was able to continue its policy of squeezing the poorly regulated parts of its credit markets without unduly impacting economic growth. For much of the rest of the world, the focus was on extreme liquidity from Central Banks and emergency payments to unemployed workers. As much of the world emerges from the pandemic-enforced lockdowns, we are seeing inflation rise as demand comes back strongly, before inventories have been rebuilt and before all workers are back on their shifts.
It is conventional wisdom in emerging markets investing that Asia (and particularly Latin American markets) tend to do best during periods of loose monetary policy and faster economic growth. It’s conventional wisdom that, whereas it is on average true, also drives me crazy because it comes from the viewpoint of tactical rather than strategic asset allocation. However, I cannot deny that it is useful for those with a 12 to 24-month view. And perhaps only that—for as frightening as 3.8% core inflation may seem, the fact that supply constraints are a major cause also means that it is likely not sustainable. It could still accelerate if wage demands spiral and the U.S. Fed refuses to tighten, but this inflationary pressure can and should be tamed— five-year inflation expectations are still only 2.5%, and 10-year lower still.
Beyond the tactical view, what are the longer-term prospects? First, we have to acknowledge the political tensions between the U.S. and China. And whereas we were always inclined to think that these tensions would persist, I, for one, thought the rhetoric of the new Biden administration would at least be less confrontational. That expectation, it appears, was in error. Yes, the focus has moved from the trade deficit to issues of human rights and political systems, but the intention, despite this, is still to try to influence China by imposing economic costs. It does seem to me that the motivation for this comes partly from wishing to be a standard bearer for basic human rights—however, it also appears partly to be out of fear that China is starting to catch up in terms of technology with the West. As laudable as it is to uphold the former, it is neither good for the world, nor in my view even possible, to try to retard the latter.
The U.S. will not take on China in a vacuum. It is seeking the help of its allies in Europe. However, as we have noted in previous essays, Europe is not as unified on this subject as the U.S. might wish. Some parts of the continent, badly served by EU policy, have increasingly been looking East for investment funds. After Brexit, the U.K. has even publicly stated that it makes sense to replace some of the lost access to the markets of Europe with an approach to China. So, whilst the banner of human rights is a far better rallying cry than mere economic concerns, it is not guaranteed success. And then there is the rest of the world, including Eastern Europe, Latin America, Central Asia and Southeast Asia, where the lure of Chinese investment, infrastructure spending and demand for raw materials can be contrasted with the U.S.’ history of largely militaristic diplomacy. In these regions, the impetus for growth and the primacy of economic development make the new China containment policy by the U.S. far from a simple sales pitch.
For our part, our focus on companies that help facilitate the growth of middle-class lifestyles across Asia and other emerging market countries naturally allies us with the economic forces that improve social outcomes and, increasingly important for these economies, protection of the environment. Our preference for domestic businesses also shields our investments to an extent from some of the potential direct impacts of any sanctions. And our desire for sustainable, long-term businesses that treat minority shareholders well aligns us with the stated goals of economies to develop their capital markets and financial systems. Nevertheless, we have to continue to be mindful of these issues and the risks they pose to our investments in the current political environment.
In fact, as we look beyond this year, the chances for strong profit growth in Asia seem to be better than they have for some years. It is rather ironic, given current headlines, that China has in the past few years sacrificed profit growth for better wage growth. In this effort, it has been joined by other economies across Asia, though less so in other regions. As the U.S. and Europe struggle with labor issues born from a declining share of labor over many years, Asia’s economies have returned by and large to a more natural balance between capitalist and worker. It is possible that the inflation spike in the U.S. continues to be met by higher wage demands and then ultimately by a tighter monetary policy. At that point, U.S. profits will be caught in the jaws of a terrible vice. For many economies in Asia, where core inflation still ranges from zero to three percent, the likely scenario is continued modest reflationary pressures. Such reflation has typically favored better earnings growth. In terms of portfolio flows into our markets and potential currency movements, it remains to be seen how businesses and asset allocators in the U.S. and Europe will deal with the confluence of a difficult political environment and the potential for improved economic momentum in emerging markets. Normally, it seems to me, economics wins out...but who knows?
Where does that leave us? Well, the CEOs and CFOs of the companies we invest in also take all of these issues seriously. Ultimately, protecting their businesses is a prerequisite for growth. And those growth prospects are considerable. Nominal GDP growth is still expected to be much stronger in Asia than the rest of the world. Savings rates are high, helping those currencies to seem well-protected. And the growing complexity and diversity of consumer preferences gives scope for businesses to build new markets. The strength of the IPO market, in which we have participated to a much greater extent than in the past, is a testament to the wave of new businesses and industries emerging in Asia. And these days, Asia dominates emerging markets—and leads their growth too.
We remain excited at the prospects for our investments and are focused on finding the businesses and management that can best navigate the obstacles while taking advantage of the opportunities.
Robert Horrocks, PhD
Chief Investment Officer