Every Chinese New Year, AsianInvestor makes 10 predictions about developments that will affect global financial markets and the portfolios of Asian investors, especially asset owners. These developments can focus on asset classes, geopolitical events, or structural issues surrounding particular markets.
In this Year of the Rat outlook, we consider the likelihood that the inflation could be higher than expected in any major market.
Is inflation likely to prove a surprise downside risk?
In Asia, inflation picked up at the end of 2019, and that has prompted some concerns that we could see further price increases during 2020. That would prove a big problem for investors, many of whom are putting assets to work on the assumption that inflation (and hence interest rates) will remain low.
In truth, their assumption that prices won't rise quickly looks sensible. Inflation pressures appear negligible, despite the fact that the Asia region is, excluding Japan, dominated by emerging markets.
While 90% of emerging market countries experienced inflation rates of above 4% in the mid-1990s, this total has fallen to 30% today. And more than 20% of emerging markets have inflation rates of under 2%. The late-2019 pickup in inflation is unlikely to be a lasting trend.
For 2020, Asia's inflation concerns mainly focus on China and India. Retail inflation, including food prices, is a possible issue throughout Asia, especially in India. Across other regional markets, the inflation risk is quite suppressed and not expected to be a major issue, said sources, referring to the dampened inflation rates among the emerging markets in the region. Should signs occur, policymakers are expected to step in if required.
Eurozone growth is likely to remain low in 2020, with inflation stubbornly low and core government bond yields largely negative. Therefore, there are growing worries about the Eurozone’s possible “Japanification” – that it will suffer an extended period of slow or negative growth and deflation.
The Eurozone and Japan both currently rely on quantitative easing (QE) and low or negative base rates but are struggling to cope with low growth and low inflation. The former also faces similar, but not identical, structural problems related to public and financial sector debt, ageing, and somewhat inflexible markets.
By the middle of the year, inflation developments in the US may condition the future dynamic of global markets. Should core inflation accelerate and the US Federal Reserve demonstrate patience in raising rates, US real returns and financial conditions would ease further while the US dollar might accelerate its depreciation.
Such a development would support a stronger outperformance of emerging assets and may extend the current business cycle by a few quarters. The rotation from quality to value stocks may then finally really take place but it is premature to play it now aggressively, one source said.
Globally, the risk of even moderate inflation is remote, but a recession could eventually set up conditions that favour a sustained period of elevated inflation in its aftermath. That would be the case if fiscal policy, aided by more frequent debt monetisation, is overused.
Conventional monetary policy stimulation works through lower policy interest rates, which help boost demand by lowering the cost of borrowing. Given today’s low policy rates, if a recession were to occur in the near term and G4 central banks were to lower rates by their average recessionary cuts since 1960, policy rates would become deeply negative.
Central bankers are currently biased toward a policy of easing, both because of previous failures to boost inflation and because debt levels are high. Money-financed fiscal policy can create inflation when overused. If printed money just offsets the decline in credit and spending that happens in recessions, then it should not produce inflation.
Coordinated fiscal and monetary policy, however, threatens central bank independence and raises the odds that fiscal policy will be overused, igniting inflation. While elevated inflation after the next recession is a risk, it is far from a foregone conclusion.
In addition, policymakers will first try conventional measures. Only if those fail, will they work towards a more coordinated fiscal and monetary policy. Were this actually to happen, then investors could face a window of opportunity to pick up select real estate and infrastructure investments at recessionary prices.
Such investments cannot be expected to serve as inflation hedges, but they should perform relatively well. High-quality real assets, dubbed core, are more likely to hold their value better than financial assets in such an environment, one source pointed out. At attractive purchase prices, such investments would deliver competitive returns even without meaningfully higher inflation.