The big picture

• One of the biggest issues currently is rising food prices. Food prices began rising in the second half of 2010 and hit record highs in January. The United Nations Food and Agriculture Organisation has recently released its February data and the food price index hit fresh record (20 year) highs in both real and nominal terms, up 2.2 per cent in the month. All of the component price indexes were higher in the month, except sugar, which fell slightly.
• The FAO expects that a combination of higher global demand and lower supply will lead to a fall in global cereal stocks, underpinning the sharp lift in prices recorded over the past year. Over the past year the FAO estimates that export prices of major grains have lifted by 70 per cent.
• At face value, record grain prices don’t seem to be supported by the drop in coarse grain stocks. While expected to fall by almost 16 per cent in 2010/11, stocks hit 8-year highs last year. But given that demand for grains has been soaring, lifting to record highs, it is important to look at grain stocks as a proportion of consumption. In 2010/11, stocks are expected to fall to 18.6 per cent of consumption, not far off the 30-year low of 16.6 per cent in 2006/07. Consumption has risen 22 per cent over the past decade versus a 18 per cent lift in production.
• Now for those in developed or advanced nations, tight grain supplies and record prices is a concern, but hardly a big deal. In the US, food represents just 7 per cent of household spending. In the UK this proportion stands at 9 per cent while food is 11 per cent of household consumption in Australia.
• But in developing nations, the issue of rising food prices is far more significant. Even in the second largest economy – China – food represents 33 per cent of household spending. More broadly across Africa and Asia food holds between 30-50 per cent of household consumption.
• So it understandable that record food prices have led to unrest across the developed world. And when you combine that with young populations that are more likely to agitate for change, widespread access to social media and autocratic governments, you have a volatile mix. According to the United Nations, around 60 per cent of people in North Africa and the Middle East are under the age of 30 whereas the proportion is closer to 40 per cent in Western Europe, the US and Australia. In Australia, 41.2 per cent of the population is under 30 and the proportion is expected to keep falling for the next 40 years.

The week ahead

• After two solid weeks of ‘top shelf’ economic indicators, the calendar thins out somewhat over the coming week. The highlight is probably the release of minutes from the last Reserve Bank Board meeting, but there are also some key lending figures that bear watching.
• On Monday the Reserve Bank releases the January data on credit card lending and debit card transactions. Consumers still remain very cautious about going into debt with the average credit card balance just 1.9 per cent higher than a year ago – below the rate of inflation.
• On Tuesday the Reserve Bank releases minutes of the March 1 Board meeting while figures on car sales and lending finance are released the same day. Reserve Bank Assistant Governor Guy Debelle also delivers a speech but it is unlikely to provide direction for investors or traders. And the Board minutes will merely confirm that interest rate settings are on hold with members preferring to assess more information before deciding the next move.
• Car sales were largely flat in February – we tip a 0.5 per cent decline. And there will be keen interest as to whether the recovery in lending finance continued in January. However if the weak housing finance figures are anything to go by, the recovery in lending probably stalled in the latest month.
• On Wednesday the December quarter data on dwelling starts (commencements) is released. In the September quarter new starts slumped by 13.2 per cent and the pronounced slide in building approvals since April and the recent drop in construction loans to 2-year lows points to softer activity ahead.
• On Thursday, detailed labour force data is released with the latest estimates of employment by industry to be released. And the Reserve Bank releases its quarterly Bulletin on Thursday but there are no indications as yet what articles it will contain. Usually they cover a broad range of topics and provide fresh insights into Reserve Bank thinking on the broader economy.
• Turning our attention overseas, a solid schedule of US economic data awaits investors over the coming week with inflation being the highlight. On Wednesday new figures on business inflation (producer prices) will be released while consumer price data is issued on Thursday. Investors have grown used to seeing core gauges of prices (excludes food and energy) rising by 0.1 per cent each month, but it’s entirely possible that both the PPI and CPI core measures lifted 0.2 per cent in February, indicating that inflation has bottomed.
• The other event of note is the meeting of Federal Reserve policymakers (FOMC) on Tuesday. No change in rate settings or the amount of ‘quantitative easing’ is expected but the commentary should show that policymakers are more positive on prospects for the economy.
• In terms of the other data releases, the Empire State manufacturing survey is released on Tuesday together with trade prices and January data on capital flows.
• On Wednesday, figures on housing starts accompany the data on producer prices as well as the December quarter current account figures. Economists expect a correction in housing starts in February – down by 2.5 per cent to a 580,000 annual rate after the out-sized 14.6 per cent gain in January. Harsh winter weather has been playing havoc with construction but overall starts are still bumping along the bottom.
• On Thursday, data on industrial production, the leading index and the Philadelphia Fed survey are released alongside the figures on consumer prices. A healthy 0.6 per cent lift in production and solid 0.8 per cent gain in the leading index will confirm that the economic recovery is in good shape.

Sharemarket

• In 2010, there was the ‘funk’ caused by European debt, now global sharemarkets are fearful of a geopolitical contagion in North Africa and the Middle East. The last geopolitical contagion affected Asia in 1997 – a financial crisis characterised by speculative attacks on currency markets. At the heart of the issue were concerns about the health of banking systems and debt levels especially in Thailand, South Korea, Malaysia and Indonesia.

This time around the issue is more about politics – with people across North Africa and the Middle East expressing their concern that their governments are not doing enough to deal with soaring food prices. Across the region around 60 per cent of people are aged below 30 and they are agitating for change. The key concern with the Africa/Middle East crisis is that oil production could be disrupted. Just like the European Debt worries of 2010, it is fear that is causing sharemarket wobbles than actual fundamentals. The world is actually well supplied with oil and OPEC members say they are prepared to lift production quotas if necessary.

Interest rates, currencies & commodities

• On commodity markets, gold and oil prices are dominating attention due to fears of a widening in the Middle East crisis. The risk for investors is that when the situation in Libya is resolved, then oil and gold prices may retreat just as quickly as they lifted. But there are also a few other commodities that bear watching at present as well. Wheat and corn prices have eased in recent days on the potential for better crops in the US and eastern Europe. If production were to lift markedly, pushing down grain and food prices, disquiet in the Middle East would ease.

The post Investor Signposts: Week Beginning March 13 2011 appeared first on AdviserVoice.

Key points

• Rising inflation is becoming a major concern in Asia and other emerging countries. So far it’s largely due to higher food prices. Non-food inflation remains reasonably benign.
• However, with strong growth having used up excess capacity and monetary conditions remaining easy, a flow on to higher non-food inflation is a growing risk.
• As such, expect further monetary tightening in Asia and the emerging world.
• This is positive for Asian and emerging country currencies generally, but is likely to continue to act as a dampener on emerging market (EM) shares relative to traditional global shares over the next six months.
• However, our cautious short term stance on EM shares doesn’t alter their favourable longer term outlook.

Introduction

Rising inflationary pressures in Asian and emerging countries are clearly starting to worry investors. Many are fretting policy makers in these countries will be forced to tighten aggressively, threatening a key driver of the global recovery and the performance of share markets in the emerging world. These concerns are most evident in China and India. Coming at a time when the US outlook is improving this has seen Asian/emerging market shares underperform developed market shares since November. But how big a threat is it?

Rising inflation so far mainly limited to food

Emerging world inflation is on the rise. So far the main driver has been higher food prices and to a lesser extent higher energy prices. The next chart focuses on Asia, but it’s a similar picture in emerging countries generally.

Source: Bloomberg, AMP Capital Investors

World food prices have now surpassed their 2008 record high largely reflecting adverse weather.

Source: IMF, AMP Capital Investors

While higher food prices have also boosted headline inflation in developed countries, the impact there is much smaller as food has a greater weight in Asian and emerging country CPI baskets than in rich countries. Food has a CPI weight of 31% in Asia and 26% in Latin America compared to 15% in Europe, 8% in the US and 16% in Australia.

Higher energy prices have also played a role but so far non-food price inflation has remained reasonably benign.

Will there be a flow on to non-food prices?

Food price inflation comes and goes. Even though food stockpiles are low, better weather in the year ahead could well see it abate – despite longer term structural forces of rising per capita incomes in emerging countries and bio fuel demand which are positive. So the key issue is whether there will be any flow-on to core inflation? Here the key determinant is the amount of spare capacity as this will determine whether companies have the pricing power to pass on increases in raw material costs and workers have the power to demand higher wages to compensate for food price increases. On this front the risks are rising, albeit from a low base. Output gaps, which show the difference between the level of actual and potential GDP or output, are a good guide to inflationary pressures. Right now they are benign. Output gaps in the emerging world have closed indicating that spare capacity has been used up, but output gaps are not as positive as was the case in 2007 and 2008. See the next chart for Asian countries.

However, if economic growth continues at its current pace, output gaps are likely to become positive leading to increasing price and wages power and potentially a pick up in core inflation over the next two years. The risk is probably greater in Brazil, India and China. Wages growth has been picking up in China and Vietnam, although it’s mainly minimum wages and overall wages growth is still low relative to nominal GDP growth. High capacity utilisation and rising labour costs are already resulting in significant upwards pressure on non-food inflation in Brazil.

Source: IMF, AMP Capital Investors

A major concern for Asia and the emerging world is that monetary policy is still relatively easy. Many countries in Asia have resisted exchange rate appreciation following China’s lead and while interest rates have been increasing because of uncertainty about the strength of the global recovery they have generally not kept up with the increase in inflation. As a result real interest rates remain negative. Relatively easy monetary policy at a time when domestic demand is strong and spare capacity has been used up add to the risk of the uptick in headline inflation flowing into underlying inflation across Asian and emerging countries, as is already occurring in Brazil.

Source: Bloomberg, AMP Capital Investors

What is the likely policy response?

The upshot is that further monetary tightening is likely in emerging countries to head off a broader based inflation threat. Central banks across Asia and emerging markets generally have been tightening but more may be required over the next six months or so. There is also likely to be a greater tolerance for currency appreciation as it will help control food prices and inflation generally.

Fortunately, the inflation threat is not as great as it was in 2007-08 as output is still close to potential and capacity pressures are not as intense (except in Brazil, amongst the majors). The surge in food prices will also act as a bit of a constraint on household spending power. As a result we don’t see the need for monetary tightening to become excessive to the extent it threatens continued growth. Rather what is required is for growth to slow back to more sustainable levels – around 9% in China and 5 or 6% in the rest of Asia.

What are the implications for EM share markets?

While monetary tightening across Asia and EMs generally is unlikely to get so aggressive that it crunches growth, it is still likely to worry investors. As such, further tightening is likely to be a continuing drag on the relative performance of share markets in Asia and the emerging world over the next six months, until it is clear inflation is back under control. This relative underperformance is being accentuated by a somewhat idyllic combination (at least for now) of improving growth, low inflation and easy money in the US and northern Europe right now which is starting to be recognised by investor flows (away from bonds and emerging market shares towards US shares).

It is important to stress though that inflation in Asia is modest by past standards. For example, in China it is now running around 5% compared to the situation in the late 1980s and mid 1990s when it reached 25 to 30%. So while it is a short term concern it is unlikely to threaten the positive longer term outlook for these countries. And finally, from a strategic perspective share valuations in the emerging world are not demanding. EM shares are trading on a forward price to earnings multiple of 11.3 times and Asian shares on 12 times, which is slightly below the global share average of 12.5 times.

What about inflation in developed countries?

Concerns about inflation have also arisen in developed countries but the risks are much lower here. As already noted, food has a much lower weight in developed countries. Secondly, there is still plenty of spare capacity in the US, Europe and Japan. This is evident in unemployment still running around 10% in Europe and the US. Finally, while monetary conditions are very easy in advanced countries, money and credit growth remains very low. So while high food and energy prices may cause occasional inflation scares in developed countries this year, headline and, particularly, underlying inflation is likely to remain benign overall at least for the next year or so.

Source: Thomson Financial, AMP Capital Investors

The post The threat of inflation in Asian & emerging markets appeared first on AdviserVoice.