Markets grapple with a stagflation quandary
James Novotny, Assistant Fund Manager, Fixed Income Alternatives, looks at the issue of stagflation and asks whether central banks could be about to make a policy mistake. He also considers the potential impact if economic growth actually picks up from here.
Stagflation (high inflation combined with economic stagnation) has been the dominant market theme since the end of the summer. Historically it has typically been accompanied by high unemployment, but at the moment unemployment is actually quite low in major developed markets. Nevertheless, it is indisputable that we have rising inflation and slowing global growth. Indeed, over the weekend New Zealand’s CPI data surprised significantly to the upside while Chinese economic data (in particular fixed asset investment and industrial production) surprised to the downside.
This matters because positioning simultaneously for higher inflation and lower economic growth is not an easy feat for investors. In fixed income, the impact of this environment has meant higher rates and a stronger USD. Within that there are nuances: for example, in high yield this has been focused on the longer end of the curve (10+ years out) and the moves have been more aggressive in higher growth markets (e.g., Hungary, Australia, Canada) that are perceived as better able to absorb higher interest rates. In currencies, we have seen the USD move higher but it has struggled against commodity FX markets, energy exporters like Russia and Norway, which have seen their FX rates be strong as commodity prices surge.
Where do we go from here, and are policymakers about to make a mistake? The Bank of England BoE) governor has said that monetary policy cannot solve supply-side problems, but the BoE will be compelled to act if it sees risk to medium-term inflation expectations. This means that the BoE are worried that the transitory inflation pressures (supply-side disruption) may last long enough to meet the cyclical inflation pressures of wage growth and rent rises in 2022.
Markets therefore anticipate central bank policy action sooner rather than later. Somewhat counter-intuitively, growth expectations are continuing to fall at the same time – as expressed in rates market curves, which have flattened as the front end (2-5 years) jumped in yield while the longer end has outperformed.
It’s certainly possible to interpret these moves as negative and worry about risk assets, but our view in the Fixed Income Alternatives team is more optimistic. Growth is still above trend overall, and despite the slowdown following the immediate Covid recovery looks set to remain that way for a couple of years, aided by a turn in the inventory/capex cycle, a boost as the Delta variant subsides and vaccinations pick up. So we’re more focused on thinking about what happens if growth picks up, which could see the reflationary trend from Q1-21 resume and the rotation out of USD assets continue.
Vaccination progress boosts consumer demand in India
Avinash Vazirani, Fund Manager, India, discusses vaccination progress in India and the resulting rise in consumer demand, as well as the country’s hot IPO market.
A billion doses of Covid-19 vaccines have now been administered in India, with around 75% of the adult population having received at least one dose, and approximately 30% having had two doses1 . The government is targeting full vaccination of the entire population by the end of the year – while we were previously sceptical about this target, it’s now looking increasingly achievable. As this figure grows, confidence strengthens and people go out more, and economic activity should recover.
Indeed, we are already starting to see this recovery coming through in time for India’s festival season, a period which is particularly important for consumer demand. For example, recent reports suggest that restaurant like-for-like sales are 25%-30% up compared with the same period in 20192. Furthermore, UBS estimates that India has excess household savings of $300bn3, which should be supportive too. While some sectors are currently experiencing supply constraints (e.g., automakers), as we’re also seeing on a global scale, other sectors have plenty of capacity, such as travel and tourism, supported by an abundance of cheap labour.
We’re also starting to see the beginning of a new cycle in the real estate sector, following a tough period for the sector as property prices had stagnated given tougher legislation. Elsewhere, the government has doubled down on infrastructure projects, especially logistics; roads, rail, metros and ports are likely to be key areas of focus. While it’s too early to tell if this’ll be followed by a boom in private sector capex, we think it could be an area of opportunity.
Meanwhile, India’s IPO market is very hot, with 42 companies already having had IPOs this year, raising over $10bn, close to the peak in 20174. Around 30 additional deals are expected to hit the market before year-end too. It’s not just the IPO market though – we’re also seeing massive amounts of money going into private equity and venture capital deals, with around $49bn raised across 840 reported deals year to date5 . We think Indian indices could look quite different next year, moving from having virtually no listed internet names, to having several large cap, listed tech/fintech companies, for example.
To summarise, we are confident about India’s economic recovery, given the improving Covid picture and resilient company results so far. Despite the MSCI India Index being at all-time highs, India corporate ROEs are at a 7-year high, and gross debt/equity ratios for large listed corporates are at a 16-year low6. We’re still able to identify many good businesses delivering strong earnings growth that are trading at attractive valuations.
Stressful times for the China property sector
Xuchen Zhang, Credit Analyst, Emerging Market Debt, discusses the risks for the Chinese property sector in the wake of the deteriorating financial position of Evergrande.
There has been discussion about whether Evergrande may become a ‘Lehman moment’ for China or even trigger a global crisis. Since early June, when the distress story of Evergrande began to unfold, Markit iBoxxx USD China Real Estate High Yield Total Return, the index we monitor for China property bonds, has lost 35% in value, the worst drawdown ever for this sector, with average yield reaching as high as 34%.
These are difficult times for Chinese property developers. On the operations side, property sales have taken a nosedive, -30% year on year sales in September, for example. Chinese people are more reluctant to buy properties on the fear that their properties couldn’t be delivered, as was the case with Evergrande. On the financing side the move in the US dollar bond market means it is very challenging for developers to refinance their upcoming debt maturities, and onshore financial institutions also have been limiting lending to the sector. Our own stress tests on a list of developers concludes that most developers’ liquidity could be under pressure in the most extreme scenario regardless of their rating.
In our view, the key risk here is that the Chinese government could miscalculate the likelihood and impact of a potential sector-wide stress and continue with its ultra-tight property policy – as a result, more developers could run into liquidity problem and China by mistake kills a sector that contributes 20% of its GDP.
Then, to everyone’s delight, such risk is alleviated by a series of statements and actions by People’s Bank of China (PBOC) last Friday. It asked banks to speed up the approval of mortgage loans and allows them to issue RMBs to free up balance sheet for lending to the real estate sector. It also commented that some financial institutions in China have tightened too much in lending to the property sector and encouraged banks to continue to provide orderly and stable funding to the it. Not surprisingly, the property bond market jumped in response to the PBOC’s positive move, up by 4% last Friday and 5% further this Monday.
That said, we are not overexcited about the easing tones and measures on property sector or the strong rally in bond prices. We are closely monitoring if the government could mismanage this situation, and constantly reviewing the positions in our strategy. The market is moving very fast and our view may change, but so far we feel relatively comfortable.
1 CoWIN Dashboard
2 Kolkata: Restaurants run out of food, down shutters as patrons indulge in revenge dining | Kolkata News – Times of India (indiatimes.com)
3 UBS India market strategy note, 6 September 2021
4 IPO frenzy: 35 companies may raise Rs 80,000 crore in Q3 – The Economic Times (indiatimes.com)
5 PE-VC investments touch record high of $49 bn in ‘21 – Times of India (indiatimes.com)
6 CLSA India strategy report, 14 October 2021
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