Download Could stagflation be the bigger threat?

COMMENTARY
JANUARY 2011
Could stagflation be the bigger threat?
Overview
Accelerating inflation in emerging markets like China, India, and Brazil have been making
headlines. And markets are looking to policy makers there to tighten their accommodative
monetary policies with a greater sense of urgency. However, in a time of fiscal austerity in the
West, what impact that rising commodity prices will have on growth should be a bigger concern
than rampant inflation, as Europe and the US are experiencing cost-push rather than demand-pull
inflation. In other words, stagflation could be a bigger threat than inflation.
What’s fuelling inflation right now is rising commodity prices. Some of this is transitory in nature,
caused by weather related events. But much of it is being fuelled by a rebound in global
economic growth, particularly in Asia, which has benefitted from China’s massive £1.9 trillion
stimulus over the last couple of years.
This is more of a policy challenge for developing economies like India and China - where food
price inflation is now 15% and 9% respectively - than for developed economies like the UK,
where food is a smaller proportion of household budgets. Acting like a consumption tax, the rising
cost of living will renew fears about a repetition of the wave of food riots that rocked poor
countries from Bangladesh to Haiti two years ago.
Investors in emerging markets will therefore have to be much more selective about which assets
they buy – as commodity exporters could benefit at the same time that net importers of food
could suffer. But such short term squeezes in agriculture often pass quickly, as farmers respond to
higher prices by increasing output, as they did when food prices spiked in 2008.
For now, though, we see any tightening in Asia as a normalisation of policy. Some Asian
currencies look significantly undervalued based on the gap between purchasing power parity and
market exchange rate based measure of GDP, so there is room to let currencies appreciate. But
because many countries are wary that that tighter monetary policy will attract further “hot
money” inflows, that could destabilise capital markets, they may turn to a broader suite of policy
instruments, like increased reserve requirements, and reductions in banking system liquidity.
Meanwhile, in the UK, where food and energy prices, a hike in valued added tax, and 25% fall in
the trade weighted value of the currency, have caused consumer price inflation (CPI) to rise to
3.7%, the Bank of England’s inflation fighting credentials are being questioned. But as inflation in
the UK is due to one-off factors rather than an overheating domestic economy, we think the
Bank of England has good reason to remain relatively sanguine. As can be seen from the chart
below, indirect taxes presently account for nearly all the inflation.
Moreover, there’s no evidence that the upward trend in households’ short-term inflation
expectations is affecting wages, which are still rising by only 2.1%. This is hardly surprising given
that the UK government’s austerity programme will lead to sizeable job losses in the public
sector. One only needs to look at the rise in unemployment, to 2.5 million, to see that the private
sector is struggling to create enough jobs to offset those being made redundant, before the cuts
have even begun in earnest. And on top of that, the housing market has stalled, with no end in
sight for the mortgage freeze.
This is why we remain relatively comfortable with the Bank of England’s view that CPI will fall
back towards 2% in 2012, once one-off causes of inflation drop out of the data.
Food and energy costs have also been rising relentlessly at the wholesale level in the US, with
producer prices climbing 1.1% in December. However, with the money supply and the velocity
of money falling – and with no meaningful pick up in lending – inflation remains subdued, with
CPI still only 1.5% in December 2010.
The only time rising commodities have caused prolonged inflation in the US in the past fifty
years was during the two oil shocks of the 1970s. Oil has again reached $100, but the bigger risk
right now is that this will slow growth, as the price of fuel leaves consumers and businesses with
less to spend on other things. And given pricing constraints, there’s the potential impact on profit
margins to consider, when for example global steel prices are forecast to rise 30-40% this year.
The bigger dilemma is actually the one facing the ECB. While inflation remains relatively subdued
in the eurozone, accelerating inflation in Germany, and the inflationary impact of a weakening
euro, could still see the ECB pressured into raising rates, even as it continues to inject liquidity
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COMMENTARY
JANUARY 2011
into Europe’s banking system. A hawkish ECB has perhaps not surprisingly put inflation fighting
back on the agenda, as it eyes the strongest monthly price increase for raw materials and fuel on
record in January.
As welcome as the strength of Germany’s economy might be, with the Jan IFO confidence
indicator now at above pre-crisis levels and at multi-decade highs, the dichotomy between the
core and the periphery is widening. And complicating matters, inflation is higher in the Club Med
countries like Spain than in Germany – the opposite of what the Euro-zone really needs, with
confidence plummeting in Portugal, Italy, Greece, and Spain.
Investors will need to remain vigilant, as markets tend to drive up borrowing costs ahead of any
rise in the inflation rate. Yet the bigger risk from rising commodity prices remains the potential
impact on growth. Paradoxically, if that cools the demand and speculation driving commodities,
inflationary pressures could abate. Right now, though, we may be facing something more akin to
the stagflation of the 1970s, than the deflationary “lost decade” Japan experienced.
Commodities have risen above their 2008 peak
550
500
450
400
* The Reuters CRB commodities index is made up of 19
commodities quoted on the NYMEX, CBOT, LME, CME and
COMEX exchanges: Aluminum, Cocoa, Coffee, Copper, Corn,
Cotton, Crude Oil (33% weighting), Gold, Heating Oil, Lean
Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver,
Soybeans, Sugar, Unleaded Gas and Wheat.
350
300
250
200
Thomson Reuters/Jeffries CRB Commodity Index*
25
/0
4
25 /20
/1 00
0/
25 20
/0 00
4
25 /20
/1 01
0
25 /20
/0 01
4
25 /20
/1 02
0
25 /20
/0 02
4
25 /20
/1 03
0
25 /20
/0 03
4
25 /20
/1 04
0
25 /20
/0 04
4
25 /20
/1 05
0/
25 20
/0 05
4
25 /20
/1 06
0
25 /20
/0 06
4/
25 20
/1 07
0
25 /20
/0 07
4
25 /20
/1 08
0
25 /20
/0 08
4
25 /20
/1 09
0
25 /20
/0 09
4/
25 20
/1 10
0/
20
10
150
Source: Bloomberg, Aberdeen Asset Management, Jan 2011
For more information
Client Services Team
Aberdeen International Fund Managers Limited
Room 2604-6, 26/F., Alexandra House
18 Chater Road
Central Hong Kong
Tel: +852 2103 4700
Fax: +852 2103 4788
www.aberdeen-asset.com.hk
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COMMENTARY
JANUARY 2011
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