On Inflation, Why Buy EM Local Currency Bonds and the “China Study – Part II”!

From: Aditya Rana
Date: Sat, Oct 13, 2012 at 2:35 PM
Subject: On Inflation, Why Buy EM Local Currency Bonds and the "China Study – Part II"!


The appropriate time to begin making strategic changes in an asset portfolio is usually when the market consensus or expectations are tilted against a particular asset class or favour a particular view on a key macroeconomic variable – for example, buying EM and European equities and bonds during the fall of 2011, buying US treasury bonds and gold during periodic episodes of cataclysmic sell-offs during the last few years or protecting against future inflation today given the currently benign outlook for inflation. With that aim in mind, I present below a note from the fund manager PIMCO which makes the case for owning assets now which provide protection against future inflation.

-Inflation in the US has averaged only 3% per annum over the last 30 years, leading to a sense of complacency amongst investors about its impact on asset returns.

-However, investors should begin to re-examine this complacent attitude as 1) the recent crisis has shown that tail risk events should be taken a lot more seriously, 2) the seeds for future inflation have been laid through unconventional monetary policies by central banks and ballooning government debt, and, 3) asset prices are much more sensitive to inflation surprises rather than the actual level of inflation, and it may be too late to hedge against inflation once its level has risen above a threshold.

-Investors should therefore begin to obtain exposure to assets which have performed well during periods of high and rising inflation – commodities, foreign currencies, gold and TIPS (inflation-protected government bonds), at the expense of stocks and bonds which have typically underperformed during such periods.

-The process of issuing government debt at lower yields cannot go on forever – ultimately, the size of debt to GDP must be reduced and given growth is likely to be subdued for a while (as highlighted by Carmen Reinhardt and Ken Rogoff in their studies), the way to reduce this ratio is through austerity, inflation or default.

-Given the political impasse in the US on the issues of implementing higher taxes and lower spending (i.e. austerity) as a means to reducing the debt/gdp ratio, the only viable options are inflation and default.

-With core-inflation at 2.1% versus averaging 2.2% over the last 20 years, inflation is unlikely to rise over the next year. However, the fact that inflation has not been reduced further given the high level of unemployment (8.3% versus an average of 5.2% over the last 15 years) and the large output gap, implies that the Fed’s unconventional monetary policies have already had an impact.

-Historical studies have demonstrated the stable link between inflation regimes and asset return, but there is little agreement on how to define inflation regimes. What is clear though is that a dynamic approach to inflation protection matters more than a static asset allocation, and it is the unanticipated changes in inflation which have the largest impact on asset returns.

-Analysing data since 1973, they found that stocks and bonds performed poorly when inflation was is higher than previously expected, compared to foreign currencies, commodities, gold, and TIPS (in order of performance as measured by the Sharpe ratios-i.e. the return divided by their risk).

-In addition, the absolute level of inflation matters less than inflation surprises – for example, during the Volcker period in the late 70s and early 80s, inflation was high but declining in absolute terms as well as in relation to expectations, leading to bonds and stocks outperforming commodities, TIPS and gold.

-The current economic environment could lead to a period of “stagflation” – characterised by low growth and high inflation. During such periods historically, foreign currencies, gold, TIPS, commodities and government bonds (in order of performance) outperform stocks and corporate bonds.

-Numerous academic studies have pointed to a negative relationship (“beta”) between stocks and inflation – with the causal relationship likely being poor economic growth leading to lower stock prices, increased government spending , higher debt/GDP ratios and monetization of debt via inflation. In addition, higher government debt typically implies higher corporate taxes leading to a vicious cycle of lower stock prices, higher government spending and inflation.

-Higher inflation also has a direct negative impact on stock prices by increasing interest rates and therefore the discount rate applied to future cash-flows.

-During periods of inflation caused by purely monetary phenomena, stocks may provide a hedge against inflation. For example, during the 1921-23 hyperinflation in Germany, stocks protected investors against the ravages of hyperinflation.

-However, stocks of companies which provide or invest in assets linked to inflation like energy, natural resources and real estate stocks, have served as a better inflation hedge than the broad stock market.

-Commodities have typically provided a good hedge against inflation, and in particular, commodities like oil and food (which make up 25% of the US CPI basket) have shown to have a higher correlation to inflation than base metals.

-Compared to other asset classes which are positively linked to inflation, commodities tend to have the highest beta – i.e. the biggest percentage gain in response to a percentage point rise in inflation. Investors can therefore hold a relatively small portion in commodities to hedge a much larger portfolio.

-Looking forward, higher inflation could either be triggered by a commodity supply shock ( closure of the straits of Hormuz or unrest in the Middle-East) or a gradual economic recovery triggering an increase in inflationary expectations. The Fed may err on the side of promoting a stronger recovery and lower unemployment, and tolerate higher inflation believing that it can be reversed. However, history suggests that this reversal process may not work as smoothly as hoped.

An interesting and thought provoking note, and supports building an exposure to commodities, commodity stocks (particularly energy) and gold in a diversified asset portfolio. While inflationary surprises may still be a few years down the road, it would be prudent to gradually build such exposure, particularly during periods when these assets experience corrections. As mentioned previously, we are likely to be in 12 to 18 month cyclical bull market for most risk assets supported by endless QE by central banks, so having exposure to EM equities, European equities and high quality US equity would also make sense. However, as we start approaching a period of upside inflationary surprises it would be prudent to reduce such exposure as equities tend to underperform, particularly during the initial phases of increases in inflation. Eventually, higher inflation is what is really needed to resolve the debt overhang in the developed world making it somewhat inevitable.

I have, previous newsletters, touched upon the theme of increasing allocations from Institutional investors in the developed world towards EM equities and bonds (Please note that EM local currency bonds also provide protection against inflation as noted above). It was therefore with interest that I read a note from Standard Chartered bank(via FT Alphaville) on this theme – some excerpts and graphs:

-“Local-currency emerging bond markets have seen ever greater levels of foreign demand as global investors flee from the ongoing European sovereign crisis and continue to allocate to fixed income securities. From less that USD 150bn in March 2009, foreign holdings of local-currency government bonds in emerging markets (EM) are now well above USD 500bn”

-“Over the past 10 years, US holdings of EM local-currency government bonds have risen dramatically. US holdings of EM countries had risen to 17% of all US holdings of non-US government bonds by end-2010 from just 1% in 2001. In 2010 alone, this share rose by 4.6 % and, considering the sustained pace of inflows to EM local-currency bonds since end-2010, it is likely to be substantially higher today.

-EM local currency debt has a vastly superior risk profile to developed country debt – stronger national balance sheets as well as a higher yield as shown below:

“The China Study” – Part II (Prof Colin Campbell-Cornell University):

To follow-up from last week’s summary of the chapter on the protein myth (and how the average American consumes about 50% more protein than is required to replace and grow body issue by consuming a diet high in animal protein) – I summarise below the first part of the chapter on “Turning off Cancer”:

After entering our cells, most carcinogens do not themselves initiate cancer – they first must be converted into products which are more reactive. With the help of enzymes, these carcinogenic products then bind tightly to the cell’s DNA to form carcinogenic-DNA complexes called adducts.

-Unless repaired or moved, these adducts have the potential to create chaos with the genetic workings of the cell. However, most adducts are repaired fairly quickly, but if they remain in place while cells are dividing to form new cells, genetic damage occurs which is then passed onto the new cells (“initiation phase’).

-The entire initiation phase can occur fairly quickly, even in a few minutes. The completion of this initiation phase is considered irreversible.

-The second phase is the called promotion. This stage occurs over a far longer period than initiation, often many years for humans. When a newly initiated cluster multiplies and grows into larger and larger masses, a visible tumour is formed.

-Like seeds in the soil, the initial cancer cells will not grow and multiply unless the right conditions are met. Promotion is irreversible, depending on whether the initial cancer growth is given the right conditions in which to grow. This is where diet become of crucial importance as dietary factors can either promote or slow cancer growth.

-The third phase, progression, begins when a group of advanced cancer cells progress in their growth until they have done their final damage. The cancer can wander from its initial home – i.e. it metastasizes, leading to death.

-Based on two research studies Prof. Campbell conducted (funded by the National Institute of Health-NIH) – one on humans and the other on animals (rats) , they found that protein intake levels can easily modify enzyme activity to metabolize a particular carcinogenic substance which causes liver cancer. Low-protein diets actually reduced tumours by multiple mechanisms.

-At the same time, they came across some other studies which shed further light on the process of cancer growth-the appearance of tiny, microscopic cells called Foci cells, which appear right after the initiation process is completed. Foci cells are precursors cluster of cells which grow into tumours, and while most Foci do not become tumours they are predictive of tumour development.

-What they then found was astonishing – Foci development was almost entirely dependent on how much protein was consumed, regardless of how much of the carcinogenic substance was consumed.

To be continued!

Be on the lookout for inflationary signs and the mitigate the development of Foci cells!



In Depth Johnson Page Inflation October 2012.pdf


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