INFLATIONARY THREAT
In fact, there is evidence to suggest China and East Asia more generally could be closer to seeing inflation re-emerge than many investors are expecting.
“This is an issue not many investors are focused on and they should be,” argues Ivailo Vesselinov, chief economist at Finisterre Capital. “There are good reasons to think inflation will recover in the months and quarters ahead.”
Output gaps are closing across the region and are positive in some cases, suggesting countries are operating closer to or above maximum capacity, which suggest outperformance is significantly more likely.
“Markets have consistently overestimated the size of negative output gaps in emerging markets,” Vesselinov argues. “They are closing faster than most analysts have predicted.”
This could have profound implications for investors if, for example, it allowed the Federal Reserve to raise interest rates more quickly. The Fed changed its rhetoric recently to suggest it now includes the outlook for other economies in its interest rate decisions and if concerns over China in particular looked less pressing, investors may see rates rise faster and more sharply than expected. In a world where the hunt for yield and the prevalence of negative yields have pushed investors to take more risk in their portfolios, interest rate sensitivity has also increased.
So while the economic situation for China and the Asia-6 more broadly shares some of the hallmarks of those faced by Japan in the late 80s, a deflationary destiny is far from pre-determined. That said, China and other countries in the region will need to focus on reform and carefully manage some significant headwinds to avoid falling into the same trap as Japan, where the pricing of inflation-linked bonds suggests investors are expecting to see 0% inflation for at least another decade.
RBC’s Lascelles says: “Chinese deflation is hardly inevitable. True, the country’s inflation rate has lately been quite low and there are certain parallels to the Japanese experience from 25 years ago: deteriorating demographics, slowing economic growth and a variety of financial market excesses. But these parallels begin to tilt askew upon closer inspection.”
