The defensive portfolio strategy has surfaced amid rising fears that the emerging world could face turbulence amid soaring prices. The development also follows China’s move on Friday to hike banks’ reserve requirements, in a bid to temper upward pressure on prices.
“Central banks have tightened policy rates less than markets expected this year, so there is a risk that either inflation gets out of control or policy rates increase abruptly to meet the inflation threat,” said Kieran Curtis, emerging markets fund manager at Aviva Investors.
Citigroup forecasts half the countries represented in the benchmark JP Morgan MSCI Emerging Markets Index will hike interest rates next year. Economies such as Mexico and Russia are expected to follow suit in 2012.
A strong economic rebound in emerging economies, rising food prices, a weak dollar and extremely loose monetary policy in the developed world – exacerbated by the US Federal Reserve’s recent decision to embark on a further round of quantitative easing – is fuelling inflation across developing nations.
Rising prices typically erode the real value of stocks, while higher borrowing rates increase corporate financing costs and eats into returns on fixed-income products, where principals are not indexed to inflation.
Monetary tightening in China, which has been faster than expected, is also weighing on financial markets. An abrupt sell-off in Asian markets on November 12 reflects investor fears that policy tightening measures in China will dent Asia’s economic growth prospects.
China's central bank on Friday said it will raise banks’ reserve requirement ratio, the country’s benchmark money market rate, by 0.5%, the fifth hike this year and the second in November. The move seeks to arrest spiralling inflation with China's consumer price index rising 4.4% in October, its fastest pace in two years.
Asset markets in South Korea, Taiwan and Brazil in particular could sell-off in the event of slowdown in China, given their strong export and commodity-trading links to China, said Jason Press, emerging markets equity strategist at Citigroup.
“An increase in interest rates in China is a prospect that is really scaring markets – although, I think that fear is overdone,” said Virginie Maisonneuve, head of global and international equities at Schroders Investment Management, with $14 billion under management.
Maisonneuve predicted further bouts of market volatility in the coming months on the back of policy tightening measures in China, which offer investors a good buying opportunity during equity market dips.
Press said that real interest rates in China will only gradually shift away from negative territory next year, due to stubborn inflationary pressure, to reach 0% by the end of 2011, despite expected hikes in the benchmark lending rate. He recommended an underweight exposure to Chinese financials but is overweight stocks in general, across benchmark indices such as JP Morgan’s MSCI Emerging Markets Index to the China mainland A-share market.
Food price inflation
Rising food prices – with food representing up to 60% of the consumer price index in some emerging markets – are also heaping on inflationary pressures. The UN’s Food and Agriculture Organization last week said the world was “dangerously close” to another food crisis in 2011, citing a global shortage of corn and wheat.
But higher soft commodity prices could offer bumper returns for the discerning equity investor.
Maisonneuve recommended that investors should strategically shift to soft commodity stocks in international portfolios due to rising consumption and income levels in developing economies. Her fund is overweight palm oil companies as well as agribusinesses in developed markets, including Monsanto, a US-based multinational agricultural company.
Inflation hedges for economies faced with strong inflation pressures also include consumer stocks, where stronger domestic currencies are boosting importers’ purchasing power, she said.
Philip Poole, global head of macro & investment strategy at HSBC Global Asset Management noted that the breakeven inflation rate – the yield differential between nominal and inflation-linked bonds – in many emerging bond markets is still below historical averages and well below pre-crisis highs. Low breakeven inflation rates demonstrate how the market is underpricing the risk of inflation, he said.
Kieran Curtis at Aviva Investors tipped South African and Polish inflation-linked bonds, where the former has a 7.5% expected annual return in real terms.
Despite galloping inflation in large emerging markets such as Brazil and China, strong growth prospects and the fair value of stocks at current valuations in general offset current inflation risks, said Press. He predicted emerging market equities will return 35% between November this year and the end of 2011.
Emerging market equity valuations then are “in no way in bubble territory at the moment” while strong projected earnings per share will offset the negative impact of inflation, he said.
According to Citigroup, the current forward price to earnings ratio for emerging market stocks represented in JP Morgan’s Emerging Market MSCI index is in line with the historical average of 11.5.
On a price to book basis, which compares a company’s stock capitalization to its balance sheet, the average ratio for emerging market stocks is 2.2, compared with 3.5 in early 2007 at the height of the global credit bubble.