Is inflation transitory or structural?


The US Consumer Price Index (CPI) rose 5.4% year-on-year (YoY) in this June, the highest YoY increase since August 2008[1]. Looking ahead, as countries continue to reopen with consumer demand picking up steam, global inflationary pressures look set to flare up. How will higher inflation affect various assets, are such rises only transitory, and how should investment decisions be made in an inflationary environment, are among the issues central to global investors’ future allocation strategies.

The extent to which equity valuations are subjected to the effect of inflation is enormous. Historically, moderate inflation rates were conducive to the stock markets. But during periods of subdued inflation, deflation could be a concern for investors. Deflation shrinks corporate profits and heightens the likelihood of bankruptcy as the overall level of debt would rise in value, increasing the risks of bankruptcy in financial companies and economic recession. But when inflation runs too hot, so does volatility. Under such an environment, budgeting costs would become difficult, leading to reduced capital expenditures and, eventually, stifling economic growth.

Within the equity space, there are areas that are more sensitive to higher inflation rates. Investors would do well to familiarise themselves with the concept of “duration”, a term commonly used by bond investors. Simply put, duration means that the longer it takes to realise the cash flow of a bond, the more sensitive its price is to changes in interest rates. For example, a five-year zero-coupon bond – whose principal and interest will only be returned in one lump sum at maturity – will see its price fall more drastically than a five-year bond that pays dividends every six months when the interest rate rises. The price of a 20-year bond will therefore be more volatile than a five-year bond.

If we apply the same principle of “duration” to equities, when inflation flares up, heightening the risk of interest rate hikes, the longer the duration a stock has, the harder its price will drop. Which ones belong to the long-duration category, you ask? Generally, those that are still in the investment phase and have yet to generate positive cash flows can be classified as long-duration stocks, such as the listed shares of some tech companies whose balance sheets are still in the red. This also explains partly why some tech stocks fell more heavily recently than the market average.

Another question investors have to ask themselves is, is the rise in inflation we see today just transitory or structural? Investors in the “transitory” camp attributed price rises to the US government’s unprecedented economic stimulus measures. Moreover, comparing inflation rates on a “year-on-year” basis means that the low-base effect is at play here. As the economic stimulus moderates next year, money supply should also slow down to single-digit growth, with inflation subsiding to acceptable levels as a result.

And in the perspective of those in the “structural” camp, the widening ideological divergence between China and the west could hinder the flow of global trade and cause inflationary pressures to pile up. While countries including the US, Europe, and Japan all unleashed quantitative easing measures after the global financial crisis, these unconventionally loose monetary policies did not accelerate inflation growth. One of the key reasons was that, riding on the wave of economic globalization, cheaply manufactured products from China and other Southeast Asian countries flooded the markets overseas and drove down prices. Having said that, global trades as a share of global GDP have been declining since 2008, with the levels seen in 2019 treading lower than that of 2014[2]. Given that the pace of deglobalization has quickened after the Covid-19 crisis, investors who believe that the higher inflation is structural are naturally reassured that there may yet be more challenges in keeping global inflation in check.


[1] Source: Wall Street Journal, as of July 2021

[2] Source: the World Bank, as of July 2021


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

Zeal ESG Insight: Governance – The cornerstone of ESG


Would you take a guess on which one of the ESG elements professional investors value the most?

Before revealing the answer, there is a story we would like to share with you. It began with a visit to a mid-sized manufacturing company in Southeast Asia many years ago. Little did we know that the moment we set foot in the premise, it would be its lobby that had us flabbergasted.

The atrium was tall and wide, while the honeydew green marble slabs covering the floor were exquisitely juxtaposed with white marble, each tile waxed so finely that they reflected vaguely the marble wall behind the concierge counter. That wall could not have been the work of an amateur interior designer – every streak and vein of the metamorphic rock was an artwork of its own, with each of the backlit marble tile carefully mounted, leaving a small gap between them so that the soft lighting seeping out of the wall would accentuate the intricate patterns of the stones further.

The concierge counter in gold polish was equally magnificent. It’s around ten-feet-wide, with the front facing the main entrance designed with wave effects. Indeed, it sounded ostentatious, but, together with an orchid arrangement sitting on the counter, nothing looked out of place.

Adding an extra touch of luxury was the backlit ceiling: lights were diffused from the top, illuminating the entire lobby without overwhelming the eyes. In the center of it hung a tasteful chandelier, glistening softly and conveying the elegance of a six-star hotel.

The splendor of the lobby certainly made an impression on us, to say the least – it resembled more of a luxury hotel than a manufacturing company.

But first, back to the question about which one of the ESG elements carries the heaviest weight. In a 2017 poll by the CFA Institute, 67% of investors would integrate corporate governance (G) into the investment decision process, more than those who would consider environmental and social factors[1]. Naturally, stock prices are highly subject to the quality of corporate governance.

Many components make up what we now broadly call corporate governance, but in essence the following two criteria should be met: is capital being put to good use, and are minority shareholders being treated as fairly as those holding larger stakes.

In the example above about the manufacturer, should it really be splurging on fancy décor? Whose interests did those marble tiles serve? Had it been a private bank, it probably wouldn’t hurt to fuss over furnishing pieces and decorative lighting. They could well command confidence from clients, which would ultimately be good for business. But the customer base in question here is that of manufacturers, who would more likely fret over product quality and costs than whether the lobby floor has marble in it. In other words, what they would generate for the company’s investors was anything but tangible returns.

Now that we have looked at what responsible corporate finance means, we think that, in investors’ analysis of how well companies are upholding governance standards, they could also pay attention to whether bigger shareholders are cognizant of the interests of smaller ones. For example:

1. Should corporates be distributing dividends? We don’t think failing to do so reflects poor governance, rather, the crux of the issue lies more in the “why”. If business performance is robust with substantial potential for further growth, the decision to not distribute dividends may be justified, or encouraged even, provided that profits are being reinvested. Ultimately, such moves will support share prices.

If instead, the profits end up being hoarded or squandered in speculative stocks, without any plans to be reinvested, the lack of dividends will reflect poorly on the corporates’ governance quality. It shows an insufficient focus on creating value for minority shareholders. As such, we think analysts should exercise more caution towards valuing these companies.

2. Are corporates hiring reputable accounting firms to handle their financial records? It could be a red flag for analysts if turnover of auditors is high, or if there’s an apparent predilection for smaller accounting firms.

3. Are they entangled in convoluted business ties with their parent companies? The more complicated these dealings are, the easier their boards could potentially manipulate the financial records.

4. How are corporates’ shares classified? The Hong Kong Stock Exchange has relaxed the rules on weighted voting rights in a bid to attract Chinese tech companies to go public in the city, giving some companies’ senior management personnel disproportionate voting rights than allotted by the shares they hold. This could put minority shareholders at a disadvantage, so we think analysts should take due note of how share classes are structured as well.


[1] Source: CFA Institute, as of Dec 2017


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.