Will inflation return?


“The return of inflation” may be too far-fetched a topic to be discussing amid the current Covid-19 pandemic, which continues to rage across the globe, with governments in the US and Europe scrambling to keep their economies afloat.

Most investors have largely focused on deflation risks, rather than the opposite. But some economists have had the foresights to recognize the risks of inflation arising on the road ahead.

It is a fund manager’s job to listen, make informed decisions, and be prepared. In this article, we will discuss why inflation will likely be upon us again.

The view that inflation remains to be muted regardless of the amount of money the US central bank is printing seems to have taken root in the market. However, upon taking a closer look on the stimulus packages the Federal Reserve and the US government rolled out, these policies have been more aggressive and effective than the quantitative easing (QE) measures adopted in the global financial crisis (GFC) in 2008.

To what extent does QE work?

In the years before the GFC, controlling short-term interest rates was generally the only strategy the central bank would employ. So whenever the economy took a downturn, the Fed would lower the Federal funds rate in an attempt to boost growth via stimulating lending, corporate investments or consumption. But the issue was, companies and consumers might not necessarily have the appetite to borrow. On top of that, banks might be reluctant to lend due to the risks involved in doing so, negating the efficacy of lowering interest rates.

So after the GFC, global central banks took it up a notch and adopted quantitative easing measures to buy government bonds directly from investors in order to lift bond prices and push down yields. Such strategy stimulates consumption as investors gain extra cash from selling bonds. The additional cash in general also leads to more deposit in the banking system, which in turn potentially encourages banks to lend.

However, this is easier said than done. The US Federal Reserve implemented three rounds of quantitative easing between 2008 and 2014, quintupling the size of its total assets[1]. But the swollen balance sheet only did little to invigorate economic growth and drive inflation higher. Commercial banks were still cautious towards providing loans, while the US economy remained subdued.

A looser-than-QE monetary policy amid Covid-19

The US appears to have taken on more aggressive policies in response to the current pandemic compared to those seen in the GFC in 2008.

The Fed, likely knowing that quantitative easing measures had a minor impact on inflation rates, has reacted much quicker, much bolder this time round.

Unlike the approach of merely reducing interest rates, the central bank no longer has to pin its hope on consumers and corporates to borrow as it is largely mandated to support Congress-driven pandemic fiscal policies, which translate government spending into cash deposits in the pockets of consumers and small and medium-sized enterprises.

Moreover, the Fed has had the issue of banks holding back from lending sorted out as the government’s Paycheck Protection and Main Street Lending Programs offer loans that come with relatively low interest rates. Some loans are even fully forgiven under certain circumstances[2].

The efficacy of these policies cannot be overlooked. While the US economy contracted significantly, the year-on-year growth rate of the country’s M2 money supply reached the highest level in 30 years in September to stand at 24.2%[3].

Will inflation return?

The ballooning money supply has had some insightful economists worried about the return of inflation. Their concerns are not without reasons.

Firstly, the incumbent Chair of the Federal Reserve was constantly pressured by the US president, Donald Trump, to loosen monetary policies over the past two years. The central bank’s independence has been compromised to some degree as the current pandemic stimulus packages are primarily driven by the Congress, with the Fed being placed in a supporting role.

Secondly, as economist Milton Friedman once said, “Nothing is so permanent as a temporary government program.” So some experts have begun to voice concerns over politicians potentially pushing out new programs to garner voters’ support now that they have had a taste of the ultra-loose monetary policies, undermining the central bank’s ability to control inflation.

Lastly, the US-China trade war as well as the ever-widening ideological differences between China and western countries will likely reduce global trade volume, leading to rising inflationary pressure.

While it’s hard to say when exactly inflation will return, such risks have heightened significantly. Investors should consider it when positioning their portfolios.


[1] Source: AVIC Securities, as of Jul 2020

[2] Source: US Small Business Administration, as of Jun 2020

[3] Source: CEIC Data, as of Oct 2020

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.

Will renminbi become a global reserve currency?


China’s financial system became the first to get back on its feet, with the country’s fiscal and monetary policies normalising after combatting the impact inflicted upon by the coronavirus outbreak. Renminbi has gradually climbed back up since.

It was only a few months back that market observers were fretting over renminbi dropping below 7.2 against the US dollar, but the overall sentiment has now taken a U-turn with some floating a prediction that it will unseat the dollar as the world’s reserve currency.

We think it’s still too early to start talking about such a possibility given the data released by the International Monetary Fund (IMF) – the US dollar accounted for 61.99% of allocated global foreign exchange reserves as of the end of Q1 2020, as opposed to renminbi’s modest share of 2.02%[1].

While renminbi’s ratio in the reserves almost doubled the level when it was first included in the Special Drawing Rights (SDR) basket, it is still dwarfed by that of the dollar.

Lessons from the past suggest that the journey to gain prominence in foreign exchange reserves resembles a marathon competition.

Renminbi might have performed well this year, but it requires much more than just a momentary victory for the currency to win the race. In a marathon, physical fitness, strategy and stamina all play a key role. So for a currency to rise through the ranks, the country’s power and government policy as well as time, will be among the most essential elements.  

Strength is all that matters

A country’s power is measured by its economic and political capacity. It anchors its counterparts’ confidence in using the currency.

In terms of economic capacity, the size of the economy is by no means the only consideration. The structure of a country’s economy is just as important.

For example, the currency of a mega sized agricultural economy would unlikely be considered a reserve currency despite the size of the economy. The reason being, foreign countries would have little use for it beyond purchasing agricultural products, which directly impacted its versatility.

With the second highest GDP globally, China runs a comprehensive economy. While the pandemic plunged global economies into a recession, resulting in a 32.9% YoY drop of the US’s GDP in the second quarter, China charted a 3.2% YoY growth over the same period against all odds[2], [3].

This is evident in trade statistics: China’s export growth has, in fact, beat expectations for six months consecutively, despite relentless discussions over foreign countries trying to decouple their supply chains from China amid the health crisis. The country’s export rose close to a whopping 10% YoY in August[4].

Standing in stark contrast was the US’s ever-widening trade deficit, which, excluding oil, would have been nearing a historical high[5].

According to a study entitled “The World in 2050” conducted by PwC, China will surpass the US to become the world’s biggest economy in thirty years[6].

But of course, it won’t be smooth sailing for China. The Soviet Union and Japan, for example, could serve as cautionary tales for China. While it might gain the upper hand in the future, it remains to be seen if China could eventually prevail in the marathon.

A country’s political capacity indicates the regime’s stability and predictability. Very often the currency of a country at war doesn’t lend itself to wide circulation with little political visibility.

While China’s political system is distinct from that of western countries, its stable governing environment and consistent policies with high predictability will most probably give an edge to internationalising renminbi.

Policy

The capital market of a reserve currency country must first be robust for it to amass enough financial assets to absorb capital circulating back to the economy.

China has in recent years gradually opened up its financial market, with the Shanghai-Hong Kong Stock Connect acting as a bridge for foreign capital to flow into the domestic equity and bond markets.

Following China’s move to reform the internal market, the Shanghai Stock Exchange Science and Technology Innovation (STAR) Board, ChiNext Board and the New Third Board, the country has propelled innovative technology companies to a historical center stage, deepening the domestic capital market.

Moreover, an open capital account allowing a free flow of capital is another requisite for a reserve currency country. One’s right to transfer local currency out of the country should never be undermined. The US dollar, Japanese yen and euro are among the most freely traded currencies that aren’t placed under capital control. Trading renminbi, however, is currently limited due to various factors.

Time

In the example of the US dollar taking over the British pound as a global reserve currency, we noticed that the continuity of such currency is pronounced and entrenched.

The British pound was no doubt a reserve currency from the late 19th to the early 20th century. While part of the currency’s value was backed by the gold standard, it became a globally traded currency also because the country’s economic strength and system was widely recognised at the time by foreign nations.

The US economy had already surpassed the UK’s at the end of the 19th century, but the British pound remained as the internationally traded currency before WWII. But after WWI and WWII, the UK’s economy took a heavy blow, so the pound’s reserve currency status was dethroned by the dollar as the US economy outgrew that of Europe given that it was practically untouched by the two world wars. The US dollar officially became an internationally traded and reserve currency as the country led the post-war development of a new economic order globally.

China’s economic strength is still a long way off to rival that of the US. It will be a while before renminbi can topple the dollar even if the Chinese economy immediately caught up with the US.

Renminbi’s recent rally

Renminbi may not become a reserve currency overnight, but it has indeed strengthened over the past few months. The impetus came down to a few factors: the uninterrupted widening of renminbi’s trade surplus after the pandemic, the interest rate differential between China and the US, and robust export data. 

According to data released by the State Administration of Foreign Exchange of the PRC, China posted a $12.7 billion net inflow of cross-border capital in non-banking sectors in August, with net foreign investments in the domestic bond market increasing by $21 billion over the same period, higher than the historical average[7]. This is down to the Chinese economy recovering at a faster pace than the rest of the world, and the widening interest-rate premium over yields on the dollar, which has further burnished the country’s appeal to foreign companies.

It goes without saying that the unit value of a given currency drops as its supply increases. The size of a central bank’s balance sheet also generally indicates the total currency volume of its respective country. In the case of the People’s Bank of China, its balance sheet has largely remained unchanged since 2014. On the other hand, the Federal Reserve’s portfolio has ballooned from $4.2 trillion in March this year to over $7 trillion as of May’s end after rolling out an unlimited quantitative easing programme and a “whatever-it-takes” asset purchase plan2. The growth rate topped 80% in just under three months’ time2.. While such measures prevented liquidity risks from building up and turning into a financial crisis, leaving the printing press for dollar bills running would naturally make it tricky to maintain the dollar’s exchange rate.

One thing worth noting: a banknote’s existence transcends the physical world in this day and age. Central banks can buy bonds or equities, create cash on the balance sheet, and settle it through routing the transaction electronically to the sellers’ accounts.

Sellers, be they corporate or retail investors, would prefer holding less cash from a return’s point of view, so the extra cash will normally be converted to consumer spending or re-investment, which in turn stimulates the economy. The whole process may have been done digitally, without the central bank actually printing any money, but it has the same effect on the economy as if the printing machines were being put to work.

Overall speaking, the likelihood of renminbi becoming a global reserve currency in the near future is low. But if China can keep the economic development on track, and maintain relatively consistent monetary policies, renminbi’s value and degree of internationalisation will probably hold sway compared with other currencies.


[1] Source: International Monetary Fund (IMF), as of Sept 2020

[2] Source: Sina Finance, as of Sept 2020

[3] Source: Xinhua News Agency, as of Sept 2020

[4] Source: Hong Kong Economic Times (HKET), as of Sept 2020

[5] Source: Financial Times, as of Sept 2020

[6] Source: BBC, as of March 2020

[7] Source: The State Council of the People’s Republic of China, as of Sept 2020

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.