As a professional investor, staying attuned to the market environment is just as important as having sufficient foresight over how one’s investing strategies can be adapted under different conditions. The US has been much more aggressive in its approach to quantitative easing measures amid the current pandemic than in 2008’s global financial crisis – the YoY growth rate of the country’s M2 money supply reached an all-time high in October to stand at 24.2%, potentially spurring the rise of inflation[1]. So if inflation does return, how should investors prepare for such a scenario?
The financial asset bearing the biggest impact of a surging inflation rate has to be government bonds. These assets are typically issued with fixed annual rates, so investors will be exposed to the risk of a decline in bond yields and the principal’s purchasing power if the inflation rate goes up.
But it’s a different story for corporate bonds. Companies will likely see an increase in cash profits if they are able to shift the cost of inflation to their clients. A rising inflation rate will also improve companies’ repayment ability as loans are fixed. In that case, corporate bond prices may be driven up, potentially offsetting part of the inflation-induced losses in purchasing power. Moreover, if it is a floating-rate note that a company issued, a rise in inflation will lift the returns on the bonds’ interests. So before investing in any bonds, investors should understand thoroughly the prospective companies’ businesses, financial conditions and the terms of their bonds.
As for the equity asset class, the return of inflation has varying impacts on different sectors. Three types of companies will likely benefit from it. Firstly, similar to the case with corporate bonds, companies with the ability to price their products can shift the cost of inflation to their clients, potentially leading to additional profits. Secondly, according to a research report published by the International Monetary Fund (IMF), some commodities are historically correlated with the inflation rate. Those operating in the related commodity space are also well placed to take advantage of the rise in inflation. Lastly, the rise in inflation might have a positive impact on banks’ profitability, whose net interest rates have been compressed amid the low-rate environment in the past few years. It could drive interest rates up, while likely reducing the rate of bad accounts, making banks the third type of companies that could potentially benefit from inflation.
But will stocks benefiting from the return of inflation necessarily see their prices rise? A research report authored by US investors Ben Inker and Jeremy Grantham noted that a higher-than-expected or a very volatile inflation rate may put pressure on the overall price-to-earning ratios[2]. So when considering whether inflation will be positive for some companies, investors will do well to take into account the possibility of their PE ratios being pushed down due to higher inflation rates.
In terms of the property sector, we built a basic rental income model to illustrate the relationship between property prices, inflation rates, and interest rates. The results show that the factors impacting property prices lie in the differentials between interest rates and inflation rates if the increases in rents correspond to that of inflation rates.
Assuming the inflation rate and interest rate go up by 3% at the same time, the impact on property prices shown in the model is negligible[3]. But if the growth in inflation rates surpasses that of interest rates, the probability of property prices going up will rise. So rate hikes do not necessarily translate to falling property prices, as the changes in the differentials between interest rates and inflation rates play a bigger role in the equation3.
The last asset class our analysis will touch on is precious metals. While some have attributed the advance of gold prices in the 70s to inflation, gold as a financial asset has still performed well in the past 20 years under subdued inflation[4]. So our view is that monetary policy has a bigger influence on the prices of precious metals than inflation does.
Gold can be seen as a currency with limited annual supply, so when the money supplies of other countries continue to expand, gold price would generally rise by virtue of scarcity. In terms of central banks’ approach to monetary policies, the differentials between short-term interest rates and inflation rates can possibly serve as a reference point. Monetary policies are generally considered loose when the former is lower than the latter, which should continue to benefit the prices of precious metals.
[1] Source: CEIC, as of Dec 2020
[2] Source: GMO LLC. 2017 Q2 Quarterly Report, as of Dec 2020
[3] Source: Zeal Asset Management, as of Dec 2020
[4] Source: Federal Reserve Bank of St. Louis, as of Dec 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.