Last week, I was in Hong Kong and in two of the seminars we hosted for investors, some issues cropped up repeatedly. Most investors were interested in three issues: the outlook for inflation in the developed world, outlook for the US dollar and the outlook for the stock market in China. For better or worse, investors in Hong Kong now think that the stock market in China holds the key for sentiment in the Hong Kong stock market. Indeed, in recent weeks, China’s Shanghai Composite Index has set the tone for the rest of the world stock markets on most days. Important as these questions are, they are also laced with considerable uncertainties.
The outlook for inflation is the trickiest of the lot. At present, inflation is far from people’s minds and it is far from the data. Producer prices in most countries are declining and the decline seems to be accelerating rather than slowing. Much was made of the positive real gross domestic product (GDP) growth in Australia in the second quarter of 2009. The data was released last week. But the real growth came about because of deflation. The GDP deflator dropped 2.2% during the quarter. That converted a nominal 1.5% contraction into a real 0.6% growth rate. We should do well to remember that what is real is not real in deflationary times and nominal is not real in inflationary times.
Right now, with capacity utilization still low in most of the developed world and with many small and medium enterprises still complaining of lack of demand from consumers, pricing power is absent. That is why sovereign bond yields in Europe and in the US have not budged much despite some improvement in economic data.
Hence, inflation in the developed world should be dismissed as a concern at least until the end of 2010, if not slightly longer. However, ironically, the risk of inflation lies not so much in strong final demand as in a weak one. If final demand strengthens meaningfully, most central banks would withdraw their stimulus confidently and reasonably promptly. However, if consumer spending power and intentions remain weak, then policymakers would be forced to think of additional stimulus measures—both fiscal and monetary. This risk is somewhat higher in the US than in euro zone. However, even in the US this risk is unlikely to materialize in the near future.
It is possible in the first quarter or early second quarter of 2010. When such additional stimulus measures are undertaken—either in terms of more government spending or in terms of more printing of money by the US Federal Reserve or a combination of the two, it might tip the scales in favour of higher inflation expectations in the bond market and among the consuming public. That, in turn, could make inflation a self-fulfilling prophecy some time in 2011.
Although the bond market seems somewhat relaxed about this risk, the US dollar remains under pressure. Data provided by the US treasury and available up to June indicate that foreign investors are queuing up not to buy US assets but to sell them. If we exclude short-dated (90-180 days maturity, at most) treasury bills, foreigners are actually net sellers of US securities that include government, corporate, agency bonds and stocks.
It is hard to pin down one particular reason for the flare-up in the price of gold last week, but eventual US inflation and currency risk remain high on the list of triggers. Therefore, for some time to come, the US dollar will remain a currency that has to be sold on any short-term strength rather than one to be bought on any weakness. Of course, as always, there are not too many alternatives. The euro is there as the anti-dollar. That is why it does not drop below 1.40 per dollar. Other than that, Norwegian krone, Singapore dollar and the Canadian dollar come to mind.
As mentioned couple of weeks ago in these columns, most Asian currencies still remain undervalued. Their day against the US dollar will come only when Asian nations feel confident enough to grow on their own strength. That depends on China showing them the lead. Fortunately, for investors, forward currency markets are discounting very little by way of dollar depreciation against the yuan in the next one to three years.
As for the stock market in China, we should leave the last word to the chairman of the China Investment Corp. (CIC), a $298 billion sovereign wealth fund, according to Reuters. On the sidelines of a conference in London, he is reported to have said that China and the US were addressing bubbles by creating more bubbles and that, as a sovereign wealth fund, CIC was taking advantage of that. So, it is now up to investors to bet on the longevity of the China bubble. It is as easy as predicting the time when a soap bubble would pop. Perhaps, this one already did in August with its 20%-plus correction. Who knows?
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org