Q2 CIO Review and Outlook

Along with the rest of the world, China has recently seen a spike in core inflation. Although, let us be honest, in the U.S. it is 3.8% year-on-year; in China, it is 0.9% year-on-year. One is a spike, the other is more like a soft fluffy cushion. I think it is in line with our previous view that China’s monetary policy was tight but not tightening. Now it appears that things may be loosening up a bit. As well they should!

China had the luxury of a more normal monetary policy because the effects of COVID have been much less severe on its economy. In all practicality, that meant that China was able to continue its policy of squeezing the poorly regulated parts of its credit markets without unduly impacting economic growth. For much of the rest of the world, the focus was on extreme liquidity from Central Banks and emergency payments to unemployed workers. As much of the world emerges from the pandemic-enforced lockdowns, we are seeing inflation rise as demand comes back strongly, before inventories have been rebuilt and before all workers are back on their shifts.

It is conventional wisdom in emerging markets investing that Asia (and particularly Latin American markets) tend to do best during periods of loose monetary policy and faster economic growth. It’s conventional wisdom that, whereas it is on average true, also drives me crazy because it comes from the viewpoint of tactical rather than strategic asset allocation. However, I cannot deny that it is useful for those with a 12 to 24-month view. And perhaps only that—for as frightening as 3.8% core inflation may seem, the fact that supply constraints are a major cause also means that it is likely not sustainable. It could still accelerate if wage demands spiral and the U.S. Fed refuses to tighten, but this inflationary pressure can and should be tamed— five-year inflation expectations are still only 2.5%, and 10-year lower still.

Beyond the tactical view, what are the longer-term prospects? First, we have to acknowledge the political tensions between the U.S. and China. And whereas we were always inclined to think that these tensions would persist, I, for one, thought the rhetoric of the new Biden administration would at least be less confrontational. That expectation, it appears, was in error. Yes, the focus has moved from the trade deficit to issues of human rights and political systems, but the intention, despite this, is still to try to influence China by imposing economic costs. It does seem to me that the motivation for this comes partly from wishing to be a standard bearer for basic human rights—however, it also appears partly to be out of fear that China is starting to catch up in terms of technology with the West. As laudable as it is to uphold the former, it is neither good for the world, nor in my view even possible, to try to retard the latter.