ASEAN as an inflation hedge

The epic proportion of fiscal stimulus in advanced economies, pent-up demand post COVID and supply-chain shortages had together raised inflation in the global economy since 2021. As the pandemic subsided in 2022, the expectation of many had been for raw material shortages to ebb and inflation worries to gradually subside.

Enter Russia’s invasion of Ukraine and its grave implication on the commodity market. Russia is an important exporter of crude oil, natural gas, aluminium, palladium and wheat among other commodities. As Western governments slap sanctions against Russia, commodity prices including Brent Crude have rallied. Higher commodity prices are likely to elevate inflation, particularly in net oil and commodity importing nations.

ASEAN stocks thrive during inflation:

Investors can prepare themselves for the equity-market volatility by investing in stocks and sectors that benefit from higher inflation. In an earlier post, I had identified sectors such as banks, insurance, energy and real estate, where companies see higher revenue during inflationary periods.

One way to play the inflation theme is by investing in ASEAN equities. If we take a look at the MSCI ASEAN index — financials constitute 38% of the index, followed by consumer staples at 8.31%, real estate at 8.19%, materials at 6.04% and energy at 4.49%. Over 60% of the index contains stocks that thrive during inflation!

Extracted from MSCI ASEAN Factsheet, January 2022

How certain sectors react to inflation:

• Financial stocks thrive during rising inflation as central banks hike their policy rate to manage price pressures. This increase in the policy rate allows banks to charge higher interest on their loans.
• Consumer staples are products that are essential for daily living such as food, clothing and personal products. Rising prices drive consumers to cut back on discretionary spending (on new gadgets, vehicles) and concentrate spending on essential items.
• Real estate benefits from higher rent and property investment to hedge against falling purchasing power of currency.
• The materials’ sector comprises companies producing chemicals, construction materials, containers and packaging goods and metals and mining products. You may have been reading about the rally in gold, silver, aluminium and copper among other metals since 2021, given the economic reopening, surge in demand and constrained supply in these items.

MSCI ASEAN constitutes countries rated investment grade:

By country, the MSCI ASEAN index is dominated by Singapore, a AAA rated credit (highest credit rating) by S&P, Moody’s and Fitch ratings. Thailand, Indonesia, Malaysia and Philippines, the other countries in the index, are all rated investment grade by the agencies. While ASEAN countries are mostly classified as emerging markets, consider them to be better quality EMs given their historical growth profile, government indebtedness, central bank policymaking and business environment.

The top 10 constituents of the index are all large cap stocks (where market capitalization exceeds USD 10 billion), indicating that the index benefits from quality companies that offer stability during periods of geopolitical unrest and risk-off.

ASEAN’s macro outlook is likely to improve in 2022:

Barring Singapore which profited from 7.6% y/y growth in 2021, all other ASEAN economies underperformed growth expectation set at the start of last year. This was led by the spread of the highly infectious Delta variant, low vaccination rates and intermittent imposition of movement restrictions in these nations. This suggests the scope for strong recovery in 2022, led by better vaccine coverage, milder impact of the Omicron variant and with pent-up demand being unleashed.

As per the IMF, the average growth rate of Thailand, Indonesia, Malaysia and Philippines is forecasted at 5.67% y/y in 2022 compared to 2.72% in 2021. This improvement in growth, led by consumer spending and business revival is likely to support companies and stocks. Consumer price inflation is also forecasted to maintain steadiness at 2.29% in 2022 compared to 2.3% in 2021, much higher than the 0.67% seen in 2020. Higher inflation will support the MSCI ASEAN index.

Good growth outlook, attracts foreign capital. The capital flow tracker prepared by the Institute of International Finance (IIF) corroborates this statement for the ASEAN region. The graph below shows foreign capital returning to EM ASEAN countries in late 2021.

Data extracted from The Institute of International Finance (IIF) capital flow tracker

Note: Please click on the chart to zoom in

Conclusion:

• Inflation pressures are likely to persist in 2022 given geopolitical developments and economic recovery.
• Investors should modify their portfolio by adding stocks that benefit from higher inflation.
• One solution is by investing in the MSCI ASEAN index. Over 70% of the index is composed of sectors that thrive during inflation.
• MSCI ASEAN’s country exposure is dominated by Singapore, a country rated AAA by the rating agencies. The index is exposed to quality large cap names that are likely to protect the portfolio from equity market volatility.

 

Using macro signals for equity investing

Investing in the equity market can seem daunting, particularly to those of us who are risk averse and worried over a lack of finance knowledge. However, history tells us that market performance can be anticipated by following macroeconomic signals and paying attention to the political and geopolitical changes in the economy.

Following the financial crisis in 2007-08, the global economy witnessed a recession where growth collapsed, interest rates were slashed and inflation was subdued. Despite the gloomy atmosphere, some stocks performed better than others given their defensive quality. Think discount stores and medical services providers that benefit from demand inelasticity. You need these goods, recession or not. Or recall India between 2010-11, when consumer price inflation rose to double digits. With input prices shooting up and hurting profit margins, commodity, industrial and bank stocks did reasonably well. These examples suggest that you can (and should) pick stocks or themes based on the macro environment.

Hard core finance professionals rely on bottom-up company analysis to select companies with good balance sheets, cash flow and rising profitability. However, bottom-up stock analysis is time consuming and arcane for individuals outside the field of finance. On the other hand, keeping track of economic changes through the news and the power of observation is more relatable. Macroeconomics can help you pick and choose investment themes and the companies that fit them. Exchange Traded Funds (ETFs) are widely available in the market and investors can access the companies within the ETF index, its investment style and historical performance. Finding the right ETF suitable to the current economic environment is relatively simple given the information available today at your fingertips.

In addition to macroeconomics, geopolitical and regulatory changes also influence stock prices. Think US-China trade war that disproportionately hurt US automakers, chip makers and electronics manufacturers. Or the regulatory crackdown in China in 2021 which hammered Chinese tech companies. Following these developments and their impact could have guided you on where NOT to invest!

Let's take a look at the different macroeconomic scenarios and the sectors that outperform and underperform in them, to assist you in your investment journey.

High growth: Periods of economic boom are ripe for equity investing given strong consumer spending, corporate optimism and credit disbursal to fund unique business ideas. In order to select the sector or company that can generate high returns, turn to the details of GDP growth in that country. What is driving growth? Is it the consumption boom? If so, what are consumers spending on? Is it corporate investment into R&D, machinery or factories? Export boom led by specific products? Think semiconductors in Korea and Taiwan, electronics in Singapore and automobiles in Japan. The details help spot the growth generating sectors and investment themes that could give you your next big investment.

A study conducted by Morgan Stanley Capital International (MSCI, provider of equity indices such as MSCI World, MSCI Emerging Markets among others) showed that industrials, consumer discretionary, financials and informational technology are the most cyclical sectors. This implies that companies within these sectors closely follow the business cycle. On the other hand, consumer staples, healthcare and utilities are the most defensive i.e., least correlated with growth and the economy.

High inflation: MSCI's research shows that high inflation lowers future growth and adversely impacts small cap companies in the medium term. Higher inflation could also take away from sectors that depend on stable cash flow over the long term such as utilities. On the other hand, sectors that act as effective inflation hedges including energy (through rising commodity prices), financials (through higher central bank policy rates that lift banks' interest income) and real estate investment trusts (REITs own real estate assets which benefit from rising rent and property prices during periods of inflation), outperform.

Emerging market equities have historically performed well during inflationary periods given the dominance of the commodity sector in their economies and / or export baskets. Examples include oil and gas in the Middle East, soybean, crude oil in Brazil, copper in Peru, petroleum, coal and coffee in Colombia and oil and gas in Indonesia.

MSCI Emerging Market Index (MXEF) vs Commodity Research Bureau Index (CRB RIND)

Extracted from 'Emerging market equities in an inflationary environment', Man Institute, August 2021

High interest rates: A high interest rate environment usually arises during periods of growth and / or inflation boom, when the central bank tightens liquidity conditions to prevent excesses. The central bank hikes the policy rate, thereby raising borrowing cost and in the process slowing economic activity. This is the environment we find ourselves in today with global central banks raising rates and tightening liquidity conditions.

Financial stocks thrive in a rising rates environment as banks and brokerage firms can charge higher interest on loans and earn higher income. Insurance firms' profit margin improves in this environment as insurers reinvest premium in long-term instruments like bonds, which earn higher interest income when rates are hiked. An analysis conducted by CI Global Asset Management showed that Canadian and US life insurers generated on average 19.36% and 27.27% return respectively during periods of interest rate hikes over the past twenty years.

Rising rates have also benefited real estate stocks such as REITs as interest rate hikes are led by robust growth and inflation which are positive for real estate prices. An analysis conducted by S&P Dow Jones research concluded that between 1970 and 2006, there were six periods with rising bond yields in the US, of which four saw US REITs produce positive total return. In two instances, REITs outperformed the S&P 500 index.

In 2021, several emerging market central banks including Bank of Russia, Banco Central do Brasil and the Hungarian National Bank among others raised their policy rate to combat inflation. Latin American central banks were among the most aggressive last year. Amidst rising rates, the LATAM sectors that produced positive returns on average were communication services, consumer staples, energy and materials. Communication services firms such as telecom as well as materials firms benefit from growth boom.

Political uncertainty: Numerous examples come to mind when contemplating the impact of political developments on equities. Taking a current example - the military standoff between Russia and Ukraine sent stocks crashing in Europe and US while also elevating commodity prices. Back in 2018, diminishing confidence in Spanish Prime Minister Mariano Rajoy's government sent Spanish and Italian stocks tumbling.

Amidst ever changing political dynamics, investors should pay attention to the sectors tied to these economic and political developments. Particularly during election period, having a quick read through candidates' election manifestos is a great tool to anticipate stock market winners and losers.

Catalyzed by the potential sanctions against Russia, oil, wheat, aluminium and palladium (key Russian exports) prices rallied. Markets fear a hit to the supply of these commodities if Western economies slap sanctions on Russia. Blue chip stocks, US treasuries, Japanese Yen (JPY) and Swiss Franc (CHF) tend to perform better in such scenarios, as they are considered safe haven, whereas companies and /or assets linked to sanctions or sanctioned entities underperform. Given the adverse supply shock on Russian natural gas, Dutch natural gas stocks rallied.

During the political uncertainty in Spain, market sentiments were tied to Spain's relations with the EU. Strong relations would signal policy continuity and boost investor sentiment. When PM Pedro Sanchez formed the government, the market rallied and bond yields fell given his commitment to standing by the Euro as well as follow sound government policies. In this case, the persona of the potential prime minister, signalled by his/her comments and election mandate determined market reaction.

Stock market investing can seem daunting. However, simple tools such as tracking the economic changes, reading through government budget documents and election manifestos go a long way in determining equity market winners and losers. You don't need a finance degree to grow your money. Just some good observation and daily reading.