Inflation and diverging monetary policy between the US and China – what do investors need to know?

After the broad vaccination roll-out and seemingly less fatal Omicron, interest rates, forex, inflation and monetary policy risks might be more relevant than Covid for market fluctuations this year.

Market consensus expects rising rates in 2022 from most countries due to the soaring inflation rate in the US and in most developed countries. However, short-term volatility (3-month time horizon) could be higher than before, partly due to the Fed’s move and continuous supply chain disruption caused by the situation in America’s West Coast ports, which will continue to have an impact on the consumer price index (CPI).

In addition, there is an unprecedented de-coupling of monetary policies between China and the US: currently China enters a period of disinflation and GDP growth slowdown, possibly around 5% for 2022, reaching its lowest level since 1991. As a result, the People's Bank of China (PBoC) is dovish and has started monetary policy easing by cutting the reserve requirement ratio (RRR) and rates since the beginning of 2022, as the Fed announces tapering and hiking rates. The PBoC will inject liquidity into the onshore market through the Medium-Term Lending Facility Rate (MLF), re-lending, re-discounting, the special facility for cutting carbon emissions, and FX purchases.

This is the first time that the two largest economies adopt monetary policies in complete opposite directions, which we expect will have a huge impact on the market. Chinese onshore interest rates will be lower and the RMB will depreciate against the USD, immediately impacting investors’ asset allocation and capital flows. Combined with accelerated geopolitical conflicts, market volatility will increase significantly for the next 12 months.

The persistently high inflation figures are bad news for fixed income investors. However, the beauty of fixed income is that the payments are indeed fixed, and if an issuer does not default, investors will get back what they were promised, providing that inflation doesn’t consume the real value of the cash flows.

For investors with a medium- to long-term perspective, emerging markets debt offers attractive prospects. Emerging markets, and in particular emerging market corporates, in our view have a clear advantage. In contrast to developed markets, emerging markets can boast relatively high starting yields. Higher yields increase the likelihood that the real return of the investment remains positive even if inflation is increasing. Emerging market corporate bonds have the additional advantage of a rather short maturity date; in fact, they have lower duration than many other fixed income asset classes. That means that once the investments reach maturity, investors will get the opportunity to re-invest the proceeds at higher yields.

There are three reasons we believe that emerging market corporates represent an attractive asset class for the current environment:

• Low duration – making it much less sensitive to further increases in US Treasury yields.
• Diversification – emerging market corporates are a very diverse universe of companies in various industries across a multitude of countries.
• Attractive risk premia – we think EM corporate bonds are the least risky asset class within emerging markets because they are well diversified with low interest rate risk. However, as many believe investing in EM corporates is a risky proposition, the risk premia are overly attractive.

Where to find value in 2022

Investors often underestimate the advantages of investing in global emerging markets. For example, the volatility and cyclicality of Asian credit markets result in less attractive risk-adjusted returns than generated from more diversified global emerging markets portfolios, especially across cycles.

On a regional level, we think investors can find attractive opportunities in Latin America. Select companies in countries like Brazil, Colombia and Mexico are a few examples.

In Asia, from a high-yield allocation standpoint, Chinese property names can offer attractive value. Within investment grade, short-dated Chinese local government financing vehicles (LGFVs), and bank hybrids (Tier 2 / AT1) we also think are good options. Furthermore, in China, fiscal capital spending on infrastructure should benefit Fixed-Asset Investment (FAI) related sectors, including building materials, machineries, etc. Green energy-related names from India and China are also attractive.

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