Blog: Forget B.R.I.Cs, C.I.V.E.TS and M.I.N.T.

Julian Chillingworth, chief investment officer at Rathbone Unit Trust Management, advises focusing on the old enemy – I.N.F.L.A.T.I.O.N.

There’s an interesting piece of research, courtesy of the bods at Société Générale, that highlights why we should be maintain a keen eye on inflation in the developing world.

Nothing new in that, but the paper reveals a telling correlation between China CPI and US core goods inflation, that essentially points to the degree by which US quantitative easing is driving China’s CPI higher, and (paradoxically) pulling up the cost of US imports and US core goods inflation – it is a reinforcing loop.

A similar chart, produced in-house, suggests a correlation can be drawn between UK RPI and China CPI data. Since May 2001, the peak and troughs reveal a synthesis, with China leading major inflection points; but at the moment, there appears to be a divergence.

On the back of this, with China tightening monetary policy and economic growth slowing, the good news is that UK RPI inflation could yet experience a slight downward bias. Longer term, however, if the correlation continues to hold true, and we account for China’s higher structural growth and commodity-led inflation, then UK RPI could be in for a nasty upwards surprise.

However, it’s not just China, there’s now more in the form of the frontier markets. Articles are littered with acronyms; we’ve moved from CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa) to MINT – (Mexico, Indonesia, Nigeria and Turkey). Longer term, they all represent potentially exciting opportunities for investors, but the risk is the hot money chasing the next hot return, leading to both asset price and domestic inflation. The net effect in years to come could be a significant rise in global inflation.

More recently, the Organisation for Economic Co-operation and Development (OECD) has called on central banks to raise their interest rates as inflation rates pick up. All very well for now, but our point is that in ten, 15 or 20 years’ time, the chart that highlights the correlation between the inflation patterns of China and the UK, might also come to highlight a unified trajectory between inflation in the UK and the nascent markets mentioned above.

The debate is therefore less about the evolution of markets per se; perhaps something about investor behaviour, but certainly (as I have mentioned in previous articles) about the efficacy of current inflation measures and the mechanisms to control it. Dare I say it, investors might even be forced to re-examine assets considered a traditional hedge.

If you think bond yields look vulnerable now, wait for the impact once nascent markets mature, as per China today, and are forced to tighten and revalue their currencies? Central bank intervention is leading to an ugly ride indeed.

Observers would do well to extract themselves from the argument that conventional mechanisms of transmission in the West are redundant, and therefore inflation risks are minimal – perhaps that’s the case for now. Ultimately the West’s influence as a price-setter (particularly the US) will be limited, and these very mechanisms will matter little in time – what inflation does within our borders will be dictated to increasingly by what happens in the markets mentioned above.

Taken to its logical conclusion, this means the inevitable readjustment of expectations and assumptions, and a dramatic shake-up of ‘norms’ for at least one generation.

Bank of England governor Mervyn King has already alluded to commodity demand impacting UK inflation, but whether he believes enough to instigate some far-sighted policy changes, is an altogether different issue.