In our first edition of Asian Aspect for 2021: stronger headline inflation might be short-lived, Biden and Xi speak for the first time and Japan has a strong end to 2020. What does it all mean for investors?
Inflationary pressures likely to peak soon
- Several APAC economies have reported stronger headline inflation recently, fueling investor appetite for reflation opportunities across emerging markets (EMs). However, this may be short lived, as transitory drivers such as energy, food and shipping costs have been the primary source of inflation in recent months.
- The peak in food prices already seems to have passed, while shipping costs only add marginally to goods prices as firms margins absorb some of the impact. Energy price base effect is likely to persist until around April, before steadily declining and dragging global headline Consumer Price Index (CPI) growth lower.
- We expect the majority of EM central banks will look through the recent surge in headline CPI as transitory, and unlikely to feed into a more sustained pick up in core inflation over the coming months.
Source: Haver, Refinitiv, World Bank, ASIRI, February 2020
Spill-overs from U.S. fiscal stimulus combined with gradual broadening of vaccine distribution will support growth and generate some inflation. However the recent spate of stronger inflation prints have been fueled primarily by transitory drivers such as energy base effects, food prices and shipping costs.
Meanwhile the backdrop of sizable negative output gaps across many economies indicates the near term spike in headline inflation is unlikely to feed into a sustained rise in core inflation.
The impact of energy price base effects (Chart 2) is expected to peak around April before steadily declining for the rest of the year. Brent rallied 60% since the end of October, partly due to the weather being colder than seasonal norms across Europe and Asia, as well as a unilateral supply cut by Saudi Arabia for Feb and March. Strong demand for pandemic-related goods supported manufacturing demand for oil; however, all these drivers should normalize later this year. Brent futures are pricing in a stabilization within the range of $57-$61 until year end, supporting the view that the annual growth rate of crude oil will steadily decline from the peak in spring, dragging global headline CPI growth lower.
Energy base will do little to lift inflation in Japan which will be driven by idiosyncratic factors this year. The temporary suspension of the “Go To” campaign travel subsidy will briefly relieve the downward pressure on accommodation prices until the campaign is reinstated, most likely during the second quarter. Mobile phone tariff cuts are now expected to start in spring. These drivers are likely to counteract the rising oil price base effect and we continue to expect deflation this year.
Aggregate food prices, as measured by the World Bank (Chart 3) were up 10.5% yy in January. Decomposing the aggregate index shows that lower than expected production of maize, vegetable and palm oils combined with strong demand fueled cereal and vegetable price indices. Futures contracts for both maize and palm oil have moved into a fairly steep contango supporting the view that the peak in international food prices may already have occurred.
However, examining internationally traded prices can be misleading as there are many factors driving food prices at the domestic level. Even if oil and grain prices were to continue rising, it is unclear how much will feed into local CPI. There may be a larger impact for lower income countries, while the impact for middle income economies maybe quite modest. For instance, Indian food inflation — which was elevated all through 2020 due to domestic bottlenecks - has actually come down very sharply in December and January, despite the rise in global food prices.
Chart 2: rapid surge in oil price unlikely to be sustained.
Source: Haver, Refinitiv, World Bank, ASIRI, February 2020
Chart 3: Impact of production declines in oils and maize likely to unwind in coming monthsSource: Haver, Refinitiv, World Bank, ASIRI, February 2020
Shipping costs have also surged recently following a shortage in container storage as a result of lockdowns in Europe and North America. This led to delays in the return of containers to Asia amid strong demand for pandemic related imports. This pressure is primarily seen across Asian shipping routes which have been the main driver of the increase in global shipping rates. These constraints are likely to persist through Q1, however, the pressures will ease with vaccine progress and as nations move out of lockdown. Furthermore, higher freight costs may only marginally add to goods prices as some of this cost may be absorbed into firms' margins, offsetting some of the pass through into inflation.
We expect the majority of EM central banks will look through the recent surge in headline CPI as transitory, and unlikely to feed into a more sustained pick up in core inflation over the coming months.
China: curtailed celebrations for the lunar new year weigh on the first quarter; inflation risks low.
- Economic data for China is limited around the lunar new year, but we have seen an abrupt fall in the services PMIs (down 3-4 points) reflecting fewer journeys being made for the holidays in an attempt to limit risks of spreading Covid-19. This is likely to weigh on first-quarter GDP and inflation as services suffer.
- Presidents Biden and Xi spoke for the first time. Sovereignty with regard to Hong Kong, Taiwan and mainland China (Xinjiang) remains key for China, while the U.S. stressed its concerns about human rights and unfair economic practices. Scope for engagement on common interests remains, with the reported appointment of Xie Zhenhua as China’s climate envoy an example that the environment offers a bridge to some easing of tensions.
We have now entered the seasonal data black hole in China: the data which we do have is not particularly encouraging for the near-term, but may provide little signal beyond the first quarter.
The PMIs suggest China’s economy slowed across both manufacturing and services in January. The fall in services has been particularly abrupt: the headline NBS non-manufacturing balance fell by 3.3 points to 52.4, with consensus only penciling in a 0.7 point drop. The Caixin index fell by slightly more, down 4.3 points to 52 (Chart 4a).
Some normalization may have been expected, given a relatively V-shaped recovery — and both indices are still at decent levels; however, the abruptness of the move suggests that government restrictions on travel for Chinese New Year seem to be biting with Bloomberg reporting that the number of trips made so far is only a quarter of that in 2020 or 2019. We had expected GDP growth to slow from 10% q/q annualized in the fourth quarter 2020 to 6% annualized in the first quarter 2021, but this suggests we will likely be marking down first-quarter growth in our February forecast, perhaps to around 4% q/q annualized — we cannot rule out a sharper slowdown in growth or even a small contraction though.
Chart 4a: services PMIs fell notably in January…Chart 4b: … pricing sub-indices still higher than normal.
Source (both charts): Haver, Refinitiv, ASIRI, February 2020
Some commentators have flagged the risk of rising global inflationary pressures. The Shanghai container index has risen very sharply and the pricing sub-indices in the PMIs have picked up somewhat (Chart 4b). But CPI inflation in China is still very low: both headline and core CPI inflation in China fell into deflationary territory, both falling -0.3% y/y in January (down from 0.2% and 0.4% y/y respectively). Services inflation fell notably, down 1pp to -0.7%, likely reflecting disruption associated with reduced travel for the lunar new year.
Inflation is unlikely to worry the People's Bank of China (PBoC). It should pick back up over the course of the year as base effects drop out and the lunar new year disruption fades, while the 10% currency appreciation since May should act to cap some of the upside pressure from the recent rise in commodities. Overall, inflation is not a primary focus of policy at the moment. The boundaries of fintech regulation — with ANT potentially becoming a financial holding company — is arguably more pressing, for example.
Following on from the temporary liquidity squeeze in the markets, PBoC communications have emphasized that their main policy rates are unlikely to change in the near-term. While the latest monetary policy report was a touch more hawkish, policy is set to remain attentive to any slowdown ahead of the 100 year anniversary of the Chinese Communist Party in July.
Presidents Biden and Xi spoke for the first time; the call appeared to be largely a re-run of the previous week’s call between Secretary of State Blinken and China’s top diplomat Yang Jiechi. Xi and Yang reportedly emphasized China’s "red lines," specifically around sovereignty with regard to Hong Kong and Taiwan (which is “the most important and sensitive”), while Blinken and Biden stressed that the U.S. would not turn a blind eye to human rights. Following the calls a State Department spokesman reaffirmed the “One China” policy.
As we have flagged before, U.S.-China tensions are expected to remain elevated, but the environment offers a bridge to some easing. The reported appointment of Xie Zhenhua as China’s climate envoy bodes well. Xie worked with previously on the Paris climate accord and also with US envoy John Kerry. Similarly, the EU and China met for their first Environment & Climate dialogue.
Japan: stronger than expected end to 2020, but a challenging start to 2021
- Japan had a strong end to 2020, leaving annual growth stronger than the great financial crisis.
- The 7.3 magnitude earthquake on February 13 reported many casualties, but fortunately no fatalities. The economic impact is not yet clear, but seems far better contained than the Great East Japan earthquake and tsunami 10 years ago. Going forward, the outlook for growth will depend on the virus cases, and vaccine distribution as well as the global recovery path.
- Japan had secured enough vaccine contracts to more than cover the entire population. However, the approval process has been slow and there are questions over potential delays in vaccine imports as well as the structure of local distribution across the country.
Japan fourth-quarter preliminary GDP was stronger than expected at 3%q/q vs expectations of 2%q/q. Business investment was much stronger than anticipated, with a 4.5%q/q surge in non-residential investment, despite weaker investment sentiment signaled in business surveys. Consumption and net exports were robust, leaving 2020 annual growth at -4.8%y/y stronger than the great financial crisis, where growth fell -5.7% y/y.
Turning to the earthquake; economic impact to the affected area is not yet clear, early reports highlight damage to many buildings and high speed rail networks. This currently seems far better contained than 10 years ago, the Great East Japan earthquake and tsunami (8.9 magnitude) killed more than 16,000 people and triggered the nuclear disaster in Fukushima. Importantly, chief cabinet Secretary Kato has confirmed that vaccine storage has not been affected by the blackouts following the earthquake.
Going forward, the outlook for growth will depend on the virus cases, and vaccine distribution as well as the global recovery path. The good news is that new cases have declined sharply, and the government are likely to end the State of Emergency as scheduled on March 7th. However, the slower pace of vaccine rollout is likely to delay the recovery for Japan relative to other G7 economies.
Meanwhile, the Pfizer-BioNTech vaccine was finally approved on February 14. Oxford-AstraZeneca approval is expected in the coming weeks while Moderna is not expected until May. Japan is the last of the G7 economies to approve a vaccine as additional local clinical trials were needed, however, the lower case rates also reduced the sense of urgency seen in other G7 countries. Vaccinations can start this week, with front line medical staff first in line. Following this there will be a gradual roll-out to the elderly and vulnerable.
Japan faces an additional hurdle given the higher degree of vaccine skepticism compared to other countries. A World Economic Forum-Ipsos survey shows that only 60% would agree to take a vaccine in Japan, compared to 77% in UK, and 75% in South Korea. Local surveys suggest that a higher proportion of elderly are willing to take the vaccine, while take up could be lower in younger generations in their 20s and 30s.
Accounting for vaccine supply, distribution and local demand, we estimate the government will be able to vaccinate approximately 35% of the adult population by June. Given the slower pace of vaccine roll-out, we expect the economy to trough in March and for the recovery to be stronger in the third quarter than in the second.
India: RBI and government committed to maintaining accommodative policy stance
- The Indian budget for 2021 set out the government's commitment to an accommodative fiscal stance. The deficit is projected to improve on the back of better revenue collections, reflecting an improving economy. The outlook for growth is still challenging and a supportive fiscal stance is thus warranted.
- The Reserve Bank of India (RBI) also signaled that it is committed to maintaining stable financial conditions and help the government meet its financing needs. We expect the RBI to remain on hold in 2021 as both headline and core inflation have started to moderate.
The budget for 2021 set out the Indian government's commitment to an accommodative fiscal stance. Overall, the budget avoided overcommitting to fiscal normalization, while prioritizing high capex spending. The outlook for growth is still challenging and a supportive fiscal stance is thus warranted.
The deficit is projected to improve to 6.8% of GDP in 2021, from 9.5% in 2020 on the back of better revenue collections, reflecting an improving economy. On the revenue side, the government is expecting tax revenue to increase by 14%, and increased divestment in state owned enterprises is projected to boost non-tax revenue growth as well. While we think the growth in tax revenue is reasonable, the real uncertainty lies in the ability of the government to execute asset sales of state-owned enterprises.
On the expenditure side, the government has allocated higher funding for capital expenditure (up 26% from last year). Among sectors, urban development, energy and industry have seen some of the largest increases in allocation.
The budget also laid out a gentle glide path for reducing the deficit to 4.5% of GDP by 2025, which will avoid any sudden tightening of fiscal policy. The government has signaled that it is comfortable with a higher debt/GDP ratio (expected to stabilize at 90%), as long as the debt profile is sustainable and India can maintain a high growth trajectory.
Given the government’s higher borrowing needs for the current fiscal year, the RBI also signaled that it is committed to maintaining stable financial conditions and help the government meet its financing needs. In line with our expectations the RBI kept its policy rate unchanged in its February meeting, however noting that systemic liquidity was in surplus in late 2020 and Jan 2021, they’ve decided to hike the Cash Reserve Ratio (currently at 3%) by 50 basis points (bps) and committed to another 50bps hike in the near future.
We expect the RBI to remain on hold in 2021 as both headline and core inflation have started to moderate (Chart 5). Headline inflation for January dropped to 4.05% y/y from 4.53% in December. The drop in food inflation was the main driver behind the falling headline figure. While the fall in food inflation is welcome, the pace of decline has caught us by surprise. We expect Indian food inflation to be relatively insulated from the rise in the global food prices as India is not a net importer of major food products (barring some oils and oilseeds).
Chart 5: Headline inflation moves back into RBI’s target range.Source: Haver, Refinitiv, ASIRI, February 2020
Oil base effects are also expected to be moderate. The fall in domestic oil prices in India was not proportionate to the fall in global prices in 2020. The hike in excise duty on petrol and diesel helped bring in some extra revenue for the government, however the benefit of falling global oil prices was not passed onto consumers. The recent rise in oil prices does present an upside risk for inflation in India- given India’s high dependence on oil imports. However in previous periods of imported inflation, the RBI has tended to look past the transitory pressures and we expect a similar response this time around.
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