Country Allocation in an Inflationary Environment

The claim:

Country allocation can be an effective way to manage inflation risk, yet most portfolios are not positioned accordingly.

The rationale:

Portfolios of U.S.-based investors already have a much higher allocation to the U.S. versus what can be justified by the country’s share of market capitalization (index weights) or the share of listed company earnings (earnings weight); Figure 1. Foreign investors also have the greatest allocations to U.S. equities since the late 1960s and suggests more limited upside for the U.S. equity market relative to the RoW due to positioning alone; Figure 2.

Figure 1. References: IMF Coordinated Portfolio Survey; MSCI; Own Calculations.

Figure 2. References: Federal Reserve Flow of Funds data; MSCI; Own Calculations.

The intuition:

Currency developments are deeply intertwined with changes to inflation. For example, the dollar is used to price commodities globally and has a well-established inverse relationship with commodities (below).

The dollar also has a role as an invoicing currency outside of the U.S. (a further ~20% of world trade). As a result, a rise in the dollar would tend to mean deflation in the value of world trade. It would also tend to mean there are fewer dollars to “go around” to service dollar debts in emerging markets, which reduces growth rates – and therefore trade volumes – in those countries.

Lastly, because the U.S. frequently runs a current account deficit (especially in physical goods), declines in the dollar results in increases in the cost of imported goods which of course translates into inflation.

So intuitively, countries which rely heavily on trade volumes and commodities might be a good first place to look for hedges to inflation. Another area to examine would be countries that have higher share of total spending linked to investment. A speech by Bank of Japan governor Kuroda highlights the reasons why business investment positively correlates with inflation rates.

“Under deflation, …when firms were forecasting that general prices or sales prices of their own products would decline, firms’ burden of paying interest rates remained large because, whatever low the nominal interest rates might become, the real interest rates would become higher than the nominal interest rates (Chart 5). By contrast, real rates of return on cash and deposits increased when prices were on a declining trend, since nominal interest rates of the deposits could not become negative (Chart 6). Under such circumstances, accumulating retained earnings mainly by cost reduction and hoarding them in cash and deposits became relatively more advantageous for firms as a form of ‘investment’ than taking risks and making fixed investment. That was a rational behavior in a deflationary environment”

 - Haruhiko Kuroda, Governor of the Bank of Japan, Japan Business Federation, Tokyo, 25 December 2014.

References: Bank of Japan.

Source: World Bank; own calculations. “Four Tigers” is the grouping of Taiwan, Korea, Singapore and HK (weighted by GDP).

The evidence:

To briefly summarize: the strong performance of Asian markets during the stagflation period of the late 1960s and 1970s can perhaps be attributed to a few factors. First, expansionary US monetary and fiscal policy contributed to rising trade surpluses and capital inflows to Asian nations. That translated into an increase in the money supply in those countries, which is strongly associated with robust equity market performance. Second, those economies were rapidly industrializing during this period, encouraged by government policy. As we have seen from the BoJ research, investment spending is linked to price changes and forced savings by consumers and capital inflows can help fund that development. Separately, the performance of Switzerland is probably more attributable to its monetary policy (with gold backing, which rose in value during the period) than to its trade-orientation.

The performance of Australia and Canada is a bit more straight forward. As commodity prices rise, domestic employment strengthens and monetary policy can be adjusted, which helps the value of the currency. And naturally, the composition of the equity market has a higher share of firms operating in the natural resource space.