Producers in both China and the US are facing higher costs, prompting growing concerns that inflation could threaten the global economy - but China isn't waiting to find out given its recent history with inflation.

Interestingly, Chinese consumers are facing much less pricing pressure than their American peers, so why are the Chinese more concerned over higher commodity prices? This could be a potential headwind to Chinese economic growth.  Top Chinese officials like Premier Li Keqiang and Vice Premier Liu He recently expressed concerns for manufacturers and the adverse effect of rising commodity prices including the potential pass-through to consumers for some goods. In response, Chinese regulators were tasked with curbing the excessive speculation in the commodity market by imposing new limits on the trading of commodities and increasing some export taxes.

China has clear reasons to fear inflation with memory of past price increases still vivid, including the +135.2% surge of pork prices and +5.2% consumption inflation in February 2020. But, in our view, the threat of no inflation pass-through is more pressing.

Is China exporting higher prices?

Since joining the World Trade Organisation in 2001, China has engineered a complete industrial system. The upstream raw materials sectors have been dominated by big companies, which are closely associated with central or local governments. These companies have the pricing power to transfer the input cost pressure to mid- and downstream companies. Notably, the producer goods price increased by +12.0% in the last twelve months, as of May 2021. But the inflation pass-through stopped here and did not flow downstream. The price of consumer goods increased by only +0.5% during the same period. Mid- and downstream companies failed to pass the higher input cost to the consumers. A few factors contributed to the no pass-through of inflation which are discussed below.

Figure 1 - China Producer Goods vs Consumer Goods

                                  Source: Bloomberg, JCB.

Firstly, the competition at the mid- and downstream level is fierce. When Chinese manufacturers had a limited technology edge, they won market share via lower prices thanks to cheap labor costs. This led to overcapacity and triggered the supply side structural reforms of 2015. Prior to the full blown COVID-19 impacts, industrial upgrading and technology innovation was still undergoing and far from complete. In short, if your competitive edge is price, you cannot jack-up price so easily.

Secondly, there is no positive domestic demand shock in China. Unlike many developed countries, the Chinese government didn't implement a large fiscal transfer to boost household balance sheets. The recent retail sales and service output data showed that demand is growing but at a lower-than pre-COVID-19 speed. With largely stable domestic demand, mid- and downstream manufacturers could not raise prices without losing market share. Due to the strong recovery of overseas demand, those downstream manufacturers, who have the capability to compete in overseas markets, may charge higher prices, i.e. exporting the inflation. However, the recent appreciation of RMB has posed a headwind. The latest survey data shows the slowdown of new export orders.

Figure 2 - Chinese producers pass through the price pressure to US customers

                                  Source: Bloomberg, JCB.

Overall, high commodity prices without inflation pass-through simply means profit squeezing for mid- and downstream firms. In late May 2021, Chinese state media reported that some downstream producers stopped taking new orders as the more they produced the more they lost. In our view, China shouldn't worry too much about the threat of the high consumer inflation for now as it is difficult for downstream producers to pass through the price pressure. However, the profit squeezing caused by the no pass-through is right here. We believe it is a headwind to Chinese economic growth, which explains why policy makers are tackling the high commodity prices.

Some Chinese trading firms have increased inventory of physical commodities and tried to corner the market. Regulators called them to stop the market speculation and manipulation. China would also maintain the macro prudent policy and keep the credit impulse low. This would avoid spurring the property bubble further. Historically, lower China credit impulse was linked to lower commodity prices.

However, things may be different this time. The expansionary fiscal policy from the Biden Administration could make the U.S., instead of China, the marginal buyer in the commodity market. While U.S. consumers use the stimulus money to pay for higher gasoline prices during their summer trips, Chinese producers could face further profit squeezing. History suggests that the turning of profitability in the Chinese corporate sector can have significant impacts on regional equity markets, with associated impacts across the macro spectrum, investors should pay attention to the lack of pass-through pricing power given this higher inflation impulse in China as an early warning sign of fading corporate profitability.

Figure 3 - China Credit Impulse falling

                                      Source: Bloomberg, JCB.

Figure 4 - China Corporate Profit Index vs MSCI Asia x Japan Index

                                      Source: Bloomberg, JCB.

Last year, we endured some major shifts in the market. Just 23 trading days resulted in the S&P 500 falling -34%. By June it had topped +40% (from its 23 March low). It can be disturbing when this happens in such a short timeframe, especially with the media going ballistic with doom and sensationalism. Is this usual?

Yes, it is. Large ups-and-downs occur all the time - though not for the past 10 years. So it feels unusual and can be tempting to time moves or cash out until things feel okay again. Here are the seven biggest market events over the last 90 years:

1. The 1929 Great Depression Crash lasted well into the 1930s. It's still by far the craziest ride in history. The market was up +32% in '29 until peaking in September. Then it fell -45% in two months. Then it rose +28%. Overall, the year was down just 8.3%. By four months into the next year the market was up +22%. It didn't last, as the next eight months would see a -44% drop. By December it was still down -25%.
2. 1931 had stocks rising in two months by +19%. It then flipped, closing around -57% by mid-December. That year is the worst year on record, finishing -44%. Would you have stayed invested? Another -51% drop over the next five months of 1932 would really test you! (This was THE bottom as it turned out.) Without warning or good news, markets rallied +112% in only 12 weeks. The S&P still fell again another -32% to settle for the entire year at -8.6%. Selling didn't subside in 1933 as there was another fall of -25%. After that, investors enjoyed a staggering +121% in July (and a bump of -29%) to finish the entire year +50% - one of the best years ever. 1934 saw another rise of +21% (and a fall of -29%). 
3. The '73/'74 oil crisis marked another rollercoaster of returns. Stocks fell -37% before bottoming in October, then rallied +21% the next month, ending the year at -26%.
4. 1980 saw stocks falling -17% only to rise +43%. The market was up +32% by year's end. 1982 witnessed a similar event with -17% followed by a +40% jump. Year-end stocks were up +20%.
5. The Black Monday crash of '87 saw the market falling -34% in only a week. It had risen +40% beforehand and ended the year almost +6% (after the worst one-day crash in history). 
6. The late '90s asset bubble had a +20% gain for five years straight up until 1999; yet in '98 it had a -9.3% fall before increasing +34% ending the last year of last century at +28%. As the dot-com bubble burst nudged by 9/11, three big 7. price swings occurred in 2001. Stocks fell -19% before rising +19%; then there was a -26% crash to close the year around -12%.
7. The 2009 GFC bottomed in early-March '09 at peak gloom but not before being slammed at -28% from 1 January. Prices then leapt +67%, closing the year at +26%.

What would you have done as an investor in response to each of these market events? Hindsight is a wonderful thing...

Three demographic discoveries that affect investments

To understand the drivers of the structural down-shift, we need to first look at the reality of the globe's demographic make-up. Our white paper discusses three demographic discoveries - and at least one of them will challenge long-held beliefs!

Discovery 1: The world population will grow for the next 30 years and there's not much that can be done to stop this. 

Discovery 2: World population will then decline and there is little that can be done to stop this if societies behave as they have done for millennia. 

Discovery 3: 'Peak Child' occured in 2011. There will never be a year in our lifetimes where more children are born. This has profound economic growth implications.

Learn more in our demographics White Paper: The GDP Downshift - Preserving Equity Returns

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Recently, there's been a lot of discussion about whether the significant government stimulus, combined with record low interest rates and unconventional monetary policy such as Quantitative Easing (QE) will finally result in rising inflation, something markets have not experienced for some time. After a number of false starts, it appears that almost every central bank is committed to these measures until they achieve their objective of realised inflation.

It's a risk of which investors should be aware. On a practical level, it means taking a look to see whether the assets in your portfolio are still match-fit in an environment of rising inflation. We have previously written on the critical role of the attacking defender as it relates to private debt illustrated through soccer, so we'll extend this soccer team analogy to explore this dynamic and the role private debt can play to help investors navigate an environment of rising inflation.

Moving market dynamics

Long-duration assets like government bonds, infrastructure, property, and high-growth equities benefit when interest rates fall by lowering the discount rate applied to all their future cashflows.  These are the first assets selected in your team when rates are falling. We have seen these champion investments perform exceptionally well over the bull market of the last 40-years, when interest rates have dropped from double digits to near-zero levels.

With the potential for rates to rise from zero and with the prospect of inflation, it's time for the coach and team manager - in markets, the portfolio manager - to make some difficult decisions about whether champion players in the twilight years of their career - for example sovereign bonds - should still be on the field, at least for the whole match. It may be time to re-evaluate whether your best past players are really your top choices going into a new season, or whether they should be retired, rested, or spend less time on the pitch because they've lost a yard of pace.

When inflation expectations rise, interest rates tend to increase, and the yield curve steepens. In these conditions, it's an opportunity to reconsider whether some of the long duration assets that have been tried and tested players in the portfolio are still fit for purpose. It might be time for short duration asset classes such as private debt to step into their role in the team.

In a rising interest rate environment, the value of long-duration assets like fixed rate corporate and sovereign bonds, fall in value because their future cashflows are discounted further than before. This isn't the case with private debt, which is short duration and senior secured debt, and in a rising interest rate environment does not fall in value, giving true diversification benefit.

Australian & New Zealand Private Debt: Appeal in a rising rate environment

The chart below illustrates various credit and fixed income investments with differing levels of duration. The longer the duration, the more sensitive the investment valuation will be to interest rate changes.   

     Source: Revolution Asset Management and Bloomberg. 'Aust & NZ Private Debt' is based on realised investment experience of the Revolution private debt strategy from December 2018 to May 2021.

In fact, the overall yield of private debt rises in line with interest rate movements upwards because the total interest earned on the assets is the floating rate benchmark plus the credit margin, instead of a fixed rate coupon. This is one of the most compelling reasons to consider an allocation to private debt in your current portfolio. The trade-off is that investors need to be comfortable with increased credit risk and the illiquidity that comes along when investing in private debt.

Like any soccer team, sometimes the coach or manager needs to bench certain assets because they don't suit the playing conditions. But when conditions turn, it could be time to bring them back into the team. Gold is a good example, which has historically served as a store of value when inflation rises. Perhaps it's also time to have an eye to the future and consider whether to promote up-and-coming players from the youth team. In this example, the coach or portfolio manager might examine whether an allocation to crypto currencies may add diversification to your portfolio in a QE world, but we'll leave it to others to continue this debate.

Re-positioning for the times

Overall, what's important is to have the right balance of attacking and defensive assets in a portfolio for the current conditions. You pick a different team when the game is played in rain and snow compared to when the conditions are fine. When it comes to investing, what's important is to choose the right assets for the prevailing economic and market environment.

Think of private debt as the attacking defender or wingback in the team, it provides the right balance in a portfolio because it produces uncorrelated returns to other assets, as we demonstrated in our previous article. It's an investment that's first and foremost a defender that aims to preserve capital, but at the same time, it can contribute to the attack and goals in the form of regular income that can either be spent or used to re-balance. Just as with soccer players, consistency is the key to selecting a fund manager that has the form for managing a portfolio through different conditions. At the same time, a good fund manager - and good players - will be well-balanced, durable and without weaknesses.

Private debt as an asset class is an especially attractive option, particularly when inflation is rising, something with which markets have not had to grapple for some time. Revolution Asset Management's goal is to be the attacking defender in investor portfolios by providing that winning and balanced combination of attack in the form of potential income, and defence in the form of aiming to provide capital preservation through all market cycles.

This article is for institutional and professional investors only and has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 ('Revolution') who is the appointed investment manager of the Revolution Private Debt Fund I, the Revolution Private Debt Fund II and the Revolution Wholesale Private Debt Fund II (together 'the Funds'). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 ('CIML') is the Trustee and issuer of units for the Funds. Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 ('Channel') provides investment infrastructure services to Revolution and Channel and is the holding company of CIML. None of CIML, Channel or Revolution, their officers, or employees make any representations or warranties, express or implied as to the accuracy, reliability or completeness of the information, including forecast information, contained in this document and nothing contained in this document is or shall be relied upon as a promise or representation, whether as to the past or the future. Past performance is not a reliable indication of future performance. All investments contain risk. This information is given in summary form and does not purport to be complete. To the extent that information in this document is considered advice or a recommendation to investors or potential investors in relation to holding, purchasing or selling units in the Funds please note that it does not take into account your particular investment objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to these matters, any relevant offer document and in particular, you should seek independent financial advice. For further information and before investing, please read the relevant Information Memorandum available on request.