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Louis Beckerling

Inflation calls for strategy change

PRICES ARE ONCE again on the march in Hong Kong, redrawing the investment landscape after almost a decade of deflation triggered by the Asian financial crisis of 1997.

The most visible positive result of this trend is the sharp turnaround in the value of real estate and the subsequent 'wealth effect' - a phenomenon that encourages individuals to borrow against the rising value of their homes and spend today to beat tomorrow's expected price rises.

Property prices have climbed to an average of $3,216 per sq ft from a low of $1,854 in April 2003, according to Midland Realty.

The recovery has meant a dramatic improvement in the fortunes of homeowners, for whom property is usually their single largest investment.

In June 2003, according to data published by the Hong Kong Monetary Authority, 106,000 homeowners were in negative equity and collectively owed banks $165billion - which was some  28 per cent more than their houses were then worth.

Those were hardly the circumstances in which householders could be encouraged to get out and spend, as surplus savings were mostly ploughed back into mortgages to keep the debt collectors at bay and the roof over the family's head.

But the rising tide of house prices has dramatically changed all that.

By April this year the number of residential mortgage loans in negative equity had decreased to some 9,200 cases and the aggregate value of loans involved to $16 billion, which was collectively 13 per cent more than their homes were worth.

But there, more or less, endeth the good news brought by inflation for ordinary households.

Following a near decade-long deflationary trend, headline inflation is now back on the rise and analysts warn this means that retirement savings targets will now have to be dramatically increased to combat the prospect of rising prices and preserve the purchasing power of retirement nest eggs at today's values.

That includes diverting more money into supplementing the enforced retirement savings under the Mandatory Provident Fund scheme and raising the risk profile of investment portfolios to 'juice-up' returns so that they beat inflation.

If we return to the days when inflation ran at up to 5 per cent, the safe haven of a 10-year US Treasury note now yielding 5 per cent simply won't be enough, warns Bruno Lee, head of wealth management for Asia Pacific in HSBC's personal financial services division.

'At a targeted return of 7 per cent [the investment return required to preserve the value of a retirement nest egg at an inflation rate of 5 per cent], a retirement bond or savings account will not do the job,' said Mr Lee.

The principal-guaranteed  savings products that proved so popular among Hong Kong savers during deflation still had a role to play in investment portfolios, he said, but a diminished one.

'The majority of their savings should still be in capital protected products and held to maturity, or perhaps a structured product with principal protection.

'In terms of yield enhancement, however, if we move up the risk/reward ladder, we could go from high-grade bonds to higher yielding emerging market bonds, or consider a global diversified equity fund, or investing some of our savings in asset allocation funds in which managers will allocate dynamically according to the market situation,' Mr Lee said. All of that, however, would entail higher risk, he added.

The deflationary environment now fading into history was the result of loose monetary policy around the globe, which ensured abundant liquidity and low interest rates, said Nomura analyst Sean Darby.

Then, savers were encouraged to invest in income-generating asset classes since they were low-risk and unlikely to see their value eroded.

But in the new environment, the emphasis had swung from income-generating savings products to capital gains, and investors have quit the safe havens of principal-guaranteed and fixed-interest products for riskier asset classes.

'As we move out of the deflationary environment, capital gains become more important, which has meant that a whole range of asset classes not normally regarded as mainstream, such as artworks or offshore property, have become key investment areas,' he said.

The result was that whereas banks were formerly competing for customers through rate-based investment products, they were now promoting  the advantages of higher-risk hedging instruments.

'Gold has also become more mainstream and can be bought through exchange traded funds,' he said.

Mr Lee warns, however, that alternative investment products, such as artworks or commodities, including the inflationary hedge traditionally offered by gold, should be treated with caution. Artworks and commodities tend to be unpredictable in terms of liquidity and volume. A customer would need to understand the time required to leave money tied up and whether it could be easily converted back to cash.

In an investment roadshow at the start of the year, Citigroup Private Bank told its clients that the flood of cash delivered courtesy of loose monetary policy was coming to an end in 2006.

'The past several years have been marked by abundant liquidity, the sources of which have largely been the United States Federal Reserve, American corporate balance-sheet repair, Asian central-bank purchases of US dollars and petrodollar profits,' noted Citigroup.

The new environment should be marked by a number of events, it added, including the sustained rise in rates by the US Federal Reserve and its counterpart in Europe, and the possible removal of China's currency's peg to the US dollar, which could see reduced demand for US Treasuries from Asian banks.

As those tighter monetary conditions took root and banking lending became more restrictive, watch for a possible re-pricing of credit risk and credit quality, said Kaven Leung, the bank's managing director and region head, North Asia and Canada.

But speaking last week, Hans Goetti, managing director and investment strategist for Citigroup Private Bank, said inflation expectations were being 'overdone' at present.

'We look at a measure of inflationary expectations used by our strategists in New York and at the sentiment for bonds, and both seem to be very high,' he said.

'We had similar extremes of pessimism in 1988, 1994 and 2000, and in all those instances if you had bought stocks sensitive to bond price movements, such as home builders or mortgage companies, you tended to make returns of 50 per cent.

'So in other words, if you are willing to take a contrarian view here we think there is a good chance you may do well over the next 12 months.'

So long as inflation did not race ahead, the return to an environment in which prices were on the rise rather than falling might not be a bad thing for equity markets, said Alfred Mak, head of treasury trading and investment for AIG Private Bank (Asia Pacific).

Hong-kong-based Mr Mak said not even the massive sell-down of stock markets recently had altered that view.

That was a view supported by Katherine Cheung of Merrill Lynch Investment Managers, though both she and Mr Mak cautioned that in the present volatile market, stock investments would raise risk levels and required careful selection. Enhancing yields on retirement portfolios might nevertheless be achieved by cautious stock picking and asset allocation, she said.

Asia and Japan remained high growth markets and Merrill's global allocation and global dynamic funds remained overweight in these geographies, she said, while sectors preferred by the fund managers included energy, financials, materials, telecoms and industrials.



Re-emergence of inflation calls for investment rethink