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Louis Beckerling

Inflation
Skyrocketing oil prices are altering the investment landscape in the region. It's having a  knock-on effect on consumers and corporate earnings and, with crude continuing to post fresh records on an almost daily basis,  inflation is set to remain the number one policy challenge in the region.
This is mainly  because of the rising cost of food, resulting from  poor harvests and competition from biodiesel  producers. Food prices are dangerously high and have sparked riots in several developing countries.
In China, food prices shot up 21 per cent in the first quarter of the year. However, worst hit was Vietnam where food prices skyrocketed to 34 per cent in April and saw inflation rise from 15.7 per cent year-on-year in February to 21.4 per cent year-on-year in April, prompting the State Bank of Vietnam  to lift its base interest rate from 8.75per cent to 12 per cent.
But few central bankers in the region have so far bitten the bullet in this aggressive way and risk triggering slower economic growth by raising interest rates to rein in inflation.
As a result, says Lehman Brothers analyst Rob Subbaraman, inflation in the Asia-ex Japan region has now been elevated to 'No1  on our worry list'.
Writing in the May16 edition of Lehman's Global Weekly Economic Monitor, Mr Subbaraman says, for the moment, Asian policymakers seem to be taking the position that the commodity price-driven inflation shock is  temporary and will  ease in the second half of the year.
However, they may be miscalculating, he warns, and if the commodity price upswing is  more structural rather than cyclical - driven by the rapid emergence of developing economies and the effects of global warming, and policy responses to that phenomenon - inflation may remain a longer-term challenge.
So how should investors respond?
Norman Villamin, head of research and strategy investments, Asia-Pacific, Citi Global Wealth Management, says one strategy adopted by wealth managers at Citi is  to invest in the sources of inflation - or buying the commodity, energy or food that is responsible for inflation.
'Another aspect to think about is that as this inflation is happening, some people are making money.
'So at a time of high energy prices, the producers of energy are making surpluses - in Russia and Brazil for instance. So investing in markets that are benefiting from inflation can be helpful.'
Price inflation may also favour companies operating in areas where demand for their output is  'inelastic' (or where consumers have less freedom to respond to rising prices by cutting back on demand).
'Think about such things as foodstuffs and health care, where cost increases can be passed on through rising prices since people still need such products or services,' Mr Villamin says. 'We also look at regulated industries, or 'cost-plus' industries which can pass on costs.
'And finally, we have seen a lot of markets allowing their currencies to appreciate which means their import costs are reduced and inflation domestically is contained. So one strategy may be to buy the currencies of those countries that use their currency strength as a strategy to combat domestic inflation.'
In Malaysia, where inflation hit a 15-month high of 3 per cent in April and looked to be heading higher, with food prices registering a 5.7per cent increase in March, a tightening of interest rates may  be expected.
But with policy favouring growth over economic tightening, Bank Negara Malaysia is  expecting to maintain its overnight interest rate  at 3.5per cent - unchanged since April 2006 despite signs of accelerating inflation.
That expectation, point out analysts, lies behind a recent slide in the Malaysian ringgit versus the greenback.
But Goldman Sachs' analyst Michael Buchanan  believes the factors supporting the currency - chiefly a substantial current account surplus and a managed currency regime - point to 'better prospects for currency appreciation'.
Currencies preferred by Goldman include the Malaysian ringgit,  Singapore dollar and the  yuan, he says, compared to those currencies in the region, including the Indonesian rupiah, the Indian rupee and the Philippine peso, 'which are less supported by current account surpluses and less managed'.
Nomura International  strategist for Asia, Sean Darby,  notes that the tentative response by central bankers in Asia has left real interest rates (nominal rates adjusted for inflation) so low or negative that they are exacerbating the demand for commodities.
'The combination of low real interest rates in emerging markets and subsidies for fuel and food has ensured that there has been no demand shock, and hence commodity prices have risen even further despite signs of a global slowdown,' Mr Darby notes in a May  report.
But this policy cannot continue for much longer, he warns, adding that Nomura has closed its recommendation of a commodity-linked inflation protection basket.
As a general rule, companies that benefit from periods of inflation or stagflation, says Mr Darby, should have low costs, high fixed-capital and resilient pricing power, and  minimal regulatory interference.
'Moreover, they should have high payout ratios -  telecoms and internet companies would be favoured - and service providers with high barriers to entry, including medical, aircraft maintenance and engineering contractors, would fit the bill. Equally, our soft commodity and energy baskets have begun to appear overbought, and we would prefer to own a basket of ports, bulk shippers and shipping, and reits [real estate investment trusts],' Mr Darby says.
But not all analysts favour reits in the present investment climate - unless they happen to be bigger and better capitalised, and hence in a position to make a predatory move on smaller or cash-strapped rivals.
'Materially tighter credit conditions are adversely affecting both the availability and price of debt at a time when a number of Singapore reits face imminent refinancing needs,' notes Kathleen Lee,  vice-president and senior analyst of ratings agency Moody's,  that advised in May that it had downgraded, or put on review for downgrade, three S-Reits and set outlooks for two others to negative.
'As we look ahead, difficult market conditions have increased the likelihood of event risk affecting credit profiles through merger or divestiture activity,' says Ms Lee,  adding that better-off S-Reits may take advantage of the attractive valuations of those peers that face liquidity problems, or trade at high discounts to net asset value.
Likewise, some entities may reconsider their strategic profiles to realise greater value for their unit holders.
Gold, the historical safe haven for investors in times of high or rising inflation, has already run up to record levels, briefly touching US$1,000 an ounce in mid-March - a price which may have hit resistance levels judging by the latest data from the World Gold Council (WGC),  and the profit-taking that has followed the price peak. In its 'Gold Demand Trends' for the first quarter, released on May 20, the WGC reports that gold demand is up in terms of the depreciated US dollar, but down 16 per cent on the same period last year in tonnage terms, at 701 tonnes. It attributes the fall in demand to 'unusually high volatility in the price'.
In India, the largest single market for gold, but also the most price-sensitive, jewellery and investment demand collapsed to 71 tonnes and 31 tonnes respectively in the first quarter, which the WGC notes are half the levels recorded in the first quarter in 2007.



Rising to the challenge