QUANTIFYING THE INFLATION TRADE ACROSS ASIA AND LATIN AMERICA

Takeaway: With expectations for QE3 now at 99% (Bloomberg), we think it's worth revisiting the post-Policy To Inflate playbook for Asia and LatAm.

***Repurposed; originally published on JUN 14, 2012.***

 

SUMMARY BULLETS:

  • Our analysis shows that the post-QE/OpTwist returns of USD-based investors in Asian and Latin American equity markets were neither a function of that index’s/economy’s exposure to rising commodity and/or asset prices; nor were those returns a function of performance in past iterations of Fed easing.
  • Thus, we would argue that outperformance in the next iteration of Fed easing (if any) will come down to identifying and taking advantage of idiosyncratic factors across the individual economies.

Dollar down; stocks, commodities and EM FX up. That’s the consensus reflation trade that has suddenly become the predominant bull case throughout the global investment community. As we have been saying since 1Q11, the reflation trade becomes the Inflation Trade as rapid commodity price gains perpetuate faster rates of reported inflation and slower growth across the global economy.

As completely detrimental as that is to any “long term” investment strategy, the reality of the situation is that most institutional investors have to chase short-term performance in one form or another. As such, if the Fed uses the recent string of anemic domestic employment growth and slowing [headline] inflation to signal or implement QE3-4 (it’s hard to keep track) next week, we would not be surprised to see another short-lived “risk” rally to another lower long-term high across global equity and commodity markets.

Turning to Asia and Latin America, we’ve taken the liberty to quantify the effects of the last three iterations of the Federal Reserve’s Policies to Inflate on their financial markets for any investors who may be looking to hit up the ol’ well once more. Our hypothesis was that those countries whose benchmark equity index was most exposed to the Inflation Trade would experience outsized returns relative to the group in both their stock market (faster earnings and economic growth) and local currency vs. the USD (capital flows; policy tightening speculation) on a S/T TREND duration (3MO). Moreover, we expected performance during these periods of reflation to be both positively and tightly correlated to the aforementioned exposure.

Using a simple linear regression analysis, we were able to dispel both components of our hypothesis, as outperformance of a given country’s stock market and local currency was not necessarily a function of its index’s (an admittedly loose surrogate for “economy”) exposure to the Inflation Trade; nor were returns always positively correlated across iterations.

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The key takeaway here is that there is hardly any relationship to be derived, suggesting that either A) country-specific fundamentals (i.e. GROWTH/INFLATION/POLICY) were the key determinants of performance or B) returns were more a function of performance in past iterations (i.e. “going back to the ol’ well”). To test the latter theory, we regressed returns of QE2 against those of QE1 and the returns of Operation Twist with those of QE2. In short, our findings here would suggest that this wasn’t the case.

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All told, our analysis shows that the post-QE/OpTwist returns of USD-based investors in Asian and Latin American equity markets were neither a function of that index’s/economy’s exposure to rising commodity and/or asset prices; nor were those returns a function of performance in past iterations of Fed easing. Thus, we would argue that outperformance in the next iteration of Fed easing (if any) will come down to identifying and taking advantage of idiosyncratic factors across the individual economies.

Below is a full performance table of the countries included in our sample.

Darius Dale

Senior Analyst

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