Time ripe for inflation investments and hedges, says Sinopia chief

The launch of a variety of fiscal stimulus packages by Asian and western governments combined with quantitative easing by some central banks has renewed concerns about the risk of significant increases in future inflation rates around the world.

Malaysia this week unveiled a larger-than-expected extra spending of 60 billion ringgit ($16.3 billion) to stimulate its moribund economy. Other Asian governments such as Australia, China, Japan, Hong Kong and Singapore have also launched stimulus packages in their bid to prevent their short-term economic output from nose-diving. China alone is injecting 4 trillion renminbi ($580 billion) into its economy.

The accompanying swelling of budget deficits and new debt issuance by the monetary authorities of many of the world's leading economies has increased the risk of future inflation. Indeed, some parties believe nominal interest rates may bottom out in some jurisdictions and may even start moving upwards again within six months.

This means now might be a good time to put on longer-term inflation hedges or invest in inflation-linked government bonds as a part of a defensive asset portfolio. "As the real interest rate is less volatile than the nominal interest rate, the volatility risk of investing in inflation-linked government bonds as opposed to nominal government bonds is lower," says Hong Kong-based Alfred Yip, chief executive of Sinopia Asset Management (Asia-Pacific) - the quantitative investment specialist arm under HSBC Global Asset Management. Yip was referring specifically to the Canadian, French, UK and US markets. "Thus, inflation-linked bonds would be a more defensive asset than nominal government bonds, especially if we expect nominal rates to start picking up in the next six to nine months."

Yip, who helps manage Sinopia's $40.3 billion in assets as of June last year, adds: "To further diversify risks and take opportunities offered by markets globally, our view is that having a diversified approach towards global inflation-linked bonds is better than having a single exposure to a single inflation- linked bond market."

Yip says during the last quarter of 2008 breakeven inflation rates - the difference between the nominal yield of a nominal bond and the real yield of an equivalent inflation-linked bond - have collapsed for many markets. This was caused mainly by a flight to liquidity, which benefited only the most liquid instruments such as nominal government bonds and bills, and affected even inflation-linked bonds issued by the same sovereign issuers.

Yip contrasts the current breakeven inflation levels using the 10-year Japan inflation breakeven rate as an example. It currently stands at -2.26%. The most pessimistic expected inflation estimate made by a major investment bank, by contrast, is -1.4% by Barclays Capital. "It means that at the current breakeven inflation level, from a price perspective, Japanese inflation-linked bonds are very undervalued as the -2.26% rate suggests an aggressively deflationary scenario, ie, prices down 2.26% every year on average for the next 10 years," he says.

"But if you look at Japanese history, even in the recessionary 13-year period in the1990s, there was only one year out of the 13 that actually ended up with significant negative inflation, which was around negative 1%, and at other times the inflation rate was hovering around zero," he says. This could make Japanese inflation-linked bonds appear cheap at present.

In the immediate term, however, deflationary pressures are persisting. For example, China's benchmark consumer price index fell by 1.6% in February from a year earlier, the first drop in more than six years, according to data released this month by the National Bureau of Statistics.