Japan and China: Shelter from tightening liquidity?

Author: Matthew Poterba, CFA, Senior Analyst

Global liquidity has tightened dramatically this year, which may be a headwind to global equity markets. However, not all central banks are tightening because not all countries have an inflation problem. There might be opportunities in countries with accommodative, counter-cyclical monetary policies. Japan and China, two countries investors are largely ignoring, are two markets that might warrant a closer look.

High inflation still coming in hotter than expected, less so in Japan and China

Inflation that remains higher than expected for longer than anticipated has been one of the themes we have been most vocal about over the past year. In fact, inflation around much of the world is the highest it’s been in the last several decades and continues to come in higher than forecasts despite strategists and economists revising their estimates higher.

Charts 1 and 2 show Citi Inflation Surprise Indices for a set of major economies. Positive values (shown in orange) indicate actual inflation above expectations, and higher values correspond to larger magnitude of those surprises. Inflation surprises currently sit in their 99th or 100th percentile for the Eurozone, United Kingdom, Canada, and Emerging Markets.

However, there are two major countries that appear more sheltered from this higher inflation dynamic – Japan and China. Although inflation surprises there are rising, they are nowhere as extreme (see Chart 2). Current inflation also remains more subdued in Japan and China.

Countries with higher inflationary pressures accelerate policy tightening

Because central banks around the world are primarily concerned with price stability, the persistence of high inflation well above their inflation targets is finally beginning to force central bankers to aggressively fight inflation by raising interest rates, even at the expense of growth. Most recent central bank announcements have contained either larger-than-expected increases in policy rates or more hawkish forward guidance, or both. As a result, the forecasts for interest rate increases continue to shift higher (Chart 3). These expectations for tighter policy are negative for equity markets.

Accommodative policy in Japan and China may present opportunity

However, not all central banks are restrictive right now because not all countries are battling high inflation. Japan and China stand out for their more dovish policies. Fewer current inflationary pressures in these countries will likely grow their central banks to maintain relatively easy policy going forward, which is more supportive of growth and equities.

In Japan, the Bank of Japan (BoJ) recently reaffirmed its 25bps upper bound for yield curve control on 10-year Japanese Government Bonds (JGBs), and opted to maintain forward guidance of no rate hikes. This indicates Japan’s ultra-easy policy stance is likely to continue for the foreseeable future.

Although China has maintained more restrictive policies in the past year, recently China has taken significant steps to ease policy and add both monetary and fiscal stimulus. The People’s Bank of China (PBoC) cut the 5yr Loan Prime Rate (LPR) – the reference rate for mortgages – by 15bps and reduced the Required Reserves Ratio (RRR) with the intention to revitalize bank lending. China also announced 33 pro-growth fiscal stimulus programs, including tax rebates and reductions, expanded credit support to businesses, and accelerated infrastructure investment. These accommodative policies are likely to support new credit creation and may help rejuvenate China’s economic and corporate profits growth.

Tighter Fed policy, echoed by other central banks around the world, seems to dominate recent news flow. However, we do not want to be geographically myopic and miss opportunities outside the US that are not as burdened by constrictive US policy. Therefore, we increased our portfolios' exposure to Japan and China. Both Japan and China stand out for their accommodative stances, which appear decidedly counter-cyclical to policies in the US and Europe.