Inflation rates have started to accelerate around the globe as economies unlock and demand for items such as automobiles, travel and raw materials increases.
In fact, many developed market economies are seeing core inflation rates moving to decade highs, and investors are asking themselves if inflation could potentially spill over to the emerging world.
This is fueling fears that emerging markets central banks may be caught flatfooted and unable to find a balance between choking off the recovery, or letting inflation run rampant, despite their success so far in keeping inflation largely under control.
In our view, rising inflation in both developed and emerging markets is not wholly unexpected. The economic rebound is creating supply imbalances as pentup demand meets a supply side still impaired by the pandemic.
We expect emerging market inflation to remain relatively contained in the coming quarters, even though EM inflation rates have risen above historical trends.
There are of course risks that inflation may move higher, especially as we see the service sector recover as economies should get back to normal. We could also see further supply bottlenecks that have pushed inflation higher, boosting goods prices further.
However, we believe elevated, post-pandemic inflation is likely to be transitory, and we don’t expect to see a reversal in the structural downtrend in emerging markets inflation that many EMs have worked so hard to cement over the last decade.
We expect disciplined economic policy, moderate growth, aging demographics, and labor-saving technology to help contain inflationary pressures.
Central banks have two options on how to react to the inflationary pressures. One policy approach is to look through elevated inflation prints, with the view that the uptick in inflation is transitory in nature with headline inflation being fueled by temporary pent-up demand and supply chain shocks.
That would mean responding cautiously to any rise in core inflation, unless output gaps tighten dramatically, or financial stability is threatened.
This approach has some merits, particularly in emerging markets where pandemic-related uncertainty prevails as vaccination programs are currently behind those in the developed world.
The second policy option would be to front load a tightening cycle to stay ahead of the inflation curve. This would help minimize the risk of inflation expectations moving away from target ranges and would likely help address financial stability concerns should a higher inflation path become more permanent.
Aggressive tightening has the added benefit of reassuring the market that policy makers remain committed to foreign exchange stability.
The front-loading approach is what we have seen this year in some emerging markets including Russia, Turkey, and Brazil.
These markets have a history of persistently high inflation, and central banks there have only recently managed to bring down inflation to single digit levels. Consequently, these central banks are wary of jeopardizing the structural downtrend in inflation and credibility they have established over the past several years.
We see this move toward policy normalization as a positive for the EM asset class, and we expect more central banks to follow suit over the coming quarters.
Throughout the pandemic, Central European central banks for example followed extremely accommodative policies, which caused real rates to move into negative territory.
However, with output gaps now closing, and turning positive in some economies, we expect EM central banks to start raising interest rates incrementally.
Notably, emerging markets are no longer as beholden to developed markets as they once were. In fact, we think many central banks in emerging markets are leading the way in terms of monetary policy normalization.
By contrast, developed market central banks seem more reluctant to raise interest rates and appear willing to risk potentially higher inflation.
The fact that EM central banks are likely willing to follow a more orthodox policy approach should give confidence to investors.
For investors in emerging markets local rates, we believe that central banks that proactively tackle risks of inflation should be a supporting factor, likely reducing the risk of inflation or currency weakness.
From an evaluation perspective, many local rate curves are pricing a more hawkish policy approach, and when comparing yields in emerging markets to developed markets, the former offer more attractive yield levels even when hedging out the currency risk.
For investors in emerging markets equities, the fact that central banks are serious about keeping inflation under control and staying ahead of the curve is a positive.
Emerging markets companies have had to endure difficult periods in the past, with businesses having to deal with persistently high inflation and volatile foreign capital flows. EM central bankers’ delayed necessary policy action that ultimately caused them to have to hike policy rates to levels that ultimately choked economic activity.
Encouragingly, we believe those days appear to have passed now, and we believe recent policy actions can help to promote both stability and economic growth over the medium term.
