As the world emerges from the COVID-19 pandemic, Western investors’ focus has shifted from the impact of a global health crisis to a lesser but still serious potential problem: inflation, and how bad it might get. Rates have been on the rise in U.S. fixed income markets – a sign that the economy is indeed recovering from the pandemic and that investors increasingly expect government spending and the post-pandemic recovery to sharply increase prices. On the other hand, central banks in major developed economies have made it clear that benchmark rates will be on hold (and ultralow) for some time.
Obviously, the question of who’s right – markets or central banks – is crucial for investors. Yet what might be getting lost in this “great inflation debate” is that it is largely a developed-market phenomenon. In emerging markets, there is little debate: For them, inflation is already a reality. And a handful of central banks – in Turkey, Brazil and Russia – have already responded by raising benchmark interest rates. If, as we expect, others follow, the inflation and rate environment may present a challenge to any investors who still view emerging markets as a homogeneous asset class.
In addressing that challenge, it is important to consider the context of the pandemic’s unevenly distributed impact and divergent policy responses. In 2020, developed-economy governments responded with massive fiscal spending, but developing countries generally could not afford to do the same. Faced with a lack of fiscal capacity, they instead pursued structural reforms, such as India’s “Make in India 2.0” initiative. Today, COVID is still not under control in most emerging markets; some level of restrictions and lockdowns remain in effect, and mass vaccinations across emerging markets are not likely to occur until the second half of this year or the first half of 2022. Yet, in the meantime, inflation pressures are picking up, leaving central banks with little choice but to embark on the path toward policy normalization – that is, tightening – before their economies have fully recovered. That stands in sharp contrast to developed economies, whose policy makers seem content to tolerate inflationary pressures and maintain accommodation at least until full recovery is assured.
Yet inflation is building globally because commodity prices are rising. The S&P World Commodity Index is up by more than 15 per cent this year, in U.S. dollar terms. For many emerging markets, one significant impact is on food prices. As well, rising oil prices will affect net energy importers such as Turkey and India. Currency weakness is also adding to inflationary pressures. So far this year, the Russian ruble has depreciated about 2.5 per cent against the U.S. dollar, while the Turkish lira is down 7 per cent against the greenback and the Brazilian real has declined more than 8 per cent, according to Bloomberg.
We can see the cumulative impact of these factors in above-target inflation. In Brazil, the mid-March inflation read was widely reported to be nearly 1 per cent – almost double the February read – translating into an annualized rate of 5.5 per cent. That is 30 basis points higher than the annualized rate in February, and 175 basis points above the central bank target of 3.75 per cent. In Russia, the consumer price index reached an annualized 5.7 per cent in February, well above the 4.25-per-cent target, and India’s core inflation is estimated to have hit 6.4 per cent annualized, driven by rising fuel and food prices. Turkey, meanwhile, has seen inflation rise to 15.6 per cent on an annualized basis.
In countries susceptible to currency weakness, the double jeopardy of rising commodity prices and declining purchasing power puts policy makers in a difficult position; for them, raising rates constitutes a defensive measure. In mid-March, Turkey’s central bank raised its policy interest rate by 200 basis points, to 19 per cent – double the increase expected by economists. (The dramatic move apparently cost the central bank governor, Naci Agbal, his job: President Recep Tayyip Erdogan, who has long opposed high lending rates, ousted Mr. Agbal two days after the rate hike.) Meanwhile, Brazil raised rates by 75 basis points to 2.75 per cent, compared with a consensus 2.5 per cent, and Russia hiked by 25 basis points to 4.5 per cent, when rates were expected to remain unchanged. Other emerging markets, such as India, Indonesia and Mexico, have held steady in their low-rate regimes so far, but if energy and food prices continue to rise, they might not be able to hold out for long.
For investors, this environment supports a selective approach to emerging market equities. We focus on high-quality companies that have a strong competitive moat, pricing power and solid underlying drivers that can withstand such pressures.
While the inflation picture for developed economies is a subject of hot debate, it is becoming clearer for emerging markets. Higher commodity prices, currency weakness and domestic factors may push more of them to follow the lead of Russia, Turkey and Brazil and raise rates in 2021. Our view: Emerging market investors need to be both diversified and selective, focusing on high-quality companies better equipped to withstand inflationary pressures – whether or not those pressures end up bleeding into developed markets.
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