Capital Ideas^TM

The recent surge in commodity prices has amplified the acceleration in inflation that we have been seeing globally, arising from disruption to global supply chains caused by the pandemic. Expectations just a few months ago were that the drivers of inflation would be transient, but inflation now looks likely to remain higher, for longer, despite the squeeze in real income and economic activity. 

An interesting observation is the difference between developed and emerging markets regarding both the impact and response to inflation. Developed market central banks have spent the last decade struggling to bring inflation up to target, while emerging market central banks have mostly continued their long-term drive to bring inflation down. The recent period, unusually, has been characterised by EM inflation being relatively more contained than that of developed markets (DM), as shown in the chart below. 

We see two key reasons for this. Firstly, because EM countries are facing a weaker economic recovery, and secondly, because EM central banks have
been more proactive in raising interest rates. 

EM still facing a weak economic recovery

EM countries, along with DM, have seen sharp contractions in gross domestic product (GDP) brought about by the pandemic, which in turn have left large output gaps (the difference between actual GDP and potential GDP). Moreover, the EM recovery has significantly lagged that of DM, partly due to less fiscal spending and lower COVID vaccination rates. Weak economic recovery/output gaps are typically associated with lower inflation rates. 

EM policy makers started rates hiking earlier than DM central banks

On average, EM central banks have been proactive in hiking rates relative to DM central banks – despite weak domestic conditions. This is for a number of reasons.

1. The rise in commodity prices hits some EM countries harder than DM

While inflation impacts consumers across the globe, the recent surge in commodity prices is having a major impact on many EM countries. Food prices, in particular, have accelerated, given that both Russia and Ukraine are major food commodity exporters, globally. Food is the single largest component of inflation baskets in many EM countries¹. Some EM countries particularly in Latin America, however, have been somewhat shielded from the rise in global food prices as they produce much of their food locally and in some cases are less dependent on wheat/grain.

2. EM central banks have to work harder at proving their credibility and to avoid inflation expectations becoming entrenched

Although many of the causes of inflation could appear to be transitory (food, energy, supply shortages from the pandemic, etc.), once inflation starts to filter down to other areas, inflation expectations rise and behaviour changes. In EM countries, this can happen more quickly compared to in DM as most EM countries do not have a history of low inflation. 

3. EM central banks are used to inflation cycles and so policy makers can use interest rates more fully to address inflation challenges

The fact that most EM central banks did not carry out quantitative easing² during the pandemic means that EM central banks can use interest rates more fully to address inflation challenges, unlike DM central banks

4. Higher interest rates help protect EM countries against capital outflows as the Fed starts to raise rates

EM countries often suffer from capital outflows during periods of rising US interest rates because higher US rates generally mean a narrower interest rate differential with EM, reducing the compensation investors receive for EM country risk. As such, EM central banks need to be ahead of the curve with raising interest rates in anticipation of Federal Reserve (Fed) action. 

Proactive EM central banks have led to higher real yield differentials 

The acceleration of rate hikes by EM central banks has driven up nominal and real interest rate³ differentials between EM and the US, as shown in the chart below and EM real yields are now mostly positive across EM.

We believe that most EM countries are in a relatively strong position to face any upcoming challenges, in light of mostly solid fundamentals. EM local currency debt looks attractive with high real yield differentials. Given the starting point for EM exchange rates and the likely decent growth outcomes for most EMs, we think EM foreign exchange should be a positive contributor to total returns this year.

 

1. Data as at 6 March 2022. CPI: consumer price index. Inflation basket refers to a set of consumer products and services whose price is evaluated on a regular basis to track inflation. Source: Morgan Stanley
2. Quantitative easing is when central banks make large scale purchases of financial assets to increase money supply, which helps lower interest rates and therefore stimulate economic growth.
3. A real interest rate is adjusted to remove the effects of inflation and gives the real rate of a bond or loan. A nominal interest rate refers to the interest rate before taking inflation into account.