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EM inflation elevated, but still relatively contained; local markets could offer relative value

Arjun Madan, Global Portfolio Strategist at Capital Group:

Higher inflation and in some cases, rising inflation expectations, have been a key focus for investors this year, in both emerging and developed markets. This is against a backdrop of large fiscal and monetary stimulus from governments around the world, and multiple COVID variants amid a gradual vaccine rollout.

There are several factors driving the acceleration in inflation, including base effects from the pandemic shock, supply side bottlenecks, high commodity prices, weak exchange rates (in some cases), and recovery in domestic demand.

This has raised concerns as to whether this uptick in inflation will be temporary or more long-lasting. Base effects and supply side bottlenecks should ease in time, but commodity prices or exchange rate pass-through into core inflation, and any strength in domestic demand could create longer-lasting effects, particularly if it has an impact on inflation expectations.

  1. Food and energy prices

Food prices: Food prices form a much larger constituent of CPI inflation in EM economies compared to developed market countries, so these economies are more susceptible to supply shocks, both global and local.

Many of these factors are likely to be transitional so it is reasonable to expect food inflation to stabilise as EM economies open up. That said, we will need to be watchful of longer-term weather and energy price driven impacts on food prices.

The median EM economy CPI basket has roughly 25% of the basket in food, compared to less than 15% for the median DM economy, and less than 10% for the US.

Food inflation has generally been rising across EM since the pandemic, but the causes have not been the same across these countries and the outlook varies too, depending on local factors. Countries such as Brazil and Russia have seen food inflation well above headline inflation, while there has been more variation within Eastern Europe and the Middle East. In Asia, food inflation has been high in only a few countries, e.g. India, while others such as Thailand and China have witnessed food price deflation. 

Energy prices: Energy prices tend to have a particularly large impact on EM, although the final effect on consumers varies as fuel prices are a politicised issue in many EM countries. Consequently, a range of regulatory interventions are in place to reduce fuel price volatility. In addition, many EM countries are large oil exporters and so benefit from an improvement in the terms of trade and fiscal balance with a rise in oil prices.

Oil prices have recovered so far this year, driven by both demand and supply factors. On the demand side, we’ve seen a strong recovery, while supply has remained constrained. Oil prices now better reflect fundamentals and it is reasonable to expect at least some stability over the next 12-24 months as higher prices drive a supply and demand response. Base effects from rising oil prices should also normalise next year, helping to ease energy price inflation.

  1. Exchange rate pass-through

The pass-through from weaker exchange rates to inflation can be quite high in EM countries, particularly among countries that are large importers and so any currency weakness will exert upward pressure on inflation.

Research from Goldman Sachs highlights that in general exchange rate pass-through (ERPT) has declined in EM economies over the past two decades. Open economies have higher pass-through, while economies with monetary policy credibility have lower pass-through. Its calculations show the highest ERPT in Turkey, Romania and Hungary, and the lowest in Indonesia, South Korea and Mexico. Moreover, its research shows asymmetric outcomes in ERPT, with FX weakness more impactful than FX strength.

More broadly, our frameworks show EM currencies to be near secularly cheap levels. While some of this is warranted by deterioration in growth and fiscal conditions, it is reasonable to expect the next decade to bring greater EM FX stability. Investors should avoid a lookback bias in these times.

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