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

3. EM credit creation

Credit creation across EM economies has remained muted. Weak credit creation, if it persists, should contribute to moderation in inflationary dynamics.

4. Weak EM economic recovery/output gaps

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. Moreover, the EM recovery has significantly lagged that of DM (as can be seen in the chart below highlighting a stronger DM PMI relative to EM), partially due to less fiscal spending and lower vaccination rates. Weak economic recovery/output gaps are typically associated with cyclically lower inflation rates. A recovery in EM supply side constraints should also eventually contribute to lower inflation, although the timing is hard to call.

5. Central bank reaction function and interest rate differentials

Monetary policy plays an important role in longer-term inflation dynamics, especially inflation expectations. On average, EM central banks have been proactive in hiking rates relative to DM central banks – despite weak domestic conditions. Tighter domestic financial conditions should help anchor inflation by depressing domestic demand and defending against currency depreciation.

Separately, longer-term nominal and real interest rates across EM have substantially repriced and should start to offer value if/when the appreciation cycle in the US dollar peaks from Modern Monetary Theory (MMT) policies.
Local bond markets in Malaysia, Mexico and Russia look especially attractive over a 12-24 month horizon.

More broadly, with globalisation of supply chains, inflation is increasingly becoming a global dynamic. EM countries will need to remain vigilant about higher inflation and MMT policies in DM countries, especially if the latter shifts aggregate demand higher in DM without adding to supply. We believe markets are likely to reward proactive central banks.

6. Investing in an inflationary environment

Inflation-linked bonds can protect investors from a negative surprise in inflation by linking the bonds’ principal and interest payments to a nationally recognised measure of inflation. This can be particularly helpful in EM as inflation shocks are more common. Inflation-linked bonds (ILB) also offer a number of other benefits to a wider group of investors including exposure to local interest rates with lower volatility, the participation in any real exchange rate appreciation and to take a more direct view on inflation relative to the market.

The ‘breakeven inflation rate’ is the difference between a long-term nominal bond yield and the real yield available on an inflation-linked bond of the same maturity. At the breakeven rate of inflation, the expected nominal return to an investor will be the same, regardless of whether they are invested in a fixed nominal bond or an inflation-linked bond, and so investors would be indifferent to owning a nominal bond versus an inflation-linked bond. The breakeven rate can be thought of as the market’s expectation of inflation in a country. For investors expecting higher inflation than the one currently priced in by the breakeven rates, they can consider inflation-linked bonds. Over the medium to long term, the driver of inflation-linked bond returns will be changes in inflation. If inflation turns out to be higher than expected, inflation-linked bonds will do better than nominal bonds and vice versa.

While breakeven rates have increased recently across markets, ILBs may still offer protection from currency weakness or higher food and energy prices in select markets, should any of these turn out to be more persistent.

Conclusion

While near-term inflation risks might be skewed to the upside, the normalisation of supply chains and abating pressures from food and energy prices should help ease EM inflation.  Meanwhile, EM central bank proactiveness should anchor inflation expectations and help stabilise already cheap EM currencies. Looking further ahead, the structural convergence of EM and DM inflation, which has been in place over the past few decades of globalisation, should continue.