There have been few silver linings to the financial and economic crisis. One has been the low inflation in developed markets (arguably too low). But this is no longer the case in emerging markets. By the end of 2010, a combination of excessive bank lending, strong economic growth and rising food prices were pushing emerging market inflation past the comfort of central bankers. Will this continue in 2011?
In the short term, emerging market inflation is likely to continue to be a problem, although arguably a manageable one. Why? First, emerging market inflation is likely to be more heterogeneous than in developed markets. While price changes in developed markets have historically been influenced by a number of common factors, such as global growth and US monetary policy, emerging market inflation has been determined by local, idiosyncratic factors. Second, the good news is that in many of the large emerging markets, while inflation is high it is decelerating. Inflation is down significantly from its 2010 peak in both India and Russia.
In assessing emerging market inflation investors will want to pay attention to three things: economic growth, bank lending and food prices. The latter two are particularly important in China, the only large emerging market where inflation is both accelerating and above its long-term average. In China, authorities are having some success reigning in the surge in bank lending. That will help eventually in bringing down the inflation rate. More problematic are food prices. In November Chinese inflation was 5.1%, two-thirds of that increase can be attributed to higher food prices, which rose by nearly 12% year-over-year. Unlike 2008 when higher food prices were largely caused by one-off supply shocks, this time the increase appears to be largely demand driven, i.e. as the Chinese get richer they are adopting a more Western diet.
The other country to watch is India. While their inflation rate is decelerating, it is still well above the central bank’s comfort zone. As in China, rising food prices are part of the problem. The other factor keeping India’s inflation rate stubbornly high is an economy bumping up against its natural speed limit. Industrial production is growing at nearly 11%, compared to a long-term average of less than 8%.
To some extent, while inflation levels are high and in a few cases rising, inflation in emerging markets is nowhere near the levels witnessed in the recent past. As a point of comparison, Brazil’s inflation rate was 15% as recently as 2003. Today, it is still under 6%. That said, emerging market valuations are no longer cheap relative to developed markets, and investor expectations have changed. While current inflation rates are likely to fall, it will take some time.
In short, for the near term – probably the first half of 2011 –the developed market environment of low inflation and low growth is likely to be a better environment for equities than that found in emerging markets. As a result, investors should consider overweighting developed markets during that period.
Sources: Bloomberg
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
