EM Inflation: Is the Scare Temporary?

25 June 2021

Despite US Federal Reserve Chairman Powell’s attempts to reassure investors, financial markets are concerned about inflation. Likewise, price growth has accelerated in key emerging market countries. In response, central banks in Brazil, Russia, Mexico, and Turkey have already begun to tighten monetary conditions.

Is Emerging Market inflation temporary? That is, does it simply reflect the post-Covid surge in food, energy, and other commodity prices? Or will the problem prove more persistent? The answer will have consequences for EM monetary policy decisions, which will have important consequences for EM currencies and equity markets in the period ahead.

EM Inflation-Targeting Builds Confidence

In recent decades, the establishment of inflation-targeting regimes by virtually all major EM central banks has played an important role in ensuring macro-economic stability and boosting investor confidence. The Table above indicates headline inflation is already above the top end of the target range in Turkey, Brazil, Russia, Mexico, India, and several others. Not surprisingly, the CBRT, BCB, CBR, and Banxico have been the first to lift interest rates.

More optimistically, however, “core” inflation remains well within the targeted range in all cases except Turkey, Mexico, Russia, and Poland. Of course, this is not to downplay the importance of headline inflation. Within EM nations, food and energy can account for 30%-50% of the CPI, compared to 10-15% in advanced economies. Therefore, higher food and energy prices potentially could have a more negative impact on EM household incomes, personal consumption, and overall economic growth. However, as monetary decisions can not directly impact these commodity quotes, EM central banks are likely to emphasise “core” inflation in the current enviroment. Monetary policy will aim to ensure rising commodity prices do not impact wage growth; thereby, preventing more persistent price pressures.

Post-Covid Scarring and Economic Slack

One reason I expect EM inflation risks will prove less persistent than in the USA is the existence of significant spare capacity in EM economies. The Chart above indicates the economic consequences of the Covid pandemic have been most significant in many EM nations, especially Latin America, India, and some other Asian nations. As a result, despite the strong initial post-Covid recovery, most EM economies will still have considerable “slack” well into 2023, especially compared to the advanced nations. Turkey, Poland, and Russia appear to have the least idle capacity; therefore, higher inflation in these countries becomes less surprising.

Covid Uncertainties Persist

Thanks to the development of highly-effective vaccines, the health emergency is now abating. However, the Chart above illustrates exactly how skewed the distribution of the life-saving vaccinations has been. Perhaps reflecting the region’s initially low level of Covid infections, Asia’s vaccination uptake has been very slow. Poorer countries, e.g. South Africa and India, also have had limited access to the required jabs. Likewise, with the exception of Chile and Uruguay, the number of people vaccinated in Latin America is about one-third the level in the advanced countries.

In the advanced nations, the vaccines appear to be not only limiting new cases, but also breaking the link between infection and hospitalisations and deaths. On the other hand, the death rate in much of Latin America, Russia, and South Africa remains high (reflecting low levels of vaccination) — Chart above. While the death rate remains low in Asia, mortality has accelerated recently in Indonesia, Thailand, and Malaysia.

More limited vaccination programs in Emerging nations will continue to pose potential economic risks. Investors and monetary authourities, therefore, will need to be on the alert for any signs of economic deceleration, e.g. the possible recent cooling in composite PMIs in India and China (Chart above).

Divergent Growth: Implications for Markets

As a result of US President Biden’s massive fiscal stimulus, US GDP growth is expected to exceed the EM expansion in both 2021 and next year. As a consequence of this divergent growth pattern, US inflation risks are likely to be more persistent than throughout the EM universe. In addition, while bloated US budget deficits pose medium-term risks, the US dollar may benefit immediately from the prospect of strong US growth and rising US bond yields.

What are the implications for EM markets and central banks? Mounting concerns about rising US inflation and Fed tapering have led to widespread weakness in EM currencies recently, following a year of “risk-on” appreciation (Chart above). Who’s potentially most vulnerable? Most importantly, countries with large external borrowing requirements are most at risk as US interest rates rise. The following Chart identifies Turkey and South Africa especially, as well as Colombia, Chile, and Malaysia.

The degree of FX over/undervaluation is also a key consideration. Turkey, Brazil, Colombia, Mexico, and Russia are very undervalued, which provides a cushion as US rates rise. Thailand, Philippines, and India, meanwhile, appear overvalued.

In addition, each country’s individual inflation risk and its initial stance of monetary policy will determine which countries are likely to tighten monetary conditions along with the Fed in the period ahead.

As we identified Brazil, Russia, Mexico, and Turkey as having the greatest inflation risk, it’s not surprising these countries got an early start on raising interest rates. Poland and India may have some catching up to do. On the other hand, as most Asian countries have low inflation risks and policy rates already above the USA, future rate hikes will lag the Fed’s tightening. Similarly, with the exceptions of Brazil and Mexico, Latin American inflationary pressures are lower than in the USA. Therefore, Latam monetary tightening will trail Fed actions initially.

Strategic Considerations: Putting the Pieces Together

  • EM inflation pressure will remain lower than in the USA through 2022. However, risks are greatest in Turkey, Russia, Poland, Mexico, and Brazil.
  • US GDP growth will outperform EM growth in 2021 and 2022. While bloated US budget deficits pose medium-term risks, fiscal stimulus may support the US dollar for now.
  • Reflecting divergent GDP growth, EM monetary tightening will lag the US Federal Reserve through 2022 in most countries, except those with heightened inflation risks.
  • The most promising EM FX outlook will be in countries with manageable external finances, undervalued currencies, and where central banks are prepared to pre-emptively tighten monetary policy prior to the Fed. Despite poor medium-term growth prospects, BRL and RUB are good examples, and now MXN can be added to the list. I also favour CLP (see my blog “Mid-2021 Review” for explicit FX forecasts through 2022).
  • Countries with large external borrowing requirements may be most vulnerable, even if the currency is undervalued: for example TRY, ZAR, and MYR.
  • Despite healthier external finances, overvalued THB, PHP, and INR may be at greater risk. Other Asian FX will weaken modestly, as monetary tightening lags behind the Fed.
  • Asian Equity Risk Premia provide a modest cushion against rising US bond yields (Chart below). Therefore, I expect Asian equities to outperform the US market.