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.
As a result of this, it is interesting to note 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 (EM) central banks have mostly continued their long-term drive to bring inflation down. Unusually, the recent period, has been characterised by EM inflation being relatively more contained than that of developed markets (DM), as shown in the chart below.
Source: Capital Group
We see two key factors as to why inflation has been more contained in emerging markets. First, EM countries are facing a weak economic recovery from the Covid-19 pandemic. While GDP has contracted in both EM and DM nations, lower fiscal spending and lower Covid vaccination rates within emerging market nations have contributed to a lag in their economic recovery. Weak economic recovery and output gaps are typically associated with lower inflation rates.
The second factor is that central banks in emerging markets have been more proactive in raising interest rates, relative to DM central banks – despite weak domestic conditions. This is for a number of reasons.
Rising commodity prices have hit a few EM countries harder than DM nations. Food prices, in particular, have accelerated, given that both Russia and Ukraine are major food commodity exporters, and this is the single largest component of inflation baskets in many EM countries.
EM central banks also traditionally have different challenges to their DM counterparts. Most notably, they have to work harder at proving their credibility and to avoid inflation expectations becoming entrenched. That said, 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 easing during the pandemic means that they can use interest rates more fully to address inflation challenges, unlike DM central banks.
Finally, higher interest rates help protect EM countries against capital outflows as the Federal Reserve 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 action across 2022 and beyond.
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 rate differentials between EM and the US. As such EM real yields are now mostly positive.
Overall, we believe that most emerging countries are in a relatively strong position to face any upcoming challenges over the coming months, in light of mostly solid fundamentals. One area in particular that we think the current market environment lends itself to is EM local currency debt, 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.
The first half of 2022 has already posed many different challenges to investors, and we believe this degree of uncertainty with likely remain for the foreseeable future. That said, emerging markets look broadly well-placed compared to their DM counterparts and we believe there are likely to be opportunities for investors with the required expertise over the coming months.
Kirstie Spence is a portfolio manager at Capital Group. The views expressed above should not be taken as investment advice.