Market Volatility
Relative value in EM local markets
Kirstie Spence
Portfolio Manager
  • Emerging market (EM) core inflation has risen by less than US inflation, in part due to weak economic conditions within EM and proactive EM central banks.
  • The acceleration of interest rate hikes by EM central banks has driven up real interest rate differentials between EM and the US, making EM local markets look relatively attractive. 

The recent surge in commodity prices has amplified the acceleration in inflation that we have been seeing globally, arising from disruption to global supply chains caused by the pandemic. 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.

An interesting observation is 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 central banks have mostly continued their long-term drive to bring inflation down. The recent period, unusually, has been characterised by EM inflation being relatively more contained than that of developed markets (DM), as shown in the chart below. 

EM inflation has risen by less than US inflation

Core inflation (year-on-year %)

As at 30 April 2022. EM inflation is weighted by the GBI EM index weights. Source: Bloomberg

We see two key reasons for this. Firstly, because EM countries are facing a weaker economic recovery, and secondly, because EM central banks have
been more proactive in raising interest rates. 

EM still facing a weak economic recovery

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. 

The EM recovery has lagged that of DM

Manufacturing PMI: EM minus DM

As at 31 March 2022. PMI: Purchasing Managers’ Index. Source: IHS Markit

EM policy makers started rates hiking earlier than DM central banks

On average, EM central banks have been proactive in hiking rates relative to DM central banks – despite weak domestic conditions. This is for a number of reasons.

As at 30 April 2022. Source: Bloomberg

1. The rise in commodity prices hits some EM countries harder than DM

While inflation impacts consumers across the globe, the recent surge in commodity prices is having a major impact on many EM countries. Food prices, in particular, have accelerated, given that both Russia and Ukraine are major food commodity exporters, globally. Food is the single largest component of inflation baskets in many EM countries, accounting for roughly 25% of the CPI basket in the median EM countries (and up to half the basket in countries such as India), compared to less than 15% for the median DM economy, and less than 10% for the US1. As demonstrated by the Arab Spring in the early 2010s, rising food prices can be hugely destabilizing in EM countries. Some EM countries particularly in Latin America, however, have been somewhat shielded from the rise in global food prices as they produce much of their food locally and in some cases are less dependent on wheat/grain.

2. EM central banks have to work harder at proving their credibility and to avoid inflation expectations becoming entrenched

Although many of the causes of inflation could appear to be transitory (food, energy, supply shortages from the pandemic, etc), once inflation starts to filter down to other areas, inflation expectations rise and behaviour changes. In EM countries, this can happen more quickly compared to in DM as most EM countries do not have a history of low inflation.

1. Data as at 6 March 2022. CPI: consumer price index. Source: Morgan Stanley

Kirstie Spence is a fixed income portfolio manager at Capital Group. She has 25 years of investment experience, all with Capital Group. She holds a master’s degree with honours in German and international relations from the University of St. Andrews, Scotland. Kirstie is based in London.

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