1. Inflation – elevated but relatively contained compared to developed markets

Higher inflation and in some cases, rising inflation expectations, have been a key focus for investors this year, in both emerging and developed markets (DM). This is against a backdrop of large fiscal and monetary stimulus from governments around the world due to the ongoing pandemic.¹

There are several factors driving the acceleration in inflation in EM, including base effects from the pandemic shock, supply side bottlenecks, high commodity prices, weak exchange rates (in some cases), and a recovery in domestic demand. Base effects will eventually come out of the system and a recovery from EM supply side constraints should contribute to lower inflation, although the timing is hard to call.

Food prices form a much larger constituent of CPI inflation in EM economies compared to developed market countries, so these economies are more susceptible to supply shocks, both global and local. Many of these factors are likely to be transitional so it is reasonable to expect food inflation to stabilise as EM economies open up. That said, we will need to be watchful of longer-term weather and energy price driven impacts on food prices.

Energy prices tend to have a particularly large impact on EM, although the final effect on consumers varies as fuel prices are a politicised issue in many EM countries. Oil prices have recovered so far this year, driven by both demand and supply factors. On the demand side, we’ve seen a strong recovery, while supply has remained constrained. Oil prices now better reflect fundamentals and it is reasonable to expect at least some stability over the next 12-24 months as higher prices drive a supply and demand response. Base effects from rising oil prices should also normalise next year, helping to ease energy price inflation.

The pass-through from weaker exchange rates to inflation can be quite high in EM countries, particularly among countries that are large importers and so any currency weakness will exert upward pressure on inflation. Our frameworks show EM currencies to be near secularly cheap levels. While some of this is warranted by deterioration in growth and fiscal conditions, it would be reasonable to expect the next few years to bring greater EM FX stability.

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 Purchasing Managers’ Index (PMI) relative to EM), partially due to less pandemic-induced fiscal spending. Weak economic recovery/output gaps are typically associated with cyclically lower inflation rates.

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.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.