Key points

• Rising inflation is becoming a major concern in Asia and other emerging countries. So far it’s largely due to higher food prices. Non-food inflation remains reasonably benign.
• However, with strong growth having used up excess capacity and monetary conditions remaining easy, a flow on to higher non-food inflation is a growing risk.
• As such, expect further monetary tightening in Asia and the emerging world.
• This is positive for Asian and emerging country currencies generally, but is likely to continue to act as a dampener on emerging market (EM) shares relative to traditional global shares over the next six months.
• However, our cautious short term stance on EM shares doesn’t alter their favourable longer term outlook.

Introduction

Rising inflationary pressures in Asian and emerging countries are clearly starting to worry investors. Many are fretting policy makers in these countries will be forced to tighten aggressively, threatening a key driver of the global recovery and the performance of share markets in the emerging world. These concerns are most evident in China and India. Coming at a time when the US outlook is improving this has seen Asian/emerging market shares underperform developed market shares since November. But how big a threat is it?

Rising inflation so far mainly limited to food

Emerging world inflation is on the rise. So far the main driver has been higher food prices and to a lesser extent higher energy prices. The next chart focuses on Asia, but it’s a similar picture in emerging countries generally.

Source: Bloomberg, AMP Capital Investors

World food prices have now surpassed their 2008 record high largely reflecting adverse weather.

Source: IMF, AMP Capital Investors

While higher food prices have also boosted headline inflation in developed countries, the impact there is much smaller as food has a greater weight in Asian and emerging country CPI baskets than in rich countries. Food has a CPI weight of 31% in Asia and 26% in Latin America compared to 15% in Europe, 8% in the US and 16% in Australia.

Higher energy prices have also played a role but so far non-food price inflation has remained reasonably benign.

Will there be a flow on to non-food prices?

Food price inflation comes and goes. Even though food stockpiles are low, better weather in the year ahead could well see it abate – despite longer term structural forces of rising per capita incomes in emerging countries and bio fuel demand which are positive. So the key issue is whether there will be any flow-on to core inflation? Here the key determinant is the amount of spare capacity as this will determine whether companies have the pricing power to pass on increases in raw material costs and workers have the power to demand higher wages to compensate for food price increases. On this front the risks are rising, albeit from a low base. Output gaps, which show the difference between the level of actual and potential GDP or output, are a good guide to inflationary pressures. Right now they are benign. Output gaps in the emerging world have closed indicating that spare capacity has been used up, but output gaps are not as positive as was the case in 2007 and 2008. See the next chart for Asian countries.

However, if economic growth continues at its current pace, output gaps are likely to become positive leading to increasing price and wages power and potentially a pick up in core inflation over the next two years. The risk is probably greater in Brazil, India and China. Wages growth has been picking up in China and Vietnam, although it’s mainly minimum wages and overall wages growth is still low relative to nominal GDP growth. High capacity utilisation and rising labour costs are already resulting in significant upwards pressure on non-food inflation in Brazil.

Source: IMF, AMP Capital Investors

A major concern for Asia and the emerging world is that monetary policy is still relatively easy. Many countries in Asia have resisted exchange rate appreciation following China’s lead and while interest rates have been increasing because of uncertainty about the strength of the global recovery they have generally not kept up with the increase in inflation. As a result real interest rates remain negative. Relatively easy monetary policy at a time when domestic demand is strong and spare capacity has been used up add to the risk of the uptick in headline inflation flowing into underlying inflation across Asian and emerging countries, as is already occurring in Brazil.

Source: Bloomberg, AMP Capital Investors

What is the likely policy response?

The upshot is that further monetary tightening is likely in emerging countries to head off a broader based inflation threat. Central banks across Asia and emerging markets generally have been tightening but more may be required over the next six months or so. There is also likely to be a greater tolerance for currency appreciation as it will help control food prices and inflation generally.

Fortunately, the inflation threat is not as great as it was in 2007-08 as output is still close to potential and capacity pressures are not as intense (except in Brazil, amongst the majors). The surge in food prices will also act as a bit of a constraint on household spending power. As a result we don’t see the need for monetary tightening to become excessive to the extent it threatens continued growth. Rather what is required is for growth to slow back to more sustainable levels – around 9% in China and 5 or 6% in the rest of Asia.

What are the implications for EM share markets?

While monetary tightening across Asia and EMs generally is unlikely to get so aggressive that it crunches growth, it is still likely to worry investors. As such, further tightening is likely to be a continuing drag on the relative performance of share markets in Asia and the emerging world over the next six months, until it is clear inflation is back under control. This relative underperformance is being accentuated by a somewhat idyllic combination (at least for now) of improving growth, low inflation and easy money in the US and northern Europe right now which is starting to be recognised by investor flows (away from bonds and emerging market shares towards US shares).

It is important to stress though that inflation in Asia is modest by past standards. For example, in China it is now running around 5% compared to the situation in the late 1980s and mid 1990s when it reached 25 to 30%. So while it is a short term concern it is unlikely to threaten the positive longer term outlook for these countries. And finally, from a strategic perspective share valuations in the emerging world are not demanding. EM shares are trading on a forward price to earnings multiple of 11.3 times and Asian shares on 12 times, which is slightly below the global share average of 12.5 times.

What about inflation in developed countries?

Concerns about inflation have also arisen in developed countries but the risks are much lower here. As already noted, food has a much lower weight in developed countries. Secondly, there is still plenty of spare capacity in the US, Europe and Japan. This is evident in unemployment still running around 10% in Europe and the US. Finally, while monetary conditions are very easy in advanced countries, money and credit growth remains very low. So while high food and energy prices may cause occasional inflation scares in developed countries this year, headline and, particularly, underlying inflation is likely to remain benign overall at least for the next year or so.

Source: Thomson Financial, AMP Capital Investors

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