NOVEMBER 29, 2010.
Emerging Wild Card: Inflation
Price pressures in emerging markets could force central banks to tighten aggressively, roiling assets and currencies.
By TOM LAURICELLA
While many investors have been fixated on the European debt crisis, concerns have been quietly building about the potential for inflation problems in emerging markets.
The fear isn't that emerging-market countries will return to the kind of hyperinflation that was so damaging in the past. Rather, the worry is that high food and energy prices, combined with capacity constraints and the Federal Reserve's easing move in the U.S., will force emerging-market central banks to raise interest rates more aggressively than is currently expected.
That's especially the case in some Asian countries, which are seen as having kept interest rates inappropriately low because of concerns about the strength in their developed-market trading partners, such as the U.S.
"They probably have let inflation go further than they otherwise would," says Robert Horrocks, chief investment officer at emerging-markets specialists Matthews Asia Funds. As a result, "there is a real risk that these economies get overheated."
That could throw a monkey wrench into the expectation that emerging-market assets and commodity prices will rise as investors chase high-yielding assets. It could also create periods of disruption that send investors to safe-haven assets like the U.S. dollar, defying broad-based expectations that emerging-market currencies will rise.
"Over the next six months, the biggest single issue investors will need to factor into their decisions is how inflation is likely to affect the landscape," says Richard Yetsenga, global head of emerging-markets currency strategy at HSBC in Hong Kong.
One main reason investors haven't been concerned about inflation in emerging markets is that economic growth has been slower than expected in a number of key countries, such as Indonesia and Malaysia.
Still, expectations are for a rebound in emerging-market economies in 2011. A number of them, such as India, are seen as already operating at full capacity.
China, facing an inflation rate of 4.4%, has already moved more aggressively to tighten monetary policy than many had expected. Reflecting China's importance today, a mid-October rate increase sparked a selloff in global stock markets and a flight into so-called safe-havens such as the U.S. dollar.
There's a "growing urgency" among Chinese officials to get monetary policy to a more appropriate stance, analysts at RBC Capital Markets wrote in a research note published Friday.
"This should prompt more decisive action in the weeks and months ahead," including multiple interest-rate increases, the RBC note predicted.
China's tightening, and expectations for more, have contributed to declines in Chinese stocks, with the Shanghai Composite Index down 12% this year.
But other Asian stock markets are still enjoying healthy gains. Indonesian shares are up 44% this year, Thai stocks are up 35%, and the main stock indexes in India and Singapore are up more than 9%.
As a result, says Matthews's Mr. Horrocks, "there's no valuation cushion" for stocks should central banks of these countries become more aggressive than expected in tightening monetary policy. "Valuations are anywhere from 10% to 20% above long-term averages," he says.
One reason that China and other Asian emerging-market central banks could start ratcheting up the pace of tightening is that interest rates remain near low levels set in the wake of the 2008 financial crisis, even though many of those countries weren't hit as hard as developed economies.
That's clear in looking at real interest rates, which are interest rates minus the rate of inflation.
When real interest rates are negative, that is seen as a sign of very easy—and potentially inflationary—monetary policy.
Based on officially set rates, in South Korea the real interest rate is negative 1.6% and in Singapore it is negative 3.3%—both very accommodative levels, notes Natalia Gurushina, director of emerging-markets strategy at Roubini Global Economics. In contrast, she says, the real interest rate in Brazil is 5.6%.
"On average in emerging Asia there's more room to normalize rates," Ms. Gurushina says. This should play out first with higher long-term interest rates—and lower bond prices—in countries facing inflation pressures. Yields would then move higher across all maturities as monetary-policy tightening becomes more aggressive.
For emerging-market economies, food and energy prices play a bigger role in inflation pressures than in developed economies. This has been a big problem for countries such as Indonesia, where inflation is at 5.7%, and India, which saw inflation surge well into the double digits over the summer before settling back to 8.6% in October.
As a result, the more that food and energy prices rise, the more aggressively those central banks may step on the brakes.
"People are not focused enough on the rise in commodity prices and what that does in emerging-market economies," says Ruchir Sharma, head of global emerging-markets equities at Morgan Stanley Investment Management. "Beyond a certain point, a rise in commodity prices is not conducive to emerging markets."
In particular, Mr. Sharma is concerned about oil prices, which finished last week just south of $84 a barrel. "If the price of oil were to get back up to $90 per barrel, I would be turning more cautious," he says.
One conundrum for investors is how more aggressive tightening would play out in the currency markets. Most investors have been operating on the assumption that with the Fed keeping interest rates at zero for the foreseeable future, any moves by emerging-market countries to raise interest rates would attract even more money from yield-hungry investors.
This is an especially important question for investors who have been piling in to emerging-market bonds priced in local currencies. Many argue it's a no-lose situation, where even if bond prices fall because of inflation pressures, rising emerging-market currencies will still provide them a profit.
But since China tightened in October, the dollar has been on the upswing, albeit with help from concerns about the European debt crisis. In the current market environment, however, higher interest rates in China have been equated with risk aversion, and thus a stronger dollar. The U.S. dollar index is up roughly 4% since mid-October.
Traders say that until expectations for emerging-market rate increases become more widespread, they could continue to prompt safe-haven buying of U.S. dollars.
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