Emerging markets' inflation trap
By Jim Jubak
Don't get caught investing in developing markets until it is clear that interest rate hikes have tamed inflation. India and Brazil may be safe by June; other emerging nations likely have more pain ahead.
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One and done. Two, we're through. Three, we're free. Four, no more. Five . . .
At some point, the central banks of India, Brazil, Indonesia, Turkey and other developing countries will decide that they've raised interest rates enough to combat inflation. They will see (real or imaginary) signs of the slowing economic growth they've been working to engineer, as well as evidence (significant or temporary) of slowing price increases. And then they'll call an end to a series of interest rate increases that are now at seven -- and counting -- in India and that are on track to take interest rates to 13% in Brazil by the end of 2011.
Then the fears of higher interest rates and slowing economic growth, which have been a heavy weight pushing down prices in these countries' markets in 2010 and so far in 2011, will lift. And at least some of the cash that has flowed out of the world's emerging stock markets to the stock markets of the world's developed nations will reverse course. At that point, if these emerging markets don't begin to outperform the U.S. stock market, they will at least close the performance gap that has opened in the last nine months or more.
At some point.
We have a long way to go until then
Of course, the big question is when this will happen. Your answer to that will determine how far into 2011 it will be before you start to move your portfolio (which you've overweighted with U.S. stocks, right?) back toward an increased exposure to emerging markets.
The answer to that "When?" is "Not yet." That's true even for the countries with the most aggressive efforts to fight inflation. For developing countries with less aggressive, more incremental policies toward fighting inflation, I'd say the answer is "Who knows?"
The nations with central banks that have most aggressively raised interest rates in this cycle -- India and Brazil -- have yet to see convincing evidence that the rate increases they've instituted have slowed growth or ended the acceleration of inflation.
In India, for example, where the Reserve Bank of India next month is almost certain to implement the country's eighth interest rate increase in the last 12 months, the economy may be showing signs of slowing. Industrial production grew by an annual rate of 1.6% in December, a big drop from the 3.6% rate in November. But many economists caution that this could result from a pattern in last year's industrial production that made it easier to beat the previous year's numbers in November than in December.
In short, the December deceleration in this one measure of growth might be a sign that the bank's interest rate increases are working, but this one figure isn't likely enough to convince the bank to reverse policy.
In fact, Reserve Bank governor Duvvuri Subbarao recently raised his projections for inflation for fiscal 2011, which ends in March, to 7% from his earlier estimate of 5.5%.
The situation is not that much different in Brazil, which has been nearly as aggressive in raising interest rates as India. In December, Brazil's central bank raised its benchmark Selic interest rate 0.5 percentage points to 11.25%. There's no sign yet that the interest rate increases have slowed inflation. In January, Brazil's IPCA inflation index rose by 0.83% for the month, increasing the annual rate to 5.99%. The January increase matched the one in November, which had marked the fastest gain in prices since April 2005.
The annual rate of 5.99% is pushing the upper limits of the Banco Central do Brasil's inflation target of 4.5%, give or take two percentage points. The futures market is pricing in another interest rate increase in March to 11.75%, and is betting on a further increase to 13% by the end of this year.
In the cases of these two countries with aggressive central banks, the smart thing for investors to do is check back in June or so. It's quite possible that Brazilian and Indian economies will be showing clear signs of deceleration by then and that their central banks might be nearly done with rate hikes. When investors can see the end of rate increases not too far in the future, it is certainly time to think about buying.
Plenty of wishful thinking in developing nations
"When?" is harder to pinpoint for the remainder of the emerging economies, because the governments and central banks in these countries are proving to be lukewarm inflation fighters at best.
To see what I mean, take a look at Indonesia. On February 10, the Indonesian government reported that GDP grew at a 6.9% annual rate in the fourth quarter of 2010. That was the fastest economic growth in six years.
That very welcome growth rate came with rising inflation, though. In 2010, inflation was 6.96%; in 2009, the figure was 2.78%.
But while inflation climbs, the Bank of Indonesia has been extremely reluctant to raise interest rates for fear of lowering the economy's growth rate -- even though conventional central bank wisdom says cutting growth is exactly what you have to do to slow inflation. Dampening growth sooner rather than later makes it easier to prevent inflation from running out of control.
When the bank did raise interest rates to 6.75% on Feb. 4, that hike was a token 0.25 percentage points. That's not much when, at 6.50% before the increase, rates were at an all-time low. It's also not much when you consider that this was the bank's first rate increase since October 2008.
Despite the surge in inflation, and the timid response by the central bank, the economic consensus was that inflation rates would fall in the short-term, because the main rice harvest begins in March. That always leads to a decline in food prices, economists noted. But a temporary, harvest-related decline in food prices really doesn't change the inflation picture in the medium term.
With Indonesia's economy growing at a rate of almost 7%, overseas cash flowing in, and global commodity prices climbing, the nation faces continued inflation from the current rate, which is also hovering around 7%. The central bank -- if it really buys the harvest/inflation argument -- is deep into very wishful thinking.
There's a lot of this going around in emerging markets. Chinese officials have repeatedly said that a good summer vegetable harvest will dramatically lower food inflation in China, removing one of the major causes for inflation that hit 5.2% in November, receded to 4.6% in December and is expected to bounce back to more than 5% in January. The People's Bank of China did respond to this rise in inflation by raising its benchmark interest rate to 6.06% on Feb. 8, but the increase was, as in Indonesia, a timid 0.25 percentage points.
The US learned its lesson in the 1970s
The problem with this kind of slow and timid response to inflation is that, as the Federal Reserve has amply proved with its own policy mistakes, small moves like these don't really cut inflation at all. They aren't enough to change behavior or attitudes, thus allowing inflation to become ingrained.
For example, in the late 1970s the Fed raised its benchmark interest rate repeatedly: from an effective 10.03% in December 1978 to 10.24% in May 1979, then to 10.47% in July 1979 and to 10.94% in August 1979. But inflation continued to climb: from 6.84% in January 1978 to 9.28% in January 1979, to 10.09% in March, to 10.89% in June, to 12.18% in September and to 13.29% in December.
With inflation that ingrained, the U.S. central bank finally pulled out the big guns, raising the benchmark Fed funds rate to 13.77% in October 1979 from 11.43% in September. Yet even that wasn't enough, and inflation continued to climb until it hit 14.76% in March 1980.
That pushed the Fed had to pull out even bigger big guns, raising interest rates in one fell swoop from 14.13% in February 1980 to 17.19% in March.
That finally broke the inflation trend, and by July 1980 inflation was down to a mere 13.13%. Inflation finished 1981 at 8.92%; by the end of 1982, it had collapsed to 3.83%. Of course, those 17% short-term interest rates sent the U.S. economy into a major recession. U.S. gross domestic product fell 7.9% in the second quarter of 1980 and 0.7% in the third quarter.
Inflation could slow, but don't count on it
I'm not saying that any emerging economy is going to repeat the U.S. experience of the late 1970s and early 1980s. But I am saying that the longer inflation is allowed to grow and the longer policy is based on an exceedingly incremental series of interest rate increases, the harder it is to discern an end to that series of hikes. And with each baby step, the likelihood grows that the central bank will be forced out of a policy of small increases designed to preserve economic growth and into a policy of big increases that produce exactly the kind of economic slowdown the bank was trying to avoid.
That doesn't mean current economic policy in those countries is necessarily headed toward inflation disaster. But countries pursuing this kind of incrementalism will need the cooperation of factors beyond their control -- good weather and good harvests, a decline in global commodity prices (I can't see why this one would happen short of a decline in growth in developing economies, but maybe you can) and/or a big pickup in U.S. growth that slows cash flows into developed economies. Those events could result in the kind of slowdown in inflation growth that the more timid central banks are hoping for. I certainly don't see domestic policies alone producing that result.
These countries might get lucky, but they might not. For investors, that will make reading the course of inflation, interest rates and economic growth in emerging economies outside of India and Brazil as difficult in the second half of 2011 as it is now.
Jim Jubak manages the mutual fund Jubak Global Equity Fund (JUBAX).
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