The reflation theme has become investors’ main focus of attention lately. This is particularly true in developed markets (DMs), which face a rapid acceleration of domestic demand amid surging commodity prices—including energy.
But the situation across emerging markets (EMs) is more varied. Many of these countries lack the fiscal space and central-bank firepower of their DM counterparts. They are therefore seeing a weaker improvement of their labor markets and a slower narrowing of their output gaps.
On the one hand, the speed of emerging markets’ recoveries will greatly depend on the progress of their respective vaccination programs, as many EMs continue to face vaccine supply shortages. On the other hand, some of them are highly vulnerable to commodity price shocks, particularly foodstuffs, as these items represent a large fraction of their Consumer Price Index (CPI) baskets, while others are more vulnerable to exchange rate (FX) volatility.
EM Inflation: A Transitory Phenomenon?
The inflation story in emerging markets remains highly differentiated, but the pandemic caused a sharp decline that was felt across all regions. While in 2019 aggregate EM inflation averaged 4.6% year-on-year (Y/Y), it fell to just 3% Y/Y in May 2020. A large part of the decline was driven by mainland China, where headline inflation fell from 5.4% Y/Y in January 2020 (the highest level since 2011, led by a surge in food prices) to 4.3% in May, declining to a trough of -0.5% in November. By May 2020, inflation had dropped ca. 1.6 percentage points (pp) in the Asia-Pacific (APAC) region (to 3% Y/Y). The Central and Eastern Europe (CEE) and Latin America (LatAm) regions also saw sizeable inflation declines from end-2019, albeit less pronounced than APAC. By contrast, the CPI drop in the Middle East and North Africa (MENA) & Sub-Saharan Africa (SSA) region (excluding Lebanon) proved more gradual, while in the Commonwealth of Independent States (CIS) it remained fairly contained.1
Since its trough in the second quarter (2Q) of 2020, inflation across emerging markets has accelerated at different paces. The steepest acceleration has been observed in the CIS region, where March 2021 inflation marked a three-year high of 6.1% Y/Y. Two countries largely drove this strong increase: (1) Ukraine (+6.8 pp increase since 2Q’20 to 8.5% Y/Y) due to a surge in food prices from a bad harvest, rising energy prices and a jump in the minimum wage; and (2) Belarus (+3.6 pp increase since 2Q’20 to 8.5% Y/Y) due to strong FX pass-through effects, food price increases, and more recently an increase in some regulated prices and tariffs. The dynamics in MENA and LatAm were less pronounced, but inflation is now above its respective three-year average and median levels. Meanwhile, inflation in CEE and APAC has accelerated slowly and remains below its 2019 levels. Weak Chinese inflation (0.9% Y/Y in April) continues to drag APAC inflation lower, but we expect it to gradually accelerate as global demand for Asian goods recovers.
Low base effects from 2020 will accelerate EM inflation in 2Q’21-3Q’21, but other factors are impacting it simultaneously. Between now and year-end 2021, the International Monetary Fund (IMF) expects headline inflation to increase in MENA & SSA and APAC, but decrease in the CIS and LatAm regions, particularly in those countries that have seen surges in food prices and currency weakness. Large output gaps will also exert downward pressures on inflation, especially in LatAm. By end-2021, inflation should be close to its 10-year average in all regions, except in the CIS where it will remain lower. Provided there are no significant deviations in the IMF inflation forecasts, these dynamics suggest that, on aggregate, inflation pressures are not as concerning as in DMs. However, the degree of inflation heterogeneity across EM countries is vast, and any regional generalization would paint an incomplete picture of inflation dynamics across EMs.
EM Inflation Drivers: Food, Energy, and FX Pass-Through
Food inflation has been rising across major emerging markets. However, several local factors impact food inflation, and the causes of higher prices have not been homogenous across regions. Inflation in items like fruit and vegetables in particular seems to vary across markets, due to local factors and climatic conditions for such items. More broadly, the IMF estimated in its latest report (April 2021) that the annual pass-through from international food prices to the domestic food CPI was much higher for middle- and low-income countries than for high-income countries (0.26 versus 0.14).2 This means that the impact on headline inflation is higher in EMs since food has a larger share in these countries’ CPI baskets. By comparison, food items in the United States and euro area represent 14% and 17.2% of their respective CPI baskets.3
Recently, agricultural prices have reached 10-year highs, but low base effects from 2020 point to a faster Y/Y acceleration over the next two quarters. This is particularly true for countries such as Brazil and Russia, where food inflation remains significantly above headline inflation. Within Central and Eastern Europe and Middle East and Africa (CEEMEA) markets, there are wider divergences. In Turkey, food inflation was as high as 17.8% Y/Y in March, led by oils and fats, fish and seafood. South Africa also saw elevated food inflation at 5.4% Y/Y, but low inflation for vegetables and fruit. Within Asia, food inflation was high only in a few markets, like the Philippines and India.4
The rise in energy prices and low base effects from 2020 will add further inflation pressures, but the (still large) negative output gaps will keep core inflation contained. Energy prices have fully recovered from their trough in 2Q’20 and are already feeding through the CPI baskets of many emerging markets. However, the pandemic caused one of the steepest contractions in gross domestic product (GDP) ever recorded and created deep output gaps. Domestic demand is expected to accelerate gradually as economies reopen and vaccination programs progress, but many countries have suffered deep structural damages to their already weak labor markets. The change in unemployment from 2019 levels is sizeable for many EMs but structurally, the damage is more severe given the level of shadow employment and the size of the informal economy in EMs.
We expect output gaps to narrow only gradually. Paired with our relatively stable FX expectations, this should help keep inflation expectations under control. But FX pass-through effects in many countries have proven sizeable, especially among large importers. Any additional bouts of EM currency selloffs will exert upward inflation pressures to this subset of countries, adding stress to inflation expectations over the short and medium run. Monitoring the financial account dynamics of these countries will therefore prove essential.
We conclude that inflation pressures, in general, are not a major concern for EMs, but need to be analyzed on a case-by-case basis and with special emphasis on countries’ respective output gaps.
We are not overly concerned by commodity-driven inflation, given that higher commodity prices tend to be correlated with stronger EM fundamentals. In addition, EM central banks can act quickly to counter more structural and persistent increases in inflation, given their low base rates and with liquidity measures at their disposal.
From an investment standpoint, current prices for EM inflation-linked bonds seem fair, in our opinion. Prices appear to warrant limited concern about a long-term impact from the recent uptick in inflation, which we expect to be temporary.
Want to learn more? Read the team’s more in-depth topic paper on this subject, with case studies in two emerging market countries.
What Are the Risks?
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1. Sources: National Central Banks, International Monetary Fund, Franklin Templeton Fixed Income Research.
2. IMF World Economic Outlook: Managing Divergent Recoveries, April 2021. There is no assurance that any estimate, forecast or projection will be realized.
3. Sources: Eurostat, US Bureau of Labor Statistics (as of May 2021).
4. Sources: National Central Banks. As of May 2021.
