Inflation in emerging markets has not yet reached a peak

Investors are looking for signs that high inflation rates are easing, but the June figures are not encouraging, writes David Rees, emerging markets economist at Schroders.

Press EC Holds

Inflation in emerging markets (EM) appears to have increased further in June. Concerns that inflation has not yet peaked could put pressure on investment in emerging markets. This is happening at a time when emerging markets are already under pressure as investors increasingly expect a global recession.

Inflation was generally higher than expected in the 13 major emerging economies that have already published their data. Based on these early figures, inflation in emerging economies appears to have risen further.

Peak is out of sight due to external shocks

Schroders sees a rise in EM inflation as a catalyst for opportunities in local bond markets. However, two external shocks earlier this year distorted the picture. Inflation in emerging economies rose again and bond markets continued to sell off. Russia’s invasion of Ukraine at the end of February led to a sharp increase in food and energy prices. Meanwhile, the imposition of lockdowns in China created another disruption in global supply chains, further increasing pressure on core inflation.

Emerging market inflation

Looking ahead, it seems unlikely that there will be a quick resolution to the invasion of Ukraine. This means that geopolitical risks from Russia will continue to cast a shadow on the outlook for commodity prices for some time to come. Energy markets are particularly vulnerable due to fears that Russia will cut gas supplies to Europe. Meanwhile, fertilizer supply disruptions threaten agricultural prices, along with climate change and national export bans on some foods.

The recession risk is growing

In addition to these risks, the macroeconomic drivers for commodities have worsened. Activity indicators have weakened and the risk of a global recession is increasing. This has put downward pressure on the prices of many commodities in recent weeks.

Food and energy inflation will decrease in the coming months. In any case, current commodity pricing is now in line with the worsening growth outlook and implies that inflationary pressures should ease. Food and energy inflation may fall by 6 and 20 percentage points respectively in the coming year. That would be enough to lower average inflation in the emerging economies by around 2.5 percentage points.

core inflation

Core inflation should benefit from a reduction in commodity shortages in the coming months. Global Purchasing Managers’ Indices (PMIs) show that supplier lead times are improving as inventories are replenished, while port activity in China appears to be normalizing. A more general shift in global demand for services should also help take the sting out of commodity inflation.

However, core inflation in EM is higher than many indicators indicated. For example, core inflation is much higher than producer prices, which themselves have risen more than corporate output prices. And the relationship between underlying inflation and exchange rate movements is completely broken.

Interest rates must be higher to ease the pressure

This suggests that the disruption of the goods sector has not been the only driver of higher inflation, and that in some cases the overheating of the economies has also pushed up prices. There are of course nuances at national level, but in general this means that the EM central banks must raise key interest rates significantly in order to dampen demand pressure.

By comparing inflation expectations for the coming year with market-priced policy rates for emerging economies, it becomes clear that central banks in Latin America are on track to achieve this. In fact, real interest rates in the region may appear prohibitive as the economic outlook worsens, suggesting opportunities exist in these markets. On the other hand, expected real interest rates in parts of Eastern Europe and Asia appear too low, meaning that these bond markets are vulnerable to further price adjustment.

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