The disruption caused by Covid-19 has been as widespread as it is unprecedented. Just about every country on earth has had to introduce restrictive measures to counter the virus, leading to instances of economic standstill and the need for aggressive fiscal stimulus.
As a UK wealth manager, the bulk of what we cover takes place in developed markets – the US, Europe, the UK itself, etc. Our investments are global, but we naturally tend to look to these key markets when we assess wider economic trends. If the Covid-19 pandemic has taught us anything, though, it’s that the world is more interwoven and codependent than we sometimes acknowledge.
So, here, we’ll explore the effects of Covid-19 and subsequent inflation on emerging markets. We’ll analyse the differences in response between emerging and developed markets, as well as the knock on effects of inflation pressures in some of the world’s less covered geographies.
How the key economies are faring
Let’s turn our attention specifically to the key emerging market economies. China, for example, managed to be ‘first in, first out’ as far as the pandemic is concerned – after a (relatively) small first wave, it has successfully avoided a second through testing and tracing on an enormous scale.
As a result, the contraction in the Chinese economy caused by Covid-19 was short-lived, with the country seeing record growth in the quarters following the initial outbreak. There are signs of potential issues going forward – shortages of semiconductors, coal and power to name a few – but, if we’re analysing the lasting impact of Covid-19 on the Chinese economy, it appears relatively limited.
In India, the story has been very different. The country was hit by a late first wave, after which the economy managed to get back on its feet and post a 1.6% expansion year-on-year between January and March 2021. Over the financial year, from May 2020 to April 2021, the Indian economy performed poorly as a result of the pandemic, with GDP narrowing by 7.3%.
The real crisis hit India in April of this year, when an enormous second wave of Covid-19 infections took hold in the country, on a scale far greater than the initial spread and, indeed, far greater than any other nation on earth. Infection rates have come down after peaking in early May, but the economic revival that was tentatively taking shape has been dampened.
Better planning has rendered the second wave less economically impactful than the first. Localised lockdowns are naturally less disruptive than the four hours notice the entire economy was given to close during the first wave. It also seems that India is over the worst of the crisis. Analysts predict a strong vaccine rollout and an uptick in economic activity globally to help the Indian economy pick up in the second half of 2021.
In the Brazilian economy, growth has been stronger than many analysts expected. The first quarter of 2021 saw 1.2% growth, some way above the 0.7% median forecasts, led principally by a 5.7% jump in the agriculture sector and a 4.6% jump in investments. This activity has come despite a second wave of infections, with the country one of the few to not impose a lockdown.
Inflation in emerging markets a concern
Of all the steps economies took to combat the impact of Covid-19, expansionary monetary policy has arguably been the most impactful. Governments in both developed and emerging markets have pumped money into their respective economies, slashed interest rates and more in a bid to shock the system back into action.
But what is really causing the insurgence of inflation in emerging markets? We can consider two components of inflation: highly volatile goods such as food and energy, which tend to have relatively high weights in EM consumer price, and core inflation, which tends to be driven more by the dynamics of domestic supply and demand.
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Most of the recent inflationary pressure has come from a slight increase in food prices and, more recently, from a rebound in energy prices from the lows we’ve seen during the pandemic. Although temporary, it’s likely that energy prices will continue to climb as global demand keeps growing. On the other hand, food inflation seems to have run far enough and may play a key role in offsetting the pressure of growing energy prices.
For what regards core inflation, whilst we see production bottlenecks and disruption in the value chain that can cause the price of some goods or sectors to rise in the short term, we do not see likely a situation where prices goes out of control over the next few years, also considered the flexibility of those economies to adapt to high levels of growth.
The real question is the extent of that resurgence of inflation. Citigroup’s emerging market inflation surprise index has jumped to its highest level since 2008, leading to countries like Russia and Brazil raising borrowing costs. There are similar noises coming from both Turkey and the Czech Republic, a sign that other emerging markets may well follow suit.
In countries like India and Mexico, inflation levels are above central banks targets. This then leads to a drop off in capital inflows to emerging markets and, indeed, the warning signs of that trend are already beginning to show. Another potential source of economic imbalances going forward would be monetary policy in the US. There is concern that we could see a situation similar to that of 2013, when signs of an earlier-than-expected tapering of US bond purchases led to capital outflows from emerging markets hitting unsustainable levels.
Emerging markets are of course watching for potential increases in the US with some preoccupation. The key issue here is the disparity in the speed of economic recovery. Slower vaccine rollouts and a lack of firepower in their own fiscal stimulus packages has meant that emerging markets are facing a slower return to financial normality. But, for now, there seems to be a widespread recognition by central banks that inflation is primarily related to short term trends and that economies will avoid ending up under too much pressure.
What does it mean for our portfolios?
Despite emerging markets equity having underperformed developed market equity since the beginning of the year, our long term analysis suggests that, over the next few years, emerging market equities will outperform. Of course, recent imbalances in the global economy have forced us to question our assumptions to be confident that they still hold.
A lot of the answers to these questions will depend on how countries manage the normalisation of their monetary policy over the next few months.
Some countries may choose to implement a more hawkish monetary policy, particularly if inflation proves to be a fundamental structural issue. If this is the case, government bonds in local currencies may suffer from capital loss, though the loss could be in some cases offset by an appreciation of the currency. Countries that don’t opt to taper may be affected by a stronger dollar, which would be problematic for both their debt and their inflation.
For government bonds in USD, we have a different scenario. They are exposed to the rise of the US treasury, which is expected to reach 2% by June 2022 – this asset class would not benefit from an appreciation of emerging currency since the bonds are denominated in USD. In that sense, we think that those countries will be more directly affected by the decisions of the Fed over the next few months.
During the pandemic, we’ve seen the powerful effect that a shock on the ratio between demand and supply of USD can have on the performance of emerging markets, so it’s important that any eventual appreciation of the currency is gradual. Currently, the view from the Fed is that both the tapering and the raising of rates will be gradual.
In this environment, emerging market debt remains a good asset class compared to the rest of the fixed income universe, since capital loss will be partially offset by their carry (~4.5% for local currency and ~3.8% for USD denominated).