Inflation is rising almost everywhere, but so far the overwhelming majority of policy response has been in the emerging world, and this is a reason we like some emerging currencies and prefer some emerging market bonds over others.
Supply, Demand, and Rising Prices
Investors have been dealing with inflation for most of 2021, and we have written about rising global inflation quite a bit recently.
Demand growth picked up in many areas coming out of the 2020 downturn, but it is probably not growing at a permanently higher rate today than before the COVID pandemic. There have also been supply constraints and dislocations, which are a feature of reopening the world economy after prolonged shutdowns.
Both of those things have been central to the rise in energy costs. The world has started needing a lot more fuel at a time when less of it is being supplied.
There have also been a number of idiosyncratic aspects to inflationary pressure in various places. There has been some tightness in labor markets, for example, because labor was hoarded or heavily subsidized throughout the pandemic to avoid layoffs and hardship. Temporary unemployment measures were so generous in some countries that they kept people out of the labor force.
As a result of those policies, in some places labor disappeared but laborers were still being paid. People who were effectively not in the labor force were acting as though they were. They still had an income and were still spending.
That produced varying labor shortages in some parts of the world, creating a supply bottleneck that is reflected in wages and average earnings rising quickly in some places.
We believe many of those inflationary developments should roll off in time. It is said, for example, that the best cure for high energy prices is high energy prices, and employment support policies that made labor less mobile are either gone or in the process of being lifted.
Most Central Bankers on Hold
The temporary nature of these dynamics is why several developed world central banks have said, again and again, that they think that higher inflation is transient and that they do not need to respond aggressively with monetary tightening.
Almost every central bank has done something, but in the developed world that something has been to scale back unconventional monetary accommodations, such as asset purchases, rather than increase policy interest rates. With respect to interest rates, most developed world central banks are telling us not to worry—at least not yet.
The financial markets expected the Bank of England to raise rates at its policy meeting in early November, but in the end the central bank didn’t move. Meanwhile, the head of the European Central Bank is still saying a rate rise is not likely next year, and no one is expecting anything out of the Bank of Japan. In fact, in Japan higher inflation is not being reported. That is also true of Asia more broadly—low inflation in China, South Korea, and Taiwan. The one exception for developed markets is New Zealand, whose central bank has increased interest rates twice, in October 2021 and again in late November.
Bond Markets—Still Not Spooked
For some periods during this year bond markets have worried about inflation. But the November 10 inflation reading out of the United States was potentially scarier than all those that preceded it. If you annualize the monthly consumer price index (CPI) increase for October, you get an 11% annualized run-rate for CPI. If anything were to spook the markets, we believe that should have been it.
But markets—although they are more concerned than central banks—were not particularly alarmed by that release, even though they had taken fright earlier this year by releases that likely were not quite as inflationary.
It is still therefore true that markets can adapt; they can get used to things. And, what central bankers in the developed world say, even if they do little, still appears to have a significant influence on how markets price themselves.
Who’s Hiking and Who’s Cutting?
In the emerging world, the story is somewhat different. Inflation is rising more quickly, and central banks do not have the same luxury developed ones do of being able to say it is temporary. And they appear to be responding.
Brazil continues to lead the way as the most aggressive hiker of interest rates, tightening six times so far in 2021, by a total of nearly 6%. And nobody thinks Brazil is finished.
Other emerging countries are not far behind Brazil. Russia has also raised rates six times in 2021, by total of 3.25%, and is not finished yet. Chile has raised rates three times since July, and each hike has been bigger than the last, a total of 2.25% so far. Mexico—three hikes. Colombia—two hikes.
Of course, some emerging economies, like some developed economies, have a more contained inflation rate and have not raised rates. South Africa has increased rates by just 0.25%. India has not moved at all.
And just to be different, Turkey has cut interest rates three times. That said, Turkey’s interest rates are the highest in our investment universe, but so is Turkey’s inflation rate. So, that’s worrying.
Because we are more concerned about inflation than central bankers, we have a Reflation macro theme. This theme adds risk to our Outlook (near-term) model over and above what the Equilibrium state of affairs would dictate due to inflation or reflation.
From a total portfolio perspective, our overall exposure to inflation as a risk factor is quite low in our view because we hold few bonds, and equities function largely as real assets, for which a general rise in inflation does not tend to devalue.
The Reflation macro theme enhances, or amplifies, the amount of risk we think the forces of inflation or reflation impart to the marketplace. These forces generally make things a bit nastier for developed world government bonds and for sectors and markets that perform best in a low-interest-rate environment. But we favor sectors that do not depend on ultra-low rates.
The Appeal of Emerging Currencies
What does this mean for our positioning?
We hold Brazilian debt, and we believe our reasoning is that much of the tightening in short rates has already occurred, and future tightening is significantly priced in, so we think there is a cushion to bond yields in Brazil. We also like the yields on South African bonds, which are very elevated despite much less inflation pressure in this country.
India has not raised rates, because inflation is still reasonably low there. However, we think bond yields in India are too low despite the low-inflationary environment, and do not find a position in Indian government bonds compelling.
In developed bonds, which are facing high inflation, we scaled back our exposures, mostly in the third quarter of 2021.
Among currencies, we like the currencies of the most aggressive monetary tighteners in the emerging world: the Brazilian real, Russian ruble, Chilean peso, and Colombian peso. We believe these currencies are deeply fundamentally undervalued in addition to (now) being backed by a greater degree of monetary policy support than elsewhere.
Of course, we continue to navigate through the inflation bump.
Thomas Clarke, partner, is a portfolio manager on William Blair’s Dynamic Allocation Strategies team.
