Investor fears about inflation and higher rates contributed to periods of selloff in emerging market (EM) equities during the second quarter. However, I think these fears may be overblown. Here, I’ll share why I’m not too worried about inflation, and why interest rate hiking cycles aren’t necessarily bad for EM equities.
Deflating inflation fears
Many EM countries remain in the throes of the COVID-19 pandemic. Demand recovery has been weak, unemployment remains high, and capacity utilization has been low with plenty of economic slack[i] and supply chain bottlenecks. In my view, significant inflation is unlikely in EM, especially over the medium term.
Now let’s consider US inflation. As the chart below shows, short-term EM inflation expectations are typically quite correlated with US inflation expectations, especially during periods of crisis. Currently, the correlation is 0.9, around the highest it has ever been.[ii]
I think most of the inflation pressure in the US will be transitory, though some of it may be permanent. For instance, I believe wage inflation in the low-skills service sector will recede as benefits and stimulus payments roll off. I also believe base effects have contributed to higher inflation in industries hit hard by the pandemic, such as travel, tourism, transportation, hospitality and entertainment. Finally, I expect supply chain bottlenecks to open up over time, easing supply-driven cost pressure. I believe these outliers, which have been a big component of the recent increase in US inflation, will ebb away over the next year.