Mirae Asset : Building on principles

Inflation in EM — What are the drivers?

Over the past two quarters, emerging markets have experienced growing inflationary pressures, as we have seen headline inflation figures in much of this region rise steadily.

We believe the drivers of this inflation are twofold: One is temporary shocks to these economies, which should mitigate by the second half of this year, and the second is a longer term structural shift towards a new normal level of inflation.

Temporary shocks from foods will ease

The first driver of inflation in the emerging markets has been what we view as short term shocks to the system, primarily food price inflation. As detailed below, we believe that inflationary pressures will diminish progressively, given food supply shocks are expected to ease in the second half of 2011 and governments have been issuing swift policy responses in several emerging market countries.

As seen in the chart below, food price increases have been large contributors to inflation in the emerging markets. Excluding food price increases, however, core inflation figures in the emerging markets appear much more benign.

Food prices have risen comparably in the developed markets as well, but food accounts for a much larger percentage of the consumer price index (CPI)¹ for many emerging market countries and thus will impact overall inflation numbers at a disproportionate rate. For example, food comprises nearly 33% of China's CPI and 38% of Russia's. By contrast, in the United States, food comprises about 8% of the CPI and in the United Kingdom, food accounts for about 11% of CPI. So, while developed nations are experiencing similar increases in food prices, the impact of food inflation on their headline inflation numbers is not as great.

We think there are several reasons to believe that the recent food inflation will be temporary. First, we believe the negative impact of weather volatility may mitigate this year. According to the FAO (Food and Agriculture Organization of the United Nations), there have been weather surprises throughout the second half of 2010, which had negatively impacted food supply globally. We expect more favorable prospects for 2011 if weather conditions are less volatile.

Second, we believe the governments of emerging market nations have been proactive in monetary policy when responding to signals of inflation. For example, after an almost three-year hiatus, we have seen China raise interest rates three times since October, 2010 to the current one-year lending rate of 6.06%.² Other emerging market countries including India, Brazil, Korea, and Indonesia, have also raised interest rates in early 2011 as well - while the long-term impact and effectiveness of such policy moves remain to be seen, we believe that governments in such developing countries are reacting appropriately to inflationary pressures.

Third, several emerging market countries including China and India are addressing issues like hoarding and speculation of food, and simultaneously, they have been seeing increased efforts globally to dedicate more resources towards the agriculture sector, from institutions such as the World Bank.³ In fact, we have seen early indications of positive results from these trends, as countries like Brazil, India, and China have all seen declines in food inflation in February, 2011.

Longer term, we believe inflation will remain in line with economic growth

We believe the recent inflation we have seen in the emerging markets is also part of a durable new trend as growth in these regions continues to outpace that of the developed world. For example, in the United States, the real GDP⁴ growth rate in the fourth quarter of 2010 was 2.8%⁵ and is expected to be 3% in 2011.⁶ Thus, the trailing five year average inflation rate in the U.S. of 2.25%⁷ is, in our opinion, appropriate, relative to the forecasted GDP growth rate.

However, when we look at China, the picture is different. China's real GDP growth rate in 2010 was 10.1% and is expected to be 9.6% this year,⁸ while annualized inflation rates averaged less than 3% over the past five years.⁹ This year, the inflation rate in China has increased to close to 5%,¹⁰ and we believe this narrowing gap between the inflation rate and the real GDP growth rate is, in part, a reflection of the strong growth of the country's economy. So while there may be some easing of Chinese inflation during the second half of this year due to the mitigation of food price inflation (as discussed above), we do not expect inflation to return to historically low levels.

Growing sociopolitical risk in the MENA region

The primary risk to our inflation outlook for 2011 is the growing sociopolitical instability in the Middle East and North African (MENA) nations.

We have recently seen turmoil in Egypt, Libya, and many other nations in the MENA region. The impact of these events has been felt across the global economy, with outcomes such as rising oil prices and lower risk appetite for emerging market equities. In the short term, such shocks to the global economy tend to increase inflationary pressures, perhaps causing monetary policy makers in the emerging markets to delay easing.

On the other hand, if such civil unrest persists, governments may decide to begin easing interest rates to fight a possible slowdown in the economy. The endpoint of such geo- political tensions is notoriously difficult to predict. Thus, they remain an ongoing risk for investors.

Is inflation in Emerging Markets really all that bad?

There might be a more profound question investors should consider, regardless of the short-term dynamics in inflation numbers: is inflation in emerging markets all that bad? We do not believe so, provided it occurs in a controlled manner.

While concerns persist about price levels and supply-side trends, we view the other side of the equation as equally important, namely income and demand-side trends. For example, the food inflation noted above has partially been driven by the demand for a higher protein diet, as wages rise in countries like China.

With this wage inflation, people living in cities like Shanghai have higher incomes and are able to enhance their standard of living, despite price increases. Thus inflation in emerging markets, assuming it is controlled, is likely not detrimental to long-term growth potential. We believe such benign inflation may, in fact, support the growing consumption power of emerging market consumers and help nurture a new generation of global corporations based in emerging markets.

The pullback in EM Equities: Could be a potential opportunity

We view the recent weak performance of emerging market equities as driven by three primary factors: (1) the rotation of funds into the developed world (mainly the U.S.) in anticipation of recovery and relative valuation, (2) profit taking after strong returns in 2010 in several emerging markets, and (3) concerns about inflationary pressures and political unrest in the emerging markets.

We appreciate the need for profit-taking in a portfolio and do not view this as a structural issue. Relative valuation however should be considered separately, but overall we believe valuations for emerging market equities generally remain compelling, particularly considering growth expectations and attractive demographics in the regions. In addition, we have continued to see current allocations to the emerging markets lagging, particularly in the U.S., as the majority of portfolios have remained heavily biased towards developed markets, in our opinion.

As noted above, we think that the third factor of inflation will ease, to a certain extent, in the second half of this year. In our opinion, rising inflation in countries like China is also a reflection of the country's growing consumption power, which will be beneficial to the country and its global trading partners going forward. Therefore, we believe investors should view the recent pullback in the emerging markets as an attractive opportunity to add exposure to this region for the longer term.

¹A Consumer Price Index (CPI) is an inflationary measure that expresses the current price of a basket of goods and services in terms of the prices during the same period in a previous year.

²The People's Bank of China (PBOC) raised one-year lending rates on October 20, 2010 to 5.56%, on December 24, 2010 to 5.81%, and on February 8, 2011 to 6.06%

³In February, 2011, the World Bank committed to providing $6 billion in a fund for food security.

⁴GDP or Gross Domestic Product is defined as the total market value of all final goods and services produced in a country in a given year

⁵Source: Bureau of Economic Analysis, US Department of Commerce, January, 2011

⁶Source: International Monetary Fund (IMF), historical and estimated data

⁷Soucre: Bureau of Economic Analysis, US Department of Commerce, January, 2011

⁸Source: International Monetary Fund (IMF), historical and estimated data

⁹Source: International Monetary Fund (IMF), historical and estimated data

¹⁰As of January, 2011, the inflation rate in China was 4.9%