Emerging market inflation and its effect on developing economies such as the US is again stirring anxiety among investors. And with good reason.
A few years ago, the worry was that rising labor and commodity costs across China, India and Brazil and many other emerging economies would put sustained pressure on consumer import prices in developed markets and add to their economies’ inflationary pressures. Central bank stimulus exacerbated these concerns.
Vanguard estimated in 2011 that a hypothetical and immediate Chinese currency appreciation of 25 percent versus the US dollar would translate into a less than 1 percent rise in the US Consumer Price Index (CPI), all else equal. This is consistent with what occurred when the yuan appreciated 17 percent against the US dollar between 2005 and 2008, according to the Vanguard report.
However, the slow recovery in developed economic growth after the 2008 financial crisis served as a counterweight on increases in the CPI over the last few years, among many other factors.
Today, growth prospects in developed economies are improving, combined with more pronounced inflation and slower growth in emerging markets. Consequently, the focus has again returned to the prospect that the US could be impacted by inflationary pressures from abroad.
During 2008-2011, it was thought that a sharp appreciation in emerging markets currencies, such as with the Chinese yuan, would be the way in which inflation would be transmitted to the US economy. These days, increasing global commodity prices and weakening price pressure from less global competition are seen as the chief potential catalysts.
Emerging markets currencies in China, Turkey, Argentina and Brazil, for example, have all seen their currencies depreciate significantly this year, as investors exited emerging markets in mass during the beginning of the year. Many investors shifted their investm! ents into developed economies such as Europe as concern mounted that growth is faltering in developing nations while advanced economies are strengthening.
For example, withdrawals from US-based exchange traded funds (ETFs) investing in emerging market equities and bonds totaled $11.3 billion this year, already surpassing the redemption of $8.8 billion for the whole 2013, according to data compiled by Bloomberg.
And it is this faltering emerging markets growth (as well as increasing commodity prices) in developing nations that have set some investors on edge. Every shade of inflation protection was snapped up during the recent emerging market sell-off, from international inflation linked bonds to international treasuries to gold (see Chart A) at what could be described as incredible discounts.
The reason is that globalization or global competition has helped keep inflation in check in developed economies. As emerging markets are forced to raise interest rates in their domestic economies to curb inflation, this could hinder the competitiveness of their businesses and thus prompt developed economies’ domestic firms to raise the price level, allowing inflation to flourish in developed economies.
Chart A: Investors Snapped Up Every Form of Inflation Protection in Early 2014
Source: Created with Y Charts
According to a 2008 study by the Organisation for Economic Co-operation and Development, “it appears reasonable to conclude that rising levels of imports from all lower cost producers will have acted directly to reduce non-commodity import price inflation by up to 1 to 2 percent per annum in most OECD economies over the past decade, with globalisation related effects in goods prices also being reflected in some services prices as well.! ” !
Using a simple accounting framework, another recent study by the OECD shows that over the past decade imports from China and, to a lesser extent, other dynamic Asian economies, have placed downward pressure on the rate of consumer price inflation in the United States and the euro area. In the reported calculations this arises from two sources: an increase in import penetration by lower-price Asian producers, and the differences between the rate of growth of their export prices and producer prices in the importing economies.
But even as we know that less global competition would allow the price level to increase, economic studies are in disagreement as to by how much global competition puts inflation in check in developed economies, and thus by what rate it would rise in its absence.
“Although this would appear to suggest that trade with lower-cost producers is placing downward pressure on domestic prices in OECD economies, the eventual effect on inflation is less clear as the calculations show only ex ante effects. The extent to which they eventually lead to lower or higher consumer price inflation will depend on the effect they have onthe behavior of other competitors and domestically generated inflation,” the OECD study found.
Thus, the impact of globalization or global competition, or its weakening , on the price level will to a great degree be a result of the developed economy’s monetary policy, the OECD states. Given the unprecedented stimulus and the Federal Reserve’s accommodative stance one could conclude that the environment is ideal for increases in the price level to follow, even as further emerging market currency depreciation could somewhat dampen any inflationary effect caused by less global competition by making imported goods and services cheaper (See Chart B).
Commodities on the Upswing
There is great debate as to whether the trend will last. Commodities markets in the US and in emerging markets are all on a tear, which! could be! inflationary. In fact, hedge funds boosted bullish commodity bets to the highest since 2012, as extreme weather threatened global crops and a polar blast increased US demand for heating fuel, according to a report by Bloomberg.
The net-long position across 18 US-traded commodities rose 18 percent to 1.25 million futures and options in the week ended Feb. 18, the highest since September 2012, US Commodity Futures Trading Commission data show. For example, investors tripled the net-long position in arabica coffee this month to the most bullish since May 2011. Gold wagers climbed to a 16-week high.
In emerging markets, Brazil, the biggest sugar and coffee grower, had the driest January in six decades, scorching crops. Moreover, Arctic-like cold is projected for the eastern two-thirds of the US at the end of the month, boosting demand for natural gas. From extreme cold in the Midwest to drought in California and South America, weather is the "big driver of commodities," Barclays Plc said in a report. Commodity funds are headed for the first monthly inflows since September 2013, EPFR Global data show.
Furthermore, The Standard & Poor's GSCI gauge of 24 raw materials climbed 1.7 percent last week, the third consecutive gain and longest rally in four months. Every commodity except copper and zinc rose, led by coffee, natural gas, hogs and sugar. The MSCI All-Country World index of equities rose 0.5 percent, while the Bloomberg Treasury Bond Index was little changed. The Bloomberg Dollar Spot Index, a gauge against 10 major trading partners, increased 0.3 percent.
Many believe the present run-up in commodity prices is purely weather driven, but this could be the beginning of a new upward trend. Investors should pay heed, because this may be a rare opportunity to purchase what is still inexpensive inflation protection, as we have long argued.
Chart B: Inflation on the 
Rise in Emerging Markets
Source: Created with Y Charts
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