Emerging and developed markets are diverging on inflation. What does it mean for asset allocation?
- In the second half of the next decade, the five-year, five year forward inflation swap shows Eurozone price rises running at 2.66%.
- Pessimism has been driven largely by rising oil prices, which are now at their highest level since April.
- China has now tipped into deflation, with CPI falling for the first time since the pandemic.
The muddled picture on global inflation has been amply displayed by the contrasting readings from the Eurozone and China. While the Eurozone could be wrestling with higher prices for some years to come, China may be entering a deflationary period. It is a complex picture, but could be an important factor in asset allocation.
In the Eurozone, the five-year, five year forward inflation swap, a measure of the market’s assessment of future price rises, showed markets now believe the ECB will struggle to get inflation back down to its target level of 2%. In the second half of the next decade, it believes inflation is likely to still be running at 2.66%.
The market’s pessimism has been driven largely by rising oil prices, which are now at their highest level since April. Tighter supply, particularly from Russia and Saudi Arabia, has offset concerns over China’s weakening demand. After significant falls in late 2022 and early 2023, gas prices have also started to edge higher. The concern is that rising energy and goods prices are likely to feed through to wage demands.
At the same time, China has now tipped into deflation. CPI fell for the first time since the pandemic. The country also saw sliding exports and imports. Its anaemic reopening after the Covid pandemic has not provided sufficient economic momentum to offset these problems, with the consumer reluctant to spend. It appears to be stepping up its efforts to stoke recovery through wider credit availability and supply side reforms.
Latin American economies also appear to be in a different place on inflation. Brazil, for example, cut its interest rates for the first time in three years, amid signs that its early and swift action on price rises has had the desired effect.
The world faces a situation where emerging markets are stimulating their economies through lower rates and rising credit availability, while developed markets labour under high debt burdens, inflationary pressures and rising interest costs.
It appears to be another argument for exposure to emerging markets over developed markets. Investors may have pared back emerging markets exposure in response to its dismal performance over the last few years, but this could be an important – and rare – source of growth in the difficult years ahead.
