EM inflation: Mind the gap
In Short
By Witold Bahrke, Senior Macro and Allocation Strategist
A regime shift is taking shape in the global inflation landscape. In Developed Markets (DM), geopolitical
risks and the changing contours of globalization, newfound fiscal largesse as well as demographics point towards an exit from the post-GFC “lowflation” era. Within Emerging Markets (EM), however, a relatively disciplined policy stance and dis-inflationary forces from China has prevented trend inflation from rising. The net result is a structural narrowing gap between EM and DM inflation. We believe such a regime shift should improve the risk-reward in EM debt, particularly in the local currency debt space.
EM vs. DM inflation: Regime shift
In the aftermath of the pandemic, regime shifts are crystalizing in the global inflation landscape. While the dust from the pandemic has not completely settled, several global macro and policy factors supports our view that developed markets (DM) inflation will settle on a higher trend compared to pre-pandemic years. In addition, the gap between Emerging Markets (EM) and DM inflation is narrowing. In stark contrast to its DM counterpart, underlying EM inflation seems to settle close to its pre-pandemic trend. The reasons behind changing inflation patterns go beyond temporarily clogged supply chains in the aftermath of Covid. Historically, inflation has been a slow mover, exhibiting multi-year trends. This time is no different, in our view.
When dissecting the risk-reward of EM bond investing, inflation in both developed markets and emerging markets naturally has a key role to play. Consequently, a regime shift towards higher DM inflation and a narrower spread between EM and DM inflation would have wide-reaching implications for EM investors, particularly when it comes to local currency sovereign debt. So how has the global inflation landscape changed in the aftermath of the pandemic?
Topic du jour: DM inflation
As a starter, let’s take a closer look at developed countries. After declining rapidly in 2022-23 (see appendix figure 1) from multi-decade highs, DM inflation is showing signs of levelling off markedly above the “lowflation” trend witnessed after the Great Financial Crisis (GFC), see chart below. As things stand, inflation is still markedly above most DM central
bank’s inflation targets of around 2% annual price changes1. Several factors have contributed. While a deep-dive into the root cause of higher DM inflation is beyond the scope of this note, three of these factors are worth highlighting.
