A Balancing Act
In investing, as in life, there is a yin and yang. The balancing act between inflation and growth that economies often face is perhaps even more pronounced in the emerging markets world: stimulate growth too much, and inflation could flare, but stamp out inflation too hard, and growth could freeze. The fire of inflation seems to have moderated in some emerging markets (at least for the time being), and some central banks, including those in China, Brazil, Indonesia, Russia and Thailand, have taken actions over the past few months to stimulate growth. I believe the fundamentals in many emerging markets look supportive of these actions—as long as it doesn’t tip out of balance. Inflation is certainly a big challenge, and I believe it will probably be a very important consideration going forward.
No country is immune to inflation and emerging markets are no exception. In emerging markets a larger percentage of the total population is in the lower-income bracket, so inflation in such items as food and fuel are particularly important. In 2010 and through the first half of 2011, many emerging markets were engaging in policies to control inflation. However, tightening measures—such as increasing interest rates or raising bank reserve requirements—can come at a potential cost, possibly triggering currency appreciation and slowing growth. We’ve seen a bit of both in some emerging economies.
In my view, tightening moves over the past two years caused some emerging market currencies to become overvalued on a price-parity basis. This is a dilemma for policymakers since a strong currency can make the country’s exports less competitive on the global market. Again, it is a delicate balance. To combat currency appreciation due to foreign inflows, some countries have introduced various capital controls. For example, Brazil has raised taxes on foreign investments in fixed income securities, and China actively controls its currency.
We’re seeing signs that growth in some of these emerging economies is slowing, too. China’s government lowered its official GDP forecast to 7.5% in 2012, down from its pace of 9.2% in 2011.1 In December and again in February of this year, the People’s Bank of China cut its cash requirement for large banks to help drive growth forward.
The flip side is that over the past few months, statistics have shown inflation has been easing in some of these emerging economies. This is an encouraging trend. For example, Russia’s consumer price index fell to 3.7% on a year-over-year basis in February, down from readings of 4.2% in January 2012, 6.1% in December 2011, and 9.6% in May 2011.2 In South Korea, inflationary pressures eased to their lowest level in a year in February, at 3.1%.3 China’s consumer price index dipped to 3.2% in February from 4.5% in January1, marking the lowest year-over-year reading in 20 months.
At this time, I believe there is a bit more wiggle room for further stimulus in China and some other emerging economies, as they appear equipped to absorb these changes potentially without dramatically negative results. Fearful talk about the slowdown in China is ubiquitous, but as I have said several times, I don’t believe China is facing a hard landing, and that is worth repeating.
In my long-term view, China still has quite a lot of potential in its favor. China’s banking system looks to be in good shape, and infrastructure investment has been booming. The country’s foreign reserves at the end of 2011 totaled US$3.2 trillion1, the largest in the world. Perhaps China’s biggest resource, though, is its 1.3 billion people,4 whose incomes and standard of living have been rising. The shift to a consumer-oriented culture is well underway and seems poised to continue for the long term. If you think the Chinese people are going to give up their new cars and go back to bicycles, I can tell you: you’re probably mistaken!
I am equally optimistic about the long-term outlook for many other emerging economies. While several developed economies are still plagued by worries about their sovereign debt levels, many emerging economies are characterized by significantly high growth rates, low debt-to-GDP ratios, and high foreign reserves. Much of the growth in emerging markets is driven by domestic consumption, which seems tied to rising incomes and the growth of a young, working population.
Of course, there are always risks. Geopolitical issues are a factor in emerging markets (as they are everywhere) and could also contribute to inflation. Oil—an area of particular interest to me—is perhaps most vulnerable to these risks. Natural disasters can also have a dramatic impact on food crops and trigger price inflation, leading to domestic unrest. In the past few years we’ve seen this impact from drought and fires in Eastern Europe and from floods in Southeast Asia. To survive and thrive, companies must be equipped to absorb the impact of any higher commodity prices.
I believe the key is to remember that inflation, like a fire, has to be constantly monitored. I think inflation will exist as long as governments aren’t restricted in creating new money. So even with the progress we’ve seen on the inflation front, I believe it is something we have to remain vigilant about this year. While some emerging nations can temporarily shift their focus from inflation-fighting to igniting growth, others are still battling inflation. It is a constant balancing act between challenges and opportunities.
As an investor, one way to try to combat the forces of inflation and slower growth in one nation over another is to diversify—by asset and by country. Fortunately for investors looking to diversify, I believe there are many potential opportunities to choose from. Investors just need to know where to look for compelling opportunities. It’s our job to do the research to look for them. It is important to remember, however, that diversification cannot guarantee a profit or protect against a loss.
In terms of our investment approach, while there is no sure path to success, we will continue to do what we have always done: invest with a long-term horizon in companies that we believe are undervalued, fundamentally strong and growing, and that we think can weather difficult times. Even though it’s hard to get the balance just right, I am optimistic about the future.
Want more? Read Dr. Mobius’ recent collaborative effort with Dr. Michael Hasenstab, Franklin Templeton Fixed Income Group’s International Bond Department Co-Director.
U.S. readers can click on this link: “Emerging Markets, Yesterday, Today and Tomorrow”
International readers can click on this link: “Emerging Markets, Yesterday, Today and Tomorrow”
1 Source: People’s Republic of China, National Bureau of Statistics.
2 Source:Russia Federal Service of State Statistics.
3 Source: Bank of Korea.
4 Source: CIA World Fact Book, January 2012.