Certain investment strategies set to do well from emerging market inflation

Emerging market inflation presents a potential key risk for investors but it also an opportunity for certain investment strategies, it is claimed.

Inflation has reared its ugly head once again, with emerging markets being a particular focus of concern, reflecting in particular higher commodity prices and tighter capacity constraints.

Investors with emerging market exposure should therefore consider protecting their portfolio against inflation and even aim to capitalise on this risk, according to Philip Poole, global head of Macro and Investment Strategy at HSBC Global Asset Management.

Inflation is already above the central bank's target rate in many emerging economies and although many central banks claim this is due to temporary factors such as high food prices, Poole argues that the risk is that a supply side inflationary shock turns into a self perpetuating inflationary process. It follows that monetary policy needs to be tightened in many emerging economies.

‘The conundrum is that if emerging market countries raise rates when the Federal Reserve and other developed world central banks are on hold, this only increases the interest rate differential and carry in emerging currencies, attracting additional capital inflows from the lower yielding developed world,’ he said.

‘There is no escaping the fact that additional inflation in emerging markets could be the end result of  ultra loose policy in the developed world and currency intervention in emerging markets, exacerbated by food and energy-related inflation pressures and rapidly closing output gaps,’ he explained.

A good way to protect against the ravages of inflation is to buy protection via inflation-linked bonds (ILBs), while these are, in HSBC Global Asset Management's view, still affordable. ILBs work like a conventional bond; however, the principle and the coupon are indexed to inflation. As inflation increases, so does the coupon payment and the principle.

Jean-Charles Bertrand, chief investment officer, Quantitative Strategies, at HSBC Global Asset Management, said emerging market ILBs are an attractive asset class and should always be considered part of an emerging market debt allocation within a diversified portfolio in order to maximise the risk return profile.

However, in the current economic climate, these present a particularly appealing investment opportunity. ‘Emerging inflation linked bonds look on average fairly priced given the current consensus expectations of the macro environment, yet there are continuing upward inflation revisions,’ he explained.

‘Current inflation is already higher than central bank targets and given the strong growth of emerging economies and the continued increase in commodities prices, we expect the rise will continue in 2011. It is important to note that at the same time market expectations for inflation (breakeven inflation rates) remain relatively moderate and generally significantly lower than the peaks in 2008,’ he added.

Meanwhile, the emerging market asset ILB space continues to increase in size, currently over US$400bn or 20% of the emerging market debt market. As the market grows, so too should liquidity and trading efficiency.

Investors can potentially capture the opportunities in inflation via an investment strategy that focuses on sovereign inflation linked bonds. Bertrand said in addition to achieving the diversification benefits, a managed strategy approach is important because the magnitude of the acceleration of inflation varies between regions and countries, as inflation is dependent on a variety of factors such as each country's output gap, sensitivity to food and energy prices and the effects of expansionary monetary policy.

‘In the current context of structural rising food and energy prices, ample foreign capital inflow and extremely loose monetary policy in developed markets, we believe that the immediate risk of high inflation is more acute in countries where the output gap has closed or turned positive and domestic demand remains strong,’ he added.