08/05/2008

Global Insight - May 2008 - Emerging Inflation

The implications of higher commodity prices are more serious for developing rather than developed economies, according to research published today by leading investment house, Standard Life Investments.

In the latest edition of Global Insight, its monthly investment view, Standard Life Investments examines the drivers of commodities, noting in particular the implications for global emerging market (GEM) economies.

Andrew Milligan, Head of Global Strategy at Standard Life Investments, said:

“The world economy is at an interesting juncture - an unusual mix of slow growth in some countries, combined with widespread inflation pressures largely driven by higher raw material costs. On some measures, global inflation reached 4.1% pa in March, the highest since early 1999. This primarily reflects higher commodity prices, specifically energy, precious and industrial metals and grains. The direction is by no means all one way though; many foodstuffs, such as coffee or sugar, are little changed from a year ago while nickel and zinc prices are some 40% lower.

“Investors have looked for a single explanation, but our analysis focuses on a complex interaction between cyclical and structural factors. Underpinning short term issues, such as one-off shocks to supply, failure to invest in supporting infrastructure, or the impact of exchange rates, our analysis warns that various long term supply constraints, say on oil output, have combined with well known shifts in demand, especially from GEM economies. On top of this, financial flows into commodities are exacerbating the situation. In the near term, triggers for investors to monitor include signs of weaker commodity demand or a turnaround in financial flows. Both macro economic and behavioural finance analysis will be required.

“The implications of higher commodity prices are more serious for developing rather than developed economies. One reason is simply the relative importance of raw materials to different economies. Food has a 10-15% weighing in the US, UK and Europe but typically 20-40% of the CPI basket in emerging economies.

“As such items are purchased frequently, consumers are very aware of price changes, which impacts on inflation expectations. However, this is still a relative price change: more expensive food and energy means consumers desire to pay less for, say, housing, clothing or electronic goods. The key issue for policy makers in OECD economies will be whether second round inflation effects appear. As long as labour markets are flexible, and monetary policy does not become accommodative, then such effects should be minimal. Hence, investors need to consider the winners and losers of the wealth transfer between different households, companies and countries.

“Emerging markets face more serious pressures as food and fuel are a much larger component of consumer spending. Commodity price increases are akin to a regressive tax; hence some analysts estimate that real wage growth over the past year has been close to zero in six of the 10 largest Asian economies. Second round effects from higher wages are often hitting corporate margins against a backdrop of slower global trade.

“The dual objectives of many central banks, maintaining price stability and solid economic growth, are increasingly difficult to reconcile. Some action is being taken to restrain inflation, such as exchange rate appreciation in China and Singapore or tighter monetary policy in India and South Africa. More will be needed as budgetary pressures force governments, in countries such as Indonesia, China and Malaysia, to reconsider fuel subsidies or price regulation. Such decisions are generally easier in a developed economy where energy intensively is materially lower, and policy frameworks are more amenable to absorbing shocks. Looking ahead, the risk is an inflation pulse forces a more aggressive response from policy makers and slower GEM growth. One conclusion of the House View is that the upturn in inflation in GEM makes individual country analysis more important, secondly it re-inforces our opinion to be wary of expensively priced equities in global emerging markets.”