The Evolving Divide

The Evolving Divide

The health and economic impacts of Covid-19 are well known. Thankfully, vaccine programs globally are proving effective at reducing transmissions and offering ways for economies to reopen.

However, the vaccination programmes are occurring at different rates, with poorer, emerging, economies lagging; and as such seeing a pickup in infections. These uneven influences are evident in charts 1 and 2:

Chart1: Vaccination Programmes Compared 

 

Source: Our World in Data, data as of 09/04/2021

Chart 2: Infection Rates

Source: Our World in Data, data as of 09/04/2021

In developed economies, such as here in the UK, vaccine success is allowing a ‘reopening’ of the economy. This will be particularly beneficial to our services sectors upon which the UK is reliant for the lion’s share of its economic growth. Improvements in UK manufacturing activity are also helping but manufacturing accounts for just 10% of our GDP whereas services accounts for 80%.

Throughout the pandemic policy support from central banks and governments has proved essential. First by providing damage limitation and second offering ammunition to kick start growth. As an aside furlough schemes have helped saving levels reach all-time highs and as consumers return to pre-pandemic spending habits most economists expect these high levels to recede.

Other interesting aspects associated with the expected surge in demand by consumers are the supply chain issues highlighted by us last week (https://www.tpllp.com/supply-chains-bottlenecks-and-cost-inflation).

Increased consumer spending, as we all know, will power up demand. Consequently, supply bottlenecks are not helpful at this juncture because it can push up prices which feeds inflation expectations currently responding to faster growth. These factors have seeped into bond markets causing bond yields to rise and contributing to sharp and fast sector rotations in equity and corporate debt markets.

In previous cycles, as developed market (DM) growth accelerates, emerging market (EM) economies typically benefit. This is normally reflected positively across EM equity markets. However, with vaccinations slow to materialise and infections rising, emerging market equities have lagged their developed market counterparts resulting in DM equities returning 9% this year and EM closure to 3%.

COVID infection rates and vaccination rollouts provide a simple generalised template for explaining economic growth prospects, but this does not explain everything for investors. They are capable of looking beyond the horizon to look through current shortcomings with vaccinations. In fact, this is what is happening right now in Europe. Consequently, there must be another or other factors at play in investor thinking holding back EM equity markets. One possibility is changing perceptions of inflation. We suspect this is influencing investor behaviour causing them to view DM equities differently from EM equities.

Inflation comes in different guises – demand pull and cost push. In DM economies demand-pull inflation is underway. As demand for goods and services outpaces production, firms respond by increasing prices. This is encouraging hiring to meet demand thereby reducing unemployment. The cycle continues when the growing need for labour leads to wage inflation which in turn increases disposable income. This is a key thesis behind growth ramping up in DM economies.

In EM economies cost push inflation is more problematic. It is caused by businesses experiencing higher input costs, such as higher component, commodity, or energy prices. An important point to note is this type of inflation is not wholly associated with increases in demand. Cost push inflation places pressure onto central banks to raise interest rates to combat its effects and in its wake curtails economic growth.

It is early days, but inflation pressures are starting to be felt within the emerging world. Chart 3 below shows how increasing costs for Chinese producers is starting to impact Chinese inflation whereas chart 4 shows how an increasing oil price is starting to impact the rate of inflation in some key Latin American countries.

Chart 3: Chinese Producer Price Index and Chinese Inflation

Source: Bloomberg, Data as of 31/03/2021

Chart 4: Latin American Inflation vs Oil Price

Source: Bloomberg, Data as of 31/03/2021

From experience we note that higher inflation and weakening growth dynamics tend to have a deleterious impact on emerging market currencies. They have weakened by almost 2.5% over the year relative to their developed counterparts. As a result, interest rates have also moved higher in these economies as EM central banks are expected to fight off the threat of inflation. These changing influences are making financial conditions tighter for EM economies; hence investor wariness has grown.

Conclusions

Global growth forecasts are increasing – the Organisation for Economic Co-operation and Development (OECD) are currently projecting global real GDP growth to be 5.6% this year.

Growth is unlikely to be synchronised across regions because recovery from COVID is disjointed. Much will depend on country specific handling of the virus with vaccines being a key tool. EM economies will eventually follow DM, but it requires their vaccination rates to increase.

In DM economies equity investors are currently sanguine about demand-pull inflation, but in EM economies cost push inflation has heightened equity investor wariness about the need for central banks to raise interest rates. Low vaccination rates and rising infections are simultaneously putting downward pressure on EM economic growth and weakening their currencies.

Global Markets