New research by JP Morgan shows that the bank expects a rise in inflation rates in the next year. Although this will affect most assets negatively, opportunities in emerging markets will remain good, due to dramatically improved economic fundamentals.
Policy-makers have changed their attitude towards inflation, according to David
Mackey, JP Morgan’s head of economic research. “Central bankers have become aware that inflation can be too low. We think we are moving towards a world where higher inflation will be tolerated”, says Mackey.
The economic recovery of Japan and emerging Asia, as well as China’s powerful continuing growth, has reversed the situation of the 1990s, when the region’s financial crisis contributed to a global fall in prices. Says Mackie, “The swing in Asia is a very important feature in the turn of landscape to a more inflationary world.”
Going forward, the bank expects a gradual tightening of monetary policy, with US Federal Reserve interest rates, currently at a real rate of 0%, gradually rising to a real rate of 2%. “The market still thinks that free money will be around”, says Jan Leuys, head of market strategy, “but free money is going to go away.”
Emerging markets today are in a much better position to counter the negative effects of a Fed tightening cycle, which in the past has repeatedly resulted in financial crises. Flexible exchange rates, a substantial reduction of budget deficits and improving external debt ratios mean that the ability to react to shocks has improved dramatically.
“More and more investors understand that emerging markets are a better risk class,” says Michael Marrese, head of sovereign strategy for EM Europe, Russia and Turkey. “Pension funds now dedicate a portion of their funds to emerging markets. That did not exist five years ago.”
Speaking on Russia, Marrese emphasized that although the growing authoritarianism of the government have placed costs on the economy, the political and legal risks have not fazed foreign investors. Investment is set to rise according to Marrese, with inflows into Russia increasing to $15 billion in 2005 up from $10.5 billion this year.
JP Morgan expects a reshuffle in the Russian government by the end of February. Says Marrese: “Putin needs a government that gives him alternatives. You’re seeing a slowdown in industrial production. In an environment where a president is so sensitive to growth, it is more likely that he will rethink his government.”