| LONDON, July 24
LONDON, July 24 Foreign investors have made
gains of some 10 percent this year on emerging market bond
portfolios but now dread future gains being eaten into by an old
foe -- food price inflation.
Billions have been pumped into emerging market bonds this
year by investors looking for alternatives to western markets
where yields are minimal or even negative, especially in Europe.
Analysts say one reason investors have bought into emerging
market bonds -- and still expect further gains -- is that
sagging global growth is seen bearing down on inflation, giving
emerging economies scope for extensive monetary easing.
A sudden rebound in food prices, which often make up a
larger share of Consumer Price Inflation baskets in poorer
developing countries, has complicated this outlook.
Maize (corn) and wheat export prices jumped some 20 percent
in the first three weeks of July over their June level, the
United Nations' Food and Agriculture Organisation said last
week. Wheat has risen 25 percent year-on-year.
However, weather-related grain price gains can also be
vulnerable to swift falls. The effect of food price rises also
varies greatly from one economy to another.
"There have been massive food price rises in the past few
weeks -- before that happened, emerging market inflation had
been coming down quite nicely," said Maarten-Jan Bakkum,
emerging markets strategist at ING Investment Management.
"If food prices continue to rise, emerging markets look less
attractive as a whole."
Higher food prices restrict policy makers' scope to cut
interest rates to spur growth and raise the spectre of
'stagflation', where low growth accompanies high inflation and
monetary policy is paralysed.
"One dynamic that is underpriced in the market is the
implication of food prices," said Manik Nairan, emerging markets
strategist at UBS.
"Wheat and sugar prices are spiralling higher and will
constrain the ability of some emerging market central banks to
ease monetary policy in a big way. If they do so, there are
large risks to the medium-term inflation outlook."
Central banks in China and Brazil have cut rates several
times this year to spur growth, by 56 and 300 basis points
respectively. Central banks in other large emerging markets like
South Korea, South Africa and Taiwan have also cut.
This has pulled investors into emerging debt in both dollars
and local currency. Yields on local debt from South Africa to
Mexico have hit multi-year or record lows, bringing dollar-based
returns on the sector to almost 10 percent this year.
South African 10-year domestic bond yields have fallen below
7 percent, lower than in distressed Spain, and yields on euro
zone titan Germany's 10-year debt are a paltry 1.25 percent.
JP Morgan estimates emerging fixed income assets have drawn
more than $43 billion of investor cash this year.
Higher inflation brings currency risk for foreign investors
and a further complicating factor is that local investors see
their real return on a bond fall when inflation rises and seek
higher yields to compensate. The erosion of real yields thus
cuts bond demand -- and prices.
"Foreign investors don't care what rouble inflation is
directly. All they care about is what the rouble does against
the dollar," said Charles Robertson, global chief economist at
Renaissance Capital, taking the example of Russia.
As long as the rouble is stable against the dollar, foreign
investors won't lose anything on inflation in Russia, he said.
But they may still lose out when local investors seek higher
yields and drive down prices, especially in countries like
India, where local investors are dominant, versus countries like
Turkey, where they make up 20-30 percent of the bond market.
While food prices are usually more significant for inflation
in emerging markets, the effect depends on the composition of
the consumption bundle in each country.
"Food prices are a big part of the CPI basket, more than 30
percent in China, India, Indonesia and also Russia," said
Not all emerging markets suffer equally. The share of food
in Brazil's CPI basket is 23.2 percent, and a good local harvest
may partly shield people from a global food price spike.
"The local harvest is still the prime determinant of local
food price inflation," said Robertson. If domestic inflation is
mitigated by domestic food supply, then this may leave monetary
easing as a plausible policy option for Brazil's central bank.
Investors will favour emerging market bonds in countries
like Hungary, the Czech Republic and Poland, where food is a
relatively small component of the consumption bundle, he added.
Central European bonds have performed well in the past few
weeks, despite rising food prices.
Beneath the headline figures of high maize and wheat prices,
the extent to which the shocks of a drought in the American
Midwest and floods in Russia should affect food prices more
generally is questionable.
"In Asia, the staple is rice, there is no obvious reason
why that has to go up," said Philip Poole, head of macro and
global strategy at HSBC Global Asset Management.
Food prices are also highly volatile and it may be too soon
to adjust monetary policy expectations. On Monday, a forecast of
rain in the U.S. Midwest where it has been unusually hot saw
maize and soybean prices tumble 2 percent.
"Prices have risen very fast since June -- if you jump 50
percent in four weeks, it's too much," said Christian Gerlach,
co-manager of Julius Baer's commodity fund.