Where Falling Inflation Means Rising Valuations

Includes: ERUS, EWZ
by: Russ Koesterich, CFA

One silver lining of the current slow growth environment is that inflation in emerging markets appears to have hit an inflection point.

In recent months, for instance, inflation in both China and Brazil has come down. In China, consumer prices rose 4.2% in November from a year earlier, a 14-month low. Similarly, in Brazil, annual inflation fell to 6.64% in November, close to the 6.5% upper limit of the Brazilian central bank’s target range.

Emerging market inflation should decelerate further in 2012 thanks to a combination of continuing slower global growth and the lagged impact of monetary tightening. Brazil’s central bank has said it expects inflation to “fall sharply” by the second quarter of next year.

With the outlook for emerging market inflation improving, my team recently ran an analysis to determine which developing countries are likely to see their valuations benefit the most from falling inflation.

Here is the list, with each country ranked in order of how much they should benefit.

  1. Brazil
  2. India
  3. Egypt
  4. South Africa
  5. Russia
  6. Turkey

To develop the list, we looked at the relationship over the last five years between valuations (as measured by price-to-book values) and inflation levels for various emerging markets. For some countries, the relationship is positive - modest inflation is better for growth and translates into higher valuations during periods of inflation.

However, for other countries, the relationship is negative and higher inflation means lower valuations. This is especially true for countries that have gone through hyperinflation in the past, where investors are particularly sensitive to inflation readings and where valuations should benefit from decreasing inflation.

For our ranking, we focused on countries with a negative relationship that also still have high levels of inflation. For instance, Mexico and Indonesia would benefit from declining inflation. But they didn’t make our list because their inflation has already come down to a good range, which has already helped their valuations.

So how much should our top six countries benefit from falling inflation? Historically, every percentage point increase of inflation in Brazil is associated with Brazil’s price-to-book value decreasing by 0.3. I would expect the opposite to hold if Brazil’s inflation decreases.

At the bottom of the list, every percentage point increase of inflation in Turkey is associated with Turkey’s price-to-book value decreasing by 0.03. The other countries on the list fall somewhere in between.

But keep in mind that emerging market inflation is likely to stay above the comfort zone of many central bankers. In addition, inflation is not necessarily slowing in all emerging markets on our list. In Turkey, for instance, inflation has accelerated since February due to a combination of an overheating domestic economy and very unconventional monetary policy.

Disclosure: Author is long EWZ and ERUS.

Source: Bloomberg.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

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