Emerging market investors position for inflation

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Emerging markets have already seen off the spectre of deflation haunting developed economies and investors are instead concerned by price rises that are likely to prompt tighter monetary conditions.

Emerging economies naturally have to run higher inflation rates as they catch up with the developed world, but the differential has widened again as they come out of recession, and analysts say energy and commodity companies are likely to benefit more than consumer plays.

The possibility of higher interest rates to dampen inflation can also make higher-yielding currencies appealing.

In countries like China, which has started to tighten credit policy, a bumper stimulus has created pockets of excessive demand and price-jumping, for instance in the property market.

"There is a big question mark over commodity prices and oil prices and how China can have an impact," said Elisabeth Gruie, emerging markets strategist at BNP Paribas. "It seems that China could be a very big source of inflationary pressures."

Emerging markets as a whole are continuing to see large flows, even though emerging stocks have lost 5 percent this year, in part due to worries about inflation.

Investors are not fleeing emerging markets, but instead looking for trades within them to lessen the inflation impact.

Morgan Stanley analysts said the current valuation level for Asia Pacific ex-Japan equities at a forward price-earnings ratio of 13 was in line with their base case inflation forecast for 2010.

"However, there are downside risks if our high inflation scenario occurs," they said in a note.

Morgan Stanley says sector performers when headline inflation is rising in Asia are energy, materials, insurance, professional services and consumer staples, while underperformers are utilities, household and personal, consumer durables, pharmaceuticals, retailing and software and services.

The bank's recommendations in a high inflation environment include India's Tata Steel and Korea Zinc.

Food prices

The International Monetary Fund forecasts inflation in emerging economies at large to accelerate by almost one percentage point to 6.2% this year - almost five percentage points above its 1.3% 2010 forecast for the world's most advanced economies.

Emerging market inflation is typically boosted by the greater weight given to food prices in the headline indexes. The FAO food price index, measuring monthly price changes for cereals, oilseeds, dairy, meat and sugar, reached a 15-month high in December and stayed at that level in January.

Morgan Stanley reckons a 10% increase in food prices would have a 4.6 percentage point impact on Indian inflation and only a 0.9 point impact on Australian inflation.

Yield appeal

However in currency and money markets, rising inflation can have an appeal, as the resulting higher interest rates provide a greater yield on investments, particularly in economies that have shown greater resilience to the global economic crisis and where demand has picked up more quickly.

In Europe, Gruie at BNP Paribas recommends going short the Czech crown, and long the Israeli shekel.

"The Czech Republic is still a very deflationary environment. The crown is still going to be a funding currency because of the lack of reasons to hike interest rates," she said.

"In Israel, I still expect rate hikes."

Czech annual inflation is below 1 percent and rate hikes are not expected until the second half, while Israel has already raised rates three times and inflation remains about the central bank's target 1-3 percent range.

Goldman Sachs recommends paying fixed interest rates in Turkey and receiving floating rates, on the expectation that Turkish interest rates will rise to rein in inflation.

"For Turkey, we continue to think that the risk of a more front-loaded tightening is not adequately priced in the forwards," Goldman Sachs analysts said in a note.

Jerome Booth, head of research at emerging markets fund manager Ashmore, recommends buying local currency in India and South Korea, countries which are unlikely to try to keep their currencies artificially low.

"India is a closed economy, inflation is heading for 9% or more - they need to tighten," Booth said.

"In Korea, inflation is a problem but the won is too cheap."