Emerging Markets and Inflation

Most of the emerging market economies were able to escape the dramatic downturn that impacted the vast majority of the developed market economies. China, in particular, was the standout growth engine for the past two years, without any real competition from the western economies. This past week, though, we saw the Chinese government “continue to raise both deposit and loan rates.” These interest rate increases are clearly aimed at slowing inflation, which is now running at a 5% annual rate, while maintaining the growth that the Chinese people and the world have come to expect. (FT 2/10/2011) I should point out, though, that over the past year Jim Chanos, the famous short seller, has been arguing that China’s economic growth has been fueled by a massive, unsustainable real estate bubble. We will see over the next 12-18 months how this plays out.

With one eye on the Egyptian events unfolding in Tahrir Square during the week, the Chinese Government clearly understands the negative impact of food price inflation, which is impacting the emerging markets. (FT 2/12/2011) There is also a debate emerging about a possible connection between the U.S. Federal Reserve policy of QE2 and the rise of inflation in the emerging markets. This is also reflected in the currency markets, where the U.S. dollar strengthened this week and we saw the Australian dollar weaken again. It was only several months ago that this was the reverse. “The Australian dollar, for example, is often used by traders as a proxy for Chinese growth, because of the country’s strong trade links with Beijing.” (FT 2/12/2011) The Australian economy withstood the global downturn, based in part on the commodity demand from China, which has fueled a very strong economy prior to the recent floods.

Investors have been moving funds from emerging market investments into equities in the western economies. In addition, Strategic Insight reported in mid-January that the move from bond funds, which they noted in November of 2010, became much larger in December of 2010. November 2010 was the first time since November 2008 that there were bond fund net outflows in the U.S. In a time of rising global inflation there is an investor preference for the hedge of equities vs. bonds. This transition from bonds to equities is expected to accelerate over the next several months.

On Thursday the Bank of England’s monetary policy committee met and Governor Mervyn King announced that they would hold interest rates steady, as the U.K. economy showed signs of recovering from the cold days of December. As the recovery continues to show signs of support from many of the developed economies, it is clear that the recovery in the U.S. housing market will be a very long process and will result in the unemployment rate remaining stubbornly high over the next 12 months. With the 2012 U.S. Presidential election less than two years away, I am certain that creating jobs in the private sector will be a high priority for both the Democrats and Republicans. The party that appears to be stronger on this issue will win the important independent voters, who will control the outcome of the presidential election.

In closing, I would like to comment on the recent announcement that AOL will acquire the Huffington Post. While many pundits and commentators have weighed in that the $315M price tag ($300M in cash and $15M in stock) appeared high and AOL’s stock slumped this week (AOL 21.22), I sense that if this acquisition results in a turnaround of AOL’s fortunes, which have been sinking for many years, the price AOL paid will seem very reasonable. It is also indicative of the media M&A market continuing to gain strength.