Inflationary pressure is not a threat to growth in emerging markets

The concept of the “Emerging Consumer” is a structural theme based on one of the strongest and most sustainable trends in the coming decades: urbanisation in the emerging markets. In 2009 the split of people living in rural and urban areas of the world was 50/50. In 2050 more than two third of the global population will be living in cities [1]. Along with any rapid urbanisation comes growth in consumer spending, as wages in cities are generally higher. Looking at these massive long-term structural drivers Leon Pedersen, fund manager of the Nordea 1 –Emerging Consumer Fund, expects consumption in the emerging markets to growth by around 300 % within the coming ten years.

Increasing inflation: a threat to growth in emerging markets?

The surge in nearly all commodity prices and the depreciation of the US-dollar culminated in the right ingredients for a mixed cocktail of worries about the future of emerging markets growth prospects.

Amongst the BRIC countries, China exhibits the lowest year-on-year headline inflation (5.3 %) followed by Brazil (6.6 %). On the other hand, India and Russia are experiencing higher inflation (9.4 %and 9.6 % respectively) [2], as their share of food and energy weights in the consumer price index baskets are higher (above 50 %). But the central banks are well aware of the problem and have been administering a remedy consisting of interest rate hikes and / or bank reserve increases. Even though these measures may hamper emerging market stocks on the short-term the outlook for mid- to long-term growth remains robust. Recently the pressure from some of the commodity markets have already eased as for example the price of oil, zinc, silver, cotton, sugar, wheat and soybeans stabilizing or partly corrected.

“We assume inflation to ease over the coming months. However, it is clearly a factor that we are continuing to monitor” says Pedersen. “But it’s also important to keep in mind that inflation doesn’t only have negative impacts on consumption” he points out. For instance, in China inflation is fuelling higher wage growth especially for lower income households. By the end of 2010, amid rising inflationary pressure, 30 provincial-level regions have raised minimum wages, with an average increase of 22.8 % year-on-year [3]. This will help boosting consumption in China and transforming the country into an economic growth model based on increased domestic consumption – one of the main goals fixed in the government’s five-year plan issued in March 2011.

Brazil’s labour market has also tightened significantly - unemployment rates have steadily fallen to just 6.5 % as of the end of April 20114. With unemployment near an all time low, wage growth has recently been one of the main inflation drivers. But as real wages have risen by 4.98 % from a year ago [4] they have also significantly spurred on domestic demand especially in the lower wage segment.

Mastering changing market conditions with a highly flexible fund set-up

As the “Emerging Consumer” as such is not a homogeneous group of people, but a mass of human beings with different needs and economic backgrounds, the Nordea 1 – Emerging Consumer Fund is based on five strategies, positioned along the wealth pyramid. They focus on diverse income classes, ranging from the lowest (“New Urban Consumer”) to the richest (“Luxury”) – all of them experiencing a different degree of inflation impact. Over the past months the fund manager has repositioned the portfolio in order to make it more resistant against the inflation impact. While doing so he could harness the fund’s main advantage: the high degree of flexibility in respect of region, sector and strategy split. “As we set up the fund concept we deliberately avoided any kind of restriction besides the 30% criteria which a company needs to fulfil concerning its share of earnings coming out of the emerging markets. This gives us the necessary suppleness to react to market changes and to choose those stocks we have the strongest conviction in”, he sums up.

In the short-term he expects some consumer staples stocks included in the “New Urban Consumer” strategy to be more impacted because of higher food and oil input costs. So, Leon for example liquidated Reckitt Benckiser and Avon, which are two companies related to personal care. He expects them to suffer because of margin pressure due to higher input costs (oil for instance) but also lower demand as the products they sell in emerging markets will be the first ones where lower income consumers will try to save, as their first priority is buying food. Regarding the “Travel” strategy, Jet Airways, an Indian airline, was sold due to its high oil exposure.

On the other hand Leon expects the “Luxury” and “Aspiration” strategies to experience the smallest impact as consumers in these segments have a relatively high disposable income and thus will not be that vulnerable to increasing food and oil prices. As such Leon bought more inflation immune stocks. One of them is Tencent Holdings, China’s largest provider of online games for mobile phones with a large instant messaging community. Cia Hering, a Brazilian textile and retail clothing company, is a further new acquisition. With its high store expansion rate, new brands and an increasing number of consumers in the middle income groups, Cia Hering is strengthening its position as the leading clothing textile company in Latin America.

The fund also meets the inflation pressures by diversifying its emerging markets exposure away from the BRIC countries and looking for new opportunities in other regions less impacted by inflation. For instance, the fund recently purchased the UK retailer Tesco. The company has become a strong player in the fast growing area of hypermarkets and superstores in Poland, Hungary and Czech Republic, but also South Korea, Malaysia and Thailand – all of them facing partly significantly lower levels of inflation than the BRIC countries.

“Even though inflation forms a short-term chock block for the emerging markets, we don’t have the slightest doubt about the sustainability of the “Emerging Consumer” trend”, Leon endorses his conviction. “We used the past months to strengthen the portfolio and found a few good buying opportunities. This already paid off. Since beginning of March we could outperform the MSCI World by more than 8 %5.”