Or perhaps the heading should be ‘Much to do About Inflation”. News headlines will be filled with doomsayers for the next 12 months at least. You can choose to be stressed out by this or you can choose to get on the front foot. As always, I’ve got a view but won’t pretend for a second that there’s no risk I’m wrong, so below I provide the two sides of the current inflation debate.
The bottom line for investors is:
- The RBA is not going to act on a 1yr inflation figure from the bottom of the pandemic. Average CPI, all inclusive, over the past two years is still only 1.8% — and that includes two factors that the RBA specifically excludes: tobacco excise (0.46% of the 1.8%, i.e., a quarter) and petrol prices (0.45% of the 1.8%). Almost all of the inflation increases over the past year were due to rebounds in items like restaurants (0.18%), new homes (0.38%), furniture (0.62%), domestic services (0.57%), and tobacco and petrol.
- Beware of headlines suggesting equities are a hedge against inflation. Equity prices aren’t uniformly impacted by inflation. There is no rule that says “inflation is good for equities”, and in fact what it does tend to do is increase uncertainty — which makes for a better market for high conviction managers like Magellan.
- Bonds will be impacted but aren’t impacted by inflation unless markets think central banks will respond. So, if you hold bonds today, what you really need to think about is where markets will land on this question over the next 2-3 years, rather than week-to-week.
- Whatever the central bank response, markets will likely overreact to the risk of “1970s-like increases in interest rates”. The world is much more sensitive to interest rates today than back then. Australian consumers (for example) are six-times more sensitive, i.e., the impact on discretionary spending by consumers will react to a 25bp per annum rise in rates today the same way they did to a 1.5% per annum increase in the 1970s — simply due to household balance sheet leverage increases. The same argument can be made for the affordability of interest rate increases in the US with corporate balance sheets or in the EU with government balance sheets.
- Markets being what they are, bond and equity markets will gyrate between inflationary fears and writing it off as a short-term issue. Like with active management in equities, this creates opportunities for canny investors in direct bonds, or active management for those that prefer to outsource. In particular, look for opportunities in inflation-linked bonds if you want to buy some protection against the uncertainty surrounding inflation, or longer duration bonds if you want to lock in higher yields that will undoubtedly present themselves over the coming months.
- Finally, on the special case of foreign exchange, most relevantly the AUD/USD, this is even more complicated and a topic unto itself. Volatility in markets in general, however, will cause weakness in the AUD — which is often perceived as a high beta asset, but will also be supported by those buying the commodity-driven inflation argument. Long-term equilibrium value for the AUD/USD is 65-70 cents.
Argument 1: Inflation will be Short-lived
The crux of this argument is:
- The “highest in 30 years” headlines we are getting now are due solely to supply bottlenecks
- Supply will normalise sometime over the next two years
- Whether that is one year or two years will depend upon whether there are more significant variants and shutdowns
- After that normalisation, inflation will return to its anaemic state prior to the pandemic
The hardest thing for investors to do at the moment is to think rationally about the current causes of inflation and its outlook. As Bill Gates once wrote in the afterword to the 1996 edition of The Road Ahead, “People often overestimate what will happen in the next two years and underestimate what will happen in ten”. Just watch the illogical day-to-day gyrations of the stock market for examples of this – companies don’t actually change in value that much day-to-day. Right now, we have these inflation headlines in our faces every day, so it’s harder to imagine what will happen next.
But the simple fact is that there is no evidence to suggest this inflationary outbreak will look like the 1970s and 1980s. Yes, that inflationary outbreak was caused by supply issues — namely oil —but as my teenagers like to say: “get a grip people” – this is not the 1970s.
Central Bank Policy Differences to the 1970s
In the 1970s, central banks did not set interest rates to manage inflation. Instead, they targeted maximum employment, production, and purchasing power — which led to wages and inflation chasing each other upwards under the belief that central banks could trade off higher inflation for higher employment (known as the Philips Curve).
Different countries attempted different goals on the Philips Curve, which in turn placed pressure on the global monetary system (based around the USD, known as the Bretton Woods System). That collapsed in the early 1970s. So when the oil crisis struck shortly afterwards, the world’s central banks had no model to adapt to fight inflation. Worse still, they were using outdated data to measure the economy they were supposed to be managing, something that thankfully is dramatically different to today.
That period of central bank policy has been described by Jeremy Siegel (in Stocks for the Long Run: A Guide to Selecting Markets for Long-Term Growth) as “the greatest failure of American macroeconomic policy in the postwar period”. So it seems naïve to look at the 70s as the rationale for panicking about inflation 40 years after that approach was abandoned. Now we have had 40 years’ experience in setting interest rates to maximise employment, but doing so within a target range of inflation.
That said, I hate models that assume because something worked in the past it will work in the future. But the argument that inflation will increase like it did in the 1970s isn’t logical. Therefore, the argument that central banks like the RBA and the Fed will raise interest rates out of a fear that inflation will return to 1970s levels is hard to stomach.
Economic Differences to the 1970s
The digital economic revolution has fundamentally and permanently changed the nature of inflation. The deflationary pressures experienced since the early 2000s have not gone away. In fact, COVID-19 accelerated digital adoption, so the long-term deflationary pressures have — if anything — increased.
Furthermore, the services economy makes up a far higher proportion of the overall economy today than in the 1970s, but just-in-time supply management was less of a feature, meaning that supply chain impacts today are more severe at first but will have less impact overall.
Argument 2: Inflation is Here to Stay
The crux of this argument is:
- Supply bottlenecks will be temporary but will unlock the inflation genie
- Central banks will respond quickly to increase interest rates
- This will further exacerbate wage pressure, locking in the inflation-wage-inflation cycle we saw in the 1970s
Firstly, there definitely is a risk that central banks will move quickly, regardless of whether we think they should or not. Central banks are being asked to make a judgement call about the risk of inflation continuing beyond (say) 1-2 years as the supply bottleneck clears, versus the risk of raising rates too early and damaging the post-pandemic recovery.
There will be extreme pressure on central banks from inflationphobes to move early and cut inflation off. And there will be pressure on them not to move early and kill a recovery before it gets started. Usually these decisions are relatively immaterial — in that getting any one decision wrong is a low risk, but every decision from now until 2024 has far more risk attached as the uncertainty of the path of the global economy over the next two years is unprecedented.
The second point is about the logic of the argument itself. Yes, supply bottlenecks are causing price increases. But there are two strong arguments refuting the real impact of this:
- The supply chain impacts of COVID-19 aren’t all So far we have seen the end of the supply chain suddenly hit by the backlog of demand, which has drained inventories. But already there is news of warehouse space shortages as companies respond by trying to secure additional inventory to catch up and supply a starved market.
For example, CBRE reports recently recorded the lowest ever vacancy rates at port warehousing in the US. At some point this wave of supply will get through to the end buyer, price competition forces will kick in, and deflationary pressures will return.
- Inflation headlines are based on one year price increases from a point of time in mid-2020, during which prices had deflated substantially — particularly in the US, where stabilising programs like JobKeeper weren’t as prominent. While the numbers make for attention-grabbing headlines (e.g., “highest inflation for 30 years”), this is not the sort of inflation that central banks will respond to – they will look for signs of real inflationary pressures by looking at (say) 2-3 year average inflation, and whether the annual figure stays high well into 2022.