By Antares Fixed Income
After several years of benign inflation and even deflation in some parts of the world, one might ask how prepared investors are for an inflation scare. Over the next few years, if returns across asset classes are paltry, investors will have little protection against an inflation shock. But with central banks acting as modern day inflation vigilantes, how likely is an inflation shock anyway? Here are 5 reasons why we believe investors should be thinking of inflation as a key risk going forward.
Global commodity prices have risen strongly from their recent slump, with West Texus Intermediate (WTI) oil up almost 100% from its trough in January 2016, coking coal prices up 125% off their lows and iron ore up 80%. Such commodity price increases will likely see higher petrol prices, and higher transport and energy costs via second round effects. For every 10c the average petrol price rises, inflation increases by approximately 0.3% as measured by the headline Consumer Price Index (CPI). As from 2017 the cumulative drag from weakening petrol prices should start to reverse, with petrol contributing to higher inflation if oil prices remain at current levels.
Rising commodity prices should also lead to higher terms of trade (value of exports relative to imports) for Australia, in turn driving national income and wages higher. The relationship between Australia’s terms of trade and labour costs is a strongly positive one, while wages are a key input into inflation.
In the post-GFC period central banks are erring on the side of accommodating much higher inflation before interest rates begin lifting measurably again. Given the salient lessons from Japan’s 20-year deflation experience, central banks are unlikely to be highly reactive when faced with rising inflation. In short, economies will be allowed to ‘run hot’ with inflation likely to overshoot.
Most governments issue around 90% of their debt as fixed rate bonds so they have a strong incentive to let inflation run higher. Higher inflation produces higher economic growth and income for the government which should lead to higher tax revenue. Governments benefit from higher revenues while their interest costs are fixed. Additionally, with rising income and assets the bonds become less costly to repay when they mature.
As inflation is a global phenomenon, what other central banks do can affect investors in Australia. In places like Japan and Europe where the risk of sustained deflation remains, governments can resort to “helicopter money” where there is an escalation in public debt financed via bond purchases through the central bank. This form of debt monetisation has the objective of promoting nominal growth but more importantly reigniting higher inflation by debasing the value of money.
While the Fed’s independence may not be compromised, we believe a Trump-led US administration could see the world’s biggest economy produce stronger growth but also much higher inflation.
Paradoxically, asset values have never been richer at a time when inflation has never been so depressed. Historically bond yields have offered some premium for inflation risk, but this buffer against inflation has also disappeared after years of quantitative easing. This therefore sets-up many asset classes for very challenging times ahead if we were to see higher inflation. And in a low return world even small changes in inflation could be devastating for investors trying to generate returns higher than inflation.
As investors we should be concerned with what higher inflation can do to our future consumption and our standard of living. While recent investment returns have benefited from a long period of low and declining inflation, we are now left with little cushion against a reversal in the fortunes of inflation. The ingredients are in place for a turn in the inflation cycle, and as a key risk, Antares is monitoring it and hedging against its likely future realisation.
For more information, visit antarescapital.com.au
This publication is issued by nabInvest Capital Partners Pty Limited (ABN 44 106 427 472, AFSL 308953) (“NCP”), a member of the National Australia Bank Limited (ABN 12 004 044 937, AFSL 230686) (“NAB”) group of companies (“NAB Group”). An investment in any product or service referred to in this publication does not represent a deposit or liability of, and is not guaranteed by NAB or any other member of the NAB Group.
This information may constitute general advice. It has been prepared without taking account of an investor’s objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs.
NCP relies on third parties to provide certain information and is not responsible for its accuracy. NCP is not liable for any loss arising from any person relying on information provided by third parties.
Any opinions expressed in this document constitute NCP’s judgement at the time of issue and are subject to change. NCP believes that the information contained in this publication is correct and that any estimates, opinions, forecasts, conclusions or recommendations are reasonably held or made as at the time of compilation. However, no warranty is made as to the accuracy or reliability of this information (which may change without notice) and actual events may vary materially.
Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Any forecast or forward looking statement in this article is provided for information purposes only. No representation is made as to the accuracy or reasonableness of any such forecast or statement or that it will be met. Actual events may vary materially.
This information is directed to and prepared for Australian residents only.