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5 reasons why you should worry about inflation

November 2016

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.

1. Australia’s inflation is highly correlated with commodity prices

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.

2. Central banks are actively seeking higher 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.

3. Governments have an incentive to inflate away their debt

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.

4. Helicopter money is on its way and it’s highly inflationary

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.

5. Asset prices are under-discounting an inflation surprise

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. 

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