Taking stock of inflation risk to equity portfolios (afr.com)

It is often said that equity investors always need to climb the wall of worry.  The most recent addition to the laundry list of concerns for investors is that the re-opening of economies will lead to inflation and create a serious issue for equity market valuations. In the early stages of the pandemic, one of the many worries was deflation as prices softened last year during the first phases of the pandemic.  More recently, bond yields have risen sharply over the past few months as markets weigh up the prospects of an overheating economic rebound further supported by monetary and fiscal stimulus leading to the unleashing of long-contained inflationary pressures.

While some fiscal measures have already started to be withdrawn, including the ending of Job Keeper in Australia in March, governments across the globe have maintained a steadfast resolve to do whatever it takes to support growth.  Federal Reserve officials have suggested that the US economy will need to spend a couple of years above trend rate of growth before policy will likely be tightened.  The RBA has indicated that it is likely to keep rates on hold until 2024.

So, with authorities reaffirming such a strong commitment to growth, are central banks about to generate inflation after more than a decade of trying?

Milton Friedman famously said ‘inflation is always and everywhere a monetary phenomenon’ in that it is produced by a more rapid increase in the quantity of money than in the real output of an economy.  While central banks expanded their balance sheets after the Global Financial Crisis, their response to the pandemic has been far more aggressive and sizeable to support capital markets and keep interest rates low.  The US Federal Reserve almost doubled its balance sheet to US$8trillion over the past year while the RBA announced a $200 billion program of quantitative easing.  In response to this rush of liquidity, we have seen a sharp rally in commodity prices, stronger infrastructure and property prices, and growth in assets like crypto currencies and digital art in the form of non-fungible tokens.

There is a big difference between a little inflation and an uncontrolled break out.  Equities can do quite well if there is a little inflation, and some sectors of the equity market will fare better than others.  Strong demand for raw materials generally sees energy and mining stocks perform well.  Consumer staples or basic goods and services will still be in demand and providers have a greater ability to pass on higher input costs even when consumers are having their purchasing power eroded by inflation.  Utility providers, despite their relatively geared balance sheets, tend to be defensive in nature as they can generally pass on higher costs onto consumers to maintain their profit margins.  Health care stocks tend to perform well when consumer budgets are tight.  And financials prefer when yield curves steepen as they have a greater capacity to expand their net interest margin and profitability.  The financial sector has been the standout performer this calendar year while the others have lagged.  Should inflation really start to emerge, the other defensive sectors can be expected to play a bit of a catch up due to their ability to pass on higher prices.

So, while consumer prices are bouncing back – should we be worried that real inflation is about to emerge?  Australian prices rose 0.9 per cent in the December quarter to be up only 0.9 per cent for the year. The main drivers of the increase were the return to full price childcare and price rises for tobacco and medical and hospital services.  These are one offs and unlikely to be repeated.  The strong housing market also contributed as purchasers sought to utilise the various government incentives on offer.

One of the key ingredients necessary to create sustained inflation is wages growth, which has slowed over the past year.  Employers have responded to the pandemic by delaying wage increases, imposing freezes, and delivering temporary wage cuts.  Recent lower award wage decisions have also dampened wage outcomes.  Even as some of these temporary measures unwind and add to some near-term wage increases, forward indicators suggest wages growth will remain soft this year.  There remains significant slack in the labour market and the underutilisation associated with the gig economy often means that workers are not getting the number of work hours they would desire.  These patterns are consistent with what we are seeing in offshore markets as well.

So, while the outlook for is for growth to rebound and some prices to lift in the short term, they are bouncing back from a low base and investors should expect some of the longer-term disinflationary trends we have been confronting for years to re-emerge through 2021.  An ageing population, the decentralisation of supply chains and technology improvements are likely to see improved resource efficiency and continue to apply downward pressure on goods and services prices.  So, while prices are likely to rebound in the short-term supporting the rotation into value and defensive stocks, inflation is unlikely to be high enough to derail equity valuations and the long duration technology and growth stocks are likely to come back into vogue.