Inflation fears will soon fade…
Investors worry about inflation but forget to consider the income side of the equation. Will inflation fears this time next year be a distant memory? I currently believe investors should take advantage of any inflation scare that adversely impacts equity prices, as an opportunity.
In an interview with RBA Governor Philip Lowe the AFR, this week, noted; “And as the RBA governor has constantly reminded his audiences, the pre-condition for the bank to raise the cash rate by next year is inflation “sustainably” within the 2-3 per cent range. We can’t rule that out,” Lowe said. “But it has a very low probability because it would require wages growth to pick up very substantially – probably above 3 per cent. So the probability of unwinding a decade-long decline in wages growth in just six months seems very low to me. It’s probably not zero but it’s close to zero.”
At the beginning of the year, when Inflation Scare 1.0 impacted market sentiment, we explained; technological innovation, automation, the materially lower level of unionised labour, and the economy’s lower reliance on oil, will see inflation trends return to the declines that were evident prior to COVID-19.
Before acquiescing to fear-mongering commentary about how inflation is going to destroy everyone’s retirement savings, and before pulling up the investing stumps, consider the following;
First, inflation is a predictable and constant companion to an economic recovery. While each recession’s causes might be different, the response has mostly been the same – cut rates, pump money into the economy and inflate.
And remember, the current debate about inflation is occurring in the middle of the very tempest US Federal Reserve Chairman Jerome Powell alluded to on 28 April when he said; “During this time of reopening, we are likely to see some upward pressure on prices.”
Powell also noted, “those [price] pressures are likely to be temporary as they are associated with the reopening process. In an episode of one-time price increases, as the economy reopens, is not the same thing as, and is not likely to lead to persistently higher year-over-year inflation into the future – inflation at levels that are not consistent with our goal of 2 percent inflation over time.”
Meanwhile, 10-year inflation break evens are just bumping up to the normal range when coming out of a recession.
In previous articles I have described several factors that suggest low inflation is structural. The depressing impact on wage growth from innovation, especially automation which displaces labour, and the 70 per cent lower level of unionised labour than just a few decades ago are both structural and keeping a lid of broad scale wage claims. Lowe can rely on this continuing.
More immediately, a reopening of international borders will bring with it skilled and unskilled migrants that will curtail the present pressure on wages in some pockets of the economy.
Finally, technology is deflationary and technological advances are exponential so too then are their deflationary influence.
While CPI takes into account commodity prices it also takes into account services prices. A large component of services is labour, indeed much larger than in commodities. Service prices are indeed a function of inflation but if rising service prices aren’t indexed against productivity increases, then it’s hard to conclude the increase in service prices is ‘bad’ because wage/income increases may also be experienced by those supplying the service.
Investors worry about inflation but forget to consider the income side of the equation. Only if service prices are increasing amid low productivity is the inflation unpalatable. Of course, commodity price increases, on the other hand, are always inflationary because wages are such a small component of their supply. But even then many commodity prices have already peaked.
Meanwhile, everyone is focused on the recent annual change in US CPI recently reported at 6.2 per cent for the headline number. What isn’t reported however is that it is offsetting a recent dip to nearly zero in early 2020. This is the base effect. Coming off a low number last year, makes this year’s number look extraordinary. Provided prices don’t continue climbing at the same high rate, next year’s number will show disinflation because this year’s number is so high.
Jerome Powell offered this comforting ‘base effect’ narrative back in April but it is the market’s job to forget that sensible and logical appraisal and instead worry the sky is at imminent risk of falling.
Others suggest the US Fed – with its foot still firmly on the QE peddle and rates at near zero – is asleep at the wheel. They point to the recent 6.2 per cent year on year inflation rate as a sign that the Fed is stoking something akin to hyper-inflation. But take a look at Japan. Japan’s QE program is a multiple of the US, in proportion to the size of its economy, and nobody is suggesting Japan is on the cusp of an inflationary outbreak. Indeed, it is constantly skirting with deflation.
I currently believe investors should take advantage of any inflation scare that adversely impacts equity prices, as an opportunity. This time next year inflation fears could be a distant memory. And that means low rates, continuing QE and disinflation. This is usually a pretty supportive environment for equities, particularly innovative growth companies.