BY Dermot Ryan, Portfolio Manager Australian Equities
It’s been decades since central banks have had to wage a war against inflation. Until COVID-19, globalisation and technology/efficiency improvements led the fight against price rises, allowing interest rates to fall to very low levels and create all sorts of distortions, particularly in assets with fixed payments/incomes.
Then the pandemic hit, reinforcing central banks predilection towards easy monetary policy. But times are changing.
Skirmishes are already appearing around the world as central banks work to douse price outbreaks. In some countries, the fight against inflation has already begun. New Zealand, South Korea, Norway, Brazil, Russia and Mexico have already lifted official interest rates.
Central banks in the United States, Canada, United Kingdom, India and South Africa have indicated they will soon take action to reduce bond purchases and, in keeping with the war analogy, put their economies into a state of battle readiness. Trying to reduce the money supply, in economies where the prices of goods and services are already accelerating.
It’s because inflation pressures are building around the globe, in large part due to supply chain disruptions flowing from the COVID-19 shutdowns and the strange effects the virus has had on both supply and demand variables.
The Reserve Bank of Australia has stated it will start moving away from ultra-loose monetary policy in the form of yield targeting but seem bemused that they might have to increase interest rates. They’re going to stop buying bonds next year and start raising the official cash rate in two years time1.
But will that be too late?
Overstimulating at the start of a pandemic was an understandable approach, but as the Reserve Bank General Philip Lowe and his brigadiers’ charge down the hill towards the increasingly menacing bond vigilantes, we wonder has the nature of the inflation war changed and could the generals be fighting the last war. Or is the inflation genie already out of the bottle when it comes to our economy?
In World War II the events surrounding the Charge of the Light Brigade and the subsequent loss by the British, revealed they had relied too much on strategies employed during an earlier war. In essence, they used the same playbook as the previous war and didn’t allow for new machinery and advancing technology2.
In our view, the Reserve Bank of Australia is making a similar mistake as they are implementing policy based on textbooks, rather than what’s happening in the economy.
From what we have seen, there are shortages of labour and capital everywhere, demand is turning up in places that it wasn’t before and supply is intermittent, when it used to be more regular and on- demand. That alone is enough to drive inflation. But on top of that we have the Reserve Bank keeping interest rates near zero and Australia’s housing market is red-hot, along with related areas of demand such as building materials and housing goods.
In short, the Reserve Bank of Australia is behind the curve.
Consider Western Australia. The Reserve Bank wants an unemployment rate of 4.5 per cent. But in WA it’s already down to 4.1 per cent3. They’ve had no lockdowns and from what we’re viewing, they’re experiencing a building, housing and mining boom. The effects of inflation are already appearing, and price rises in the state are well above national averages4 and businesses are in dire need of workers and reporting rapidly rising wages. But as we can see from overseas economies this will only accelerate, the US just posted headline inflation of 6.2 per cent5, the highest rise on the Bureau of Labor Statistics CPI measure for three decades. If this inflation stays, then we might be going back towards the higher interest rates that were around 30 years ago.
Along the east coast of Australia, a massive re-opening is taking place. And already the effects of rampant demand on intermittent supply are obvious. We expect this to create both price rises and shortages in the economy.
In many parts of the economy if you go into your local café or restaurant, there are ‘staff wanted’ signs on doors and it can be difficult to get a table.
Inflation is in the real economy, no matter what the textbooks say.
This riding tide of prices, and the Reserve Bank’s reticence to move quicker on monetary policy, creates opportunities for investors but portfolios may need to be rebased.
Inflation is running at around 3 per cent and that becomes the base for generating real portfolio returns6.
To achieve that, a portfolio needs companies with operating leverage – companies that have a fixed cost base that can grow their top lines and increase margins as well as sales.
A good example of this occurred at the end of the World War II. Beer prices surged and not only did breweries sell more beer, but they also sold it at a higher margin. The post war years were wonderfully profitable for these businesses.
Away from operating leverage, investing in commodities could be beneficial for investors, particularly where there’s scarcity.
There is a shortage of energy as we transition away from fossil fuels. Ironically, we’ve found that fossil fuels are also in short supply because companies haven’t reinvested to bring more supply to market. And that’s because they’re worried about how long fossil fuels will be in place.
Energy prices are going up and we are seeing shortages of power that’s triggering blackouts in China and Europe which has flow on impacts.
Aluminium smelters overseas have had to go offline, which has boosted the demand for aluminium and alumina not produced in China. As a result, there’s been price growth for companies in Australia like South32 and Alumina Limited7.
We are also seeing opportunities across the resources space as liquified natural gas prices hit record highs on the spot market and demand continues to peak. Gas will probably be a transition fuel as the strong commitments to decarbonise flow through economies over the next decade.
Energy isn’t the only scarce product. Supply chain issues have hit retailers. But if retailers can manage supply and sell it to customers who have a high level of demand, they can do so at a high price which is good for margins. Supermarkets apply a profit margin on their products, so as prices go up, so too do dollar profits.
For example, beverage companies could benefit from re-openings of economies, boosting operating margins. We imagine it will be a big summer as people go out and meet their friends and family so drinks and meals will be in demand. There’s also opportunity among infrastructure groups, particularly where their revenue is tied to inflation. For example, pipeline company APA’s contracts are inflation linked. Revenue will increase as inflation rises.
While the Reserve Bank continues to operate from a textbook, interest rates will remain low.
There will still be support for some assets that have been overbought due to low interest rates but the time for that strategy is starting to run out.
In our view, investors could consider taking profits on some of these long duration assets that are overbid, for example residential property or technology stocks. Ultimately, the fight against inflation is heating up, whether or not the Reserve Bank wants it to, so we believe that investors should be actively seeking yield within their portfolios.
While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (AMP Capital) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance.