Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist
(AMP Capital)
Concerns around inflation have started to pick up over the past six months, driven in part by real-world supply and demand dynamics and in part by what we call base effects.
In the case of the former, constraints on movement over the past twelve months have pushed spending away from services, such as restaurants and holidays, to goods. Coupled with localised limitations on production (for example, where factories have had to wind back their capacity during lockdowns) and trade, the effect has been rising prices for in-demand categories such as new and used cars and building supplies.
At the same time, the deflation recorded in the 2020 June quarter is about to drop out of annual inflation measures, leaving only the subsequent upswing in the September quarter behind. Annual inflation year on year, from June quarter to June quarter, will be measured off an extremely low base – the worst of the pandemic – and will appear to be more significant than it really is.
As a result, CPI in Australia is likely to come in at around 3.7% for the June quarter (it fell by 1.9% over the same period in 2020).
While the headline figures are striking, they aren’t likely to be an ongoing problem for markets. The base effect will disappear next quarter when the 1.6% rise from the 2020 September quarter drops out, and some of the bottlenecks in supply will ease as production moves to meet demand and consumption moves back towards services in reopening economies. The ongoing rollback of pandemic unemployment benefits in the US will also put pressure on workers to return to the labour market and keep a lid on wage inflation.
So although inflation is likely to continue to rise in many developed economies, it won’t continue to do so on the scale we’re seeing at the moment and it isn’t likely to mean the end of the bull market, given that central banks have given strong indications that they won’t respond to transient inflation with monetary tightening.
Central banks will look beyond the noise
Both the RBA and the Federal Reserve (amongst others) have set out very clearly a new approach to inflation targeting that deals with this very issue, and they won’t move on interest rates until they have evidence of a sustained increase in actual (rather than projected) inflation. In response to recent rising inflation, the Fed says it is cautiously optimistic, but that it will be some time until “substantial further progress” has been made towards its goals. If the situation progresses as we expect, it should begin to taper its bond-buying program around the end of the year but this shouldn’t be confused with monetary tightening, which is a long way off.
The RBA wants to see wages growth “sustainably above 3%” in order to be confident of meeting its 2-3% inflation target. This is likely to be several years away despite recent improvement in the labour market. Our earlier prediction that the first rate rises will occur in 2023 (ahead of the RBA’s prediction of 2024) still seems broadly accurate.
How will markets react?
Nevertheless, some investors will have jitters over the prospect of rising inflation, no matter how temporary, and bond yields are likely to rise in response. This will have flow-on effects for share markets, and in particular growth stocks which are highly sensitive to higher discount rates.
Inflation fears are one of a number of factors that could trigger a short-term stock market correction at this point in time, along with geopolitical concerns and US taper talk (although it is worth noting that shares actually rose through the 2014 tapering).
It’s worth noting, however, that cyclical bull markets usually don’t end until excesses build and central banks move to aggressively tighten monetary policy, driving a collapse in earnings. This still appears to be a long way off. Looking through the noise, improving growth and earnings on the back of vaccines and reopening means the outlook for share markets over the next year or two remains positive.
An inflection point for inflation
But considered in an even larger context we appear to be at a turning point – the bottoming of a 40-year decline in inflation that started in the early 1980s and has been driven by aggressive inflation targeting on the part of central banks. Just as those policies represented a regime shift, so does this new, more relaxed attitude likely to mark a new era in monetary policy.
Other economic conditions taking shape will potentially contribute to this dynamic: bigger government acting as a drag on productivity; lower competition as a result of slowing globalisation; and the declining ratio of workers to consumers affecting wages growth and productivity. Fiscal expansion will also amplify the inflationary effect of low rates, as opposed to the counterweight provided to easy money by fiscal austerity through the last decade.
The end result, in all likelihood, is unlikely to be a return to the eye-watering inflation of the early 1990s, but rather inflation around the target band of 2-3%, which would itself represent a step-change from recent years. However, the bottoming in inflation and long-term bond yields would spell the end for a near 40-year tail wind that has helped propel growth assets higher, thanks to low bond yields, and constrain returns more closely to underlying yields and earnings growth.
Important notes
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties 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. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.