Navigating inflation and interest rates

Inflation is back, and the longer it stays, the harder it will be to get rid of. Globally, it took a combination of protracted Covid lockdowns, plus trillions of dollars of Government debt (a bill for tomorrow’s taxpayers) plus sanctions on Russian oil and gas (circa 12% and 20% of global supply respectively), for global inflation to reach levels not seen in decades. Consequently, Central Banks have lifted interest rates by at least 4% to 5%, in most countries, but only time will tell, if that has been sufficient to prevent an inflationary feedback loop, fed by rising input costs, and random instability?

In simple terms, inflation is symptomatic of either, not enough supply or too much demand. So, the only way to combat inflation, is to increase supply (build more houses) or decrease demand (increase interest rates).

The inflationary spike during covid, was a combination of not enough supply (Covid lock downs stopped people going to work, so goods and services couldn’t be made and or delivered), and too much demand (sitting at home during lock down, what else was there to do, but buy stuff).

While the inflationary spike, triggered by sanctions against Russia, after they invaded the Ukraine, was caused by European countries using their financial muscle to ‘re-structure’ the global supply chain, for coal, oil, and gas. The Europeans wanted to stop buying coal, oil, and gas from Russia, so they outbid other countries, for non-Russian, coal, oil and gas. Which meant the other countries either had to go without, or setup trading relations with Russia.

Arguably the most severe disruptions, caused by Covid lockdowns and Europe changing their suppliers of coal, oil, and gas, should have passed. So, are we in for a ‘soft-landing’ or are there other forces keeping inflation elevated?

In theory there are three levers to reduce national demand.

1. Governments can increase general taxes ⁽²⁾. The current Government’s forecast is for revenue, from all taxes, levies, and fees, to increase from $635billion (or 25% of GDP) in 2022/23, to $735billion (or 25.2% of GDP) in 2026/27. So, taxes are increasing, but roughly in line with the economy, so that shouldn’t impact inflation.
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2. Governments can spend ⁽³⁾ less. The current Government’s forecast is for their expenditure to rise from $630billion in 2022/23 (24.8% of GDP) to $760billion in 2026/27 (26.1% of GDP), and net debt will increase from $548billlion in 2022/23 (21.6% of GDP) to $703billion in 2026/27 (24.1% of GDP). So, expenditure will grow materially faster than the economy, which is inflationary, unless of course it is offset by productivity.
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3. And last, but not least, the Central Bank (RBA – Reserve Bank of Australia) can increase interest rates and everyone with a loan (households, businesses, and Governments) will have to pay more interest and thereby have less to spend, particularly families who aren’t able to run a deficit.

So, no surprise, increasing taxes and reducing spending doesn’t tend to be popular with voters. Hence Governments, the World over, don’t tend to campaign on a platform of higher taxes and lower spending. Which is why, fighting inflation, is often left to the Central Bank.

Which brings me to the outlook for interest rates. Of course, no one actually knows, but if I use the US 10-year Government bond rate as a proxy for the views of global bond investors, an argument can certainly be made, on the back of the recent (Sept / Oct 2023) spike in bond yields, that central bank interest rates, will need to go higher and stay higher for longer, for inflation to come down.

Unemployment in the US and EU is the lowest it has been in decades and wages growth is the strongest it has been in over a decade, and as can be seen in the chart below, it is similar story in Australia.

However, despite the strong employment income growth, the chart below (left) illustrates, the general deterioration in productivity, and it is the combination of productivity (pos+ or neg-) with wages growth, which equals unit labour cost. To illustrate, the unit labour cost of a cup of coffee (so the unit, is 1 cup of coffee), is the wage rate multiplied by the time taken (productivity) to make the cup of coffee. So, no surprise, there is a high correlation between the unit labour cost in Australia and CPI (inflation) in Australia.

To put it another way, there is little spare capacity ⁽⁷⁾ in the Australian economy. Higher employment income has helped in attracting and retaining staff, but it’s not actually leading to higher productivity (an increase in supply), although obviously, it is helping many households meet the higher cost of living, including interest rates.

Lastly, housing. High inflation and high interest rates don’t typically translate into high demand, so typically, you won’t see an increase in supply, although if you did, it would bring down prices. The chart below (left) illustrates the total commencements, per quarter, of houses in dark blue, units etc. in light blue, superimposed on periods of expansion and contraction in the Australian housing sector from 1986 to 2022. The dotted line, at the top, indicates the level of commencements required, per quarter, to reach the Government’s target of 1.2million ‘well-located’ homes over 5years. The chart to the right illustrates new dwelling inflation and building costs.

In short, right now, it is not obvious as to where the additional supply is going to come from, to bring down inflation, and without the new supply, all the evidence points towards higher prices.

A soft landing was possible, when the only challenge was returning to pre-covid supply chain efficiency and general productivity. But we are now in the 3rd year of record low unemployment, with some of the strongest employment income growth since the mining boom, and without the return of productivity, even the ‘narrow path’ will close.

What to do about your portfolio?

My best guess is that the dance between inflation, interest rates and wages, still has many quarters, if not years, to play out. It is hard to imagine a recession with record low unemployment and record high employment income growth, but equally it is hard to imagine inflation coming back down in such an environment, so something, at some point, will have to give.

At the end of the day, the best strategy remains, own a diversified portfolio of quality, competitive and innovative businesses, and make sure you have enough cash and cash flow, to never be a forced seller.

In the current market I have been talking to clients about CSL, ResMed (RMD) and Sonic Healthcare (SHL). For some reason the healthcare sector is out of favour. Maybe it is because it was so ‘defensive’ during covid. Maybe it is rising interest rates. Maybe it is the threat of new ‘competition’ (GLP1s). But whatever the reason, if you stick to quality and diversify, healthcare will remain a sensible investment.

Index

1. Graph 1.1, https://www.rba.gov.au/publications/smp/2023/aug/the-international-environment.html
2. Page 64, https://budget.gov.au/content/overview/download/budget_overview.pdf  
3. Page 67, https://budget.gov.au/content/overview/download/budget_overview.pdf
4. https://fred.stlouisfed.org/series/DGS10#    
5. Page 17, of the RBA, Financial Stability Report, October 2023, https://www.rba.gov.au/publications/fsr/2023/oct/pdf/financial-stability-review-2023-10.pdf    
6. Graph 11 and 13,  https://www.rba.gov.au/speeches/2023/sp-gov-2023-06-07.html
7. https://www.rba.gov.au/publications/smp/2023/may/domestic-economic-conditions.html
8. Graph4.6,  https://www.rba.gov.au/publications/smp/2023/feb/inflation.html

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Ken Howard is a Private Client Adviser at Morgans. Ken's passion is in supporting and educating clients so they can attain and sustain financial independence.

If you have any questions about your financial plan or your share portfolio, your strategy, investments or would just like to catch up, please do not hesitate to give me a call on 07 3334 4856.

General Advice warning: This article is made without consideration of any specific client’s investment objectives, financial situation or needs. It is recommended that any persons who wish to act upon this report consult with their investment adviser before doing so. Morgans does not accept any liability for the results of any actions taken or not taken on the basis of information in this report, or for any negligent misstatements, errors or omissions.