Data Release…Australian Q1 CPI:
March quarter CPI was published yesterday, coming in at +0.6% QoQ, well below consensus at +0.9% QoQ, and also well below the prior quarter (+0.9% QoQ). Annual CPI also missed consensus estimates, +1.1% YoY vs +1.4% YoY, and +0.9% YoY as at December 2020. In this piece I briefly look at why the inflation print missed consensus estimates, but then delve into why inflation is expected to rise, and what it means for interest rate markets.
So, first things first, how did the market get it wrong? Firstly, it’s likely a timing issue. It generally an accepted fact that inflation is rising, it’s just a matter of timing, and then by how much. The latter is the most debated point, which I’ll touch on below. Here and now, the main reason for the miss against consensus is likely the “introduction, continuation and conclusion of a number of government schemes” that remained a factor through the March quarter. This has seen in price falls for new dwellings (-0.1% QoQ) and tertiary education (-1.7% QoQ), both are meaningful contributors to aggregate inflation data.
A meaningful miss this time around and still well below the RBA’s +2.0% – 3.0% target, although forecasts for Q2’21 CPI have the rate of change increasing to +3.2% YoY. Much of this is expected base effect, but also factoring in the end of select government policies that held prices down in select parts of the market, i.e. housing. Beyond Q2’21, consensus forecasts are for CPI to fall back to a +1.7% – 2.0% range out to the end of 2023, still under the RBA’s target range.
Australian CPI – Components & Proportions…
(Source: Bloomberg, Mutual Limited)
Inflation is still low, so, why the boggle?
Setting the scene…
Up until recently, the last 4 – 6 months or so, inflation was this almost mythical beast of days gone past. Often discussed in hushed tones by grizzled bond traders over a pint at the Mitre Tavern in Melbourne, or Ryan’s Bar in Sydney, reminiscing over the good ‘ol days when fundamentals mattered.
And, then along came the COVID pandemic, followed by a raft of extraordinary fiscal and monetary counter-measures, followed eventually by the discovery of an ‘effective’ vaccine. Economies re-opened, workers returned to their jobs, and consumer and business spending patterns began to normalise, and in many cases pend up demand was unleashed. An increasingly likely sustainable recovery has taken hold, ensured by continued fiscal largesse and extraordinarily accommodative monetary policy.
Consensus forecasts are for the US economy to grow by +6.3% YoY over 2022, and then +4.0%YoY in 2023, well up on the +2.2% YoY generated in 2019 (pre-pandemic) and -3.5% YoY contraction over 2020. Also, potentially surpassing Chinese growth over the near term. Closer to home, Australia is also set to record economic expansion comfortably above trend growth, up +4.4% YoY in 2021, and then +3.3% YoY in 2022 (consensus). This compares to +1.9% YoY in 2019 and -2.4% YoY over 2020.
While the post-pandemic recovery seems reasonably well entrenched, governments globally (especially in the US) continue to pump stimulus into their respective economies, both fiscal and monetary. The expected net result of these twin stimulatory forces, combined with vaccination programs etc, is an awakening of the aforementioned inflation beast, and all the market guts and gore that come with it…that is steepening yield curves.
“Woe to you, oh earth and sea
For the Devil sends the beast with wrath
Because he knows the time is short
Let him who hath understanding reckon the number of the beast
For it is a human number
Its number is”…inflation
Apologies to Iron Maiden
At least that’s what some quarters of the market believe to be the case, inflation to ratchet up, necessitating tightening of monetary policy, i.e. tapering of bond purchases and rate hikes, all sooner than previously priced in. Central banks on the other hand are more sanguine on inflation risk and continue to back an accommodative stance, confident in their ability to a) read and manage the inflation impulse, and b) that any inflationary spike will be transitory. The fear within some corners of the market, is that once the inflation genie is out of the bottle, amidst such accommodative monetary policies, it will rise sharply and wreak havoc on rates (higher) and potentially curtail the recovery.
Reflecting these growing inflationary concerns, bond yield curves steepened over January – March this year. Yields on ACGB 10-year bonds rose from a near historical low of 0.98% to 1.92%, or +94 bps by the end of March as markets began to price in eventual tightening of monetary conditions. It’s just a matter of when. The RBA is guiding later, the market is pricing sooner, although yesterday’s CPI numbers support the RBA case for now. Offshore bond markets have reflected similar moves. While the moves are aggressive, almost a doubling of rates, the prevailing rate (now down to 1.74%) is still very, very accommodative in an historical context.
The RBA’s target inflation rate is +2.0% – 3.0% actual, not just forecast, but actual, and sustainably so. The RBA has been targeting inflation since around 1992, give or take, with the +2.0% – 3.0% target “sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.” Since inflation targeting became a thing, CPI has averaged +2.5%, with a high of +7.7% (Sep-02) and low of -0.4% (Sep-97). Realistically, inflation has not been problematic for around ten-years, when CPI was consistently above the top end of the RBA’s target.
So, why would inflation get out of hand after so many years of being dormant? There are two broad elements at play, cost-push inflation and demand-pull inflation. The former relates to rising input costs – and we’ve seen that with iron ore prices, copper prices, food prices, etc all are up aggressively over the past-year. Changing supply chain management and dynamics comes into play here. The other is demand-pull, and reflects where demand exceeds supply, and much of this likely comes from pent-up demand, but also low interest rates and asset value inflation providing a boost to wealth and therefore consumption patterns. The question is, and there is no answer yet, is this boost to inflation (a rise is a given), a one off, transitory adjustment (toward targets), or the start of a broader and more sustained inflationary cycle (exceeding targets).
While we are not of the view that a rise in inflation is around the corner and indeed pre-ordained, we are thinking a lot about more about what a potential inflation pathway might look like.
We see a multitude of issues that need to be considered in greater detail than recent years, such as;
- How differently must a balanced portfolio look like if the bond/equity correlation changes materially in an inflationary world?
- How is the post-COVID global supply chain changing, and what does that mean?
- Are there any structural deflationary forces that are changing (eg. Technology costs)?
- Is there a change in inflation psychology?
- What capacity exists for price increases to be passed on to consumers?
- What labour market wage pressures exist (if any)?
- To what extent are governments “crowding out” the private sector?
- Historically, any contraction in global trade and globalisation is, ceteris paribus, inflationary
- For most of the past 40 years, monetary policy has been asymmetric in its implementation – how differently must it be applied in an inflationary environment where global debt is at record levels, and therefore the global sensitivity to changes in interest rates has never been higher?
- What are the implications of the fiscal multiplier being lower in such a highly indebted world?
While we don’t profess to have all of the answers to the above issues, we believe that a different set of questions must be asked by investors today.
Investing in a rising inflation environment….
If we assume for the moment that inflation will increase over the near to medium term, and bond yields will rise with it, which is in line with consensus, what is the best asset mix? Basically, in most cases, inflation erodes real asset values, so there are only so many places to hide so to speak. Gold for example is typically seen as an inflation hedge, although it’s not perfect as it doesn’t pay an income stream, relying solely on value gains. Commodities is another example as they tend to move in line with inflation – often because rising commodity prices contribute to inflation.
Sticking to the more vanilla, and our own sandpit, I’ll have a brief look at bonds vs equities, and within bonds, fixed vs floating. Historically, rising inflation is detrimental to fixed income returns, with bond returns inversely correlated to inflation. With equities, however, it’s not as clean-cut. Correlations depend on the rate of inflation, with recent research indicating “the correlation between equity returns and inflation flips depending on the inflation level, and is only strong at inflation extremes (high or low).” (source: Down Under Daily, Minack Advisors). The same source suggests the tipping point for equities and inflation, in the US at least, is inflation around +2.5%.
Equities thus far have all but ignored inflation risk, mainly because inflation has yet to meaningfully increase. Stocks did elicit minor wobbles in line with spiking bond yields earlier in the year, reflecting valuation risk, however these wobbles were short-lived.
Major stock indices globally are still up +6.0% – 11.0% YTD, despite rising inflation concerns. Bond indices on the other hand, are down -3.0% YTD (Bloomberg Ausbond Govt 0+ Yr Index). There is further downside risk to long bonds (fixed) given the consensus outlook for yields. If we look at the ACGB 2031 maturing bonds, they’re yielding 1.74% as I type. Forecast yields on 10-year bonds are pushing toward 2.00% by year end, which implies a capital loss (against today’s price) of a further -c.3.0%. This is an extreme case, shorter dated ACGB’s will incur less of a capital loss given the shorter duration. Semi’s and fixed rate corporate bonds will also face similar losses as yields rise.
An alternative to fixed rate bonds, but still in the conservative / capital preservation part of the investment spectrum, is floating rate notes, or FRN’s. Australian banks are the main issuers into the FRN space, with the market around c.$120bn in size. FRN’s carry minimal duration risk with coupons resetting at a spread (fixed at issue) over the prevailing bank bill rate every 30 or 90 days (typically). The main risk to FRN is the traded margin, or credit spread, which can cause capital losses if they widen materially – not our base case.
The pay-off profile over the remainder of the year around fixed income is largely asymmetric, that is all one way. If consensus proves correct, not always a given, but there is a strong case for higher yields, then fixed income assets will likely fall in value (capital loss). It is highly unlikely that yields will fall, a very low probability event in the least.
Given the prevailing market conditions, from a long position, i.e. holding bonds outright, you don’t necessarily need to be right about FRN’s, but you definitely don’t want to be wrong on fixed rate bonds.
Mutual Limited is an active investor in the FRN space, it is our core area of focus, we like to think we’re pretty good at it. To follow are some performance and AUM growth numbers for our core funds.
Mutual Income Fund (‘MIF’), $705m:
Targets BBSW+1.20% net, invests in senior and subordinated ADI paper. Min 40% senior debt, max 60% sub debt. Min 60% to the big four, max 40% to regionals. Minimal interest rate risk with duration <0.49 years). Only invest in FRN’s. Performance to 31 March 2021. Inception: April 2013.
Mutual Credit Fund (‘MIF’), $620m:
Targets BBSW+2.20% net, invests min 60% APRA regulated paper, max 30% ABS/RMBS and max 10% non-APRA regulated. At least 80% of holdings to be investment grade. Minimal interest rate risk with duration <0.49 years). Only invest in FRN’s. Performance to 31 March 2021. Inception: February 2020
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