The impact of developed market inflation on investment portfolios

Global bond yields are on the rise from their lows earlier in the year, putting pressure on equity valuations. One reported driver has been a broad increase in developed market inflation and this pick-up (admittedly off low or negative levels) gives us pause for thought. With very low levels of interest rates and high asset valuations, it doesn’t take much of a move in inflation to eat away at the purchasing power of our investment incomes.

Where do Australia’s levels of inflation sit in comparison to other major markets?

The last reported1 Australian headline consumer price index (CPI) was higher than forecast at 1.3 per cent, and while that’s lower than the Reserve Bank of Australia’s (RBA) range of two to three per cent, it was sufficient to give many commentators reason to suggest that this would remove any chance that the RBA could further lower Australian cash rates.

Resulting from the Brexit-driven fall in the Pound Sterling, UK inflation has started to rise sharply, reaching one per cent in September. Although considered low by historic standards, the Bank of England is forecasting inflation to hit at 2.8 per cent in 20182, well above its two per cent target, while the country’s National Institute of Economic and Social Research has gone further, predicting inflation to hit four per cent by the second half of next year3.

The Eurozone’s largest market, Germany, has seen unemployment fall to its lowest levels since its reunification in 1990. This is causing legislators to publically worry about inflationary pressures in the German economy – inflation was reported at 0.7 per cent in October4, again historically low, although it was negative in February and April.

And across the Atlantic, core CPI in the US is at 2.2 per cent5, while the core consumer deflator – the measure of choice of the US Federal Reserve (Fed) – is at 1.7 per cent6, straddling their two per cent target. Importantly, wage growth has picked up to its highest levels since 2009 with the Fed dropping their long-held prediction7 that inflation would stay low in the near term. They now expect inflation to, in fact, pick up.

There are several factors worth watching in regards to impact of inflation on investments

Firstly, governments are no longer fixated on austerity, with political pressures instead encouraging expenditure to try to address economic disparities. However increasing government spending in recovering economies is likely to add to price pressure.

There is also increasing commentary from central banks that they will allow inflation to run hot – above the two per cent line in the sand. In particular, Bank of England Governor Mark Carney recently said he believes that an overshoot in inflation was better than another 400,000 - 500,000 people being unemployed8.

And there has also been a bounce in commodity prices, but again off very low levels. The inflationary effect of this move is being accentuated by falling unemployment and, at least in the US, potential capacity constraints. The usual relationship between inflation and unemployment is negative – unemployment up, price pressures down – but Goldman Sachs9 points out that this relationship has been masked. For example, in 2011/12 when oil was over $100 a barrel, unemployment was high, masking the price effect of high unemployment. In 2015 the reverse was true, oil dropped to $27 and unemployment in the US was falling quickly. In 2016 we see both oil prices (up) and unemployment (down) moving to re-establish inflation.

Keep in mind that developed market growth is likely to remain low in the medium term

This will likely be driven by low productivity and poor demographics. However, the re-emergence of inflation will erode the purchasing power of our savings and is likely to keep pressure on bond prices. A combination of rising inflation and rising bond yields will put downward pressure on equity prices. While they have moved, our view is that developed market bond prices do not yet fully reflect these inflation risks and that inflation is likely to surprise on the upside, leading to further poor bond performance.

Against this backdrop we continue to emphasise the importance of diversification and generally recommend that if you’re an investor that you consider the inclusion of hard assets in your portfolio, including property and infrastructure, which may provide inflation protection benefits.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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