Inflation: An Oily Issue

This week we continue with our examination of the news flow that has been rocking markets. We find it interesting that the headlines have inextricably linked the latest burst in inflation and energy prices squarely with the Russia-Ukraine escalation story. However, for those of you that have been long-term readers, you may remember that we had previously made the call for triple digit oil prices even before the Putin-made fiasco. The latest round of sanctions may have only sped up the process. Similarly, we made the call that higher inflation numbers were likely to be printed due to the fiscal impetus and the nature of the responses to Covid-19. Alongside  this, we posited that central banks may find it more difficult to normalise policy than the markets may be expecting.

​So with that, let us get into what we see as likely outcomes for the markets going forward. Starting off with energy. 

Energy

Despite jawboning from the US government, led by Biden announcing the release of 30 million barrels from the Strategic Petroleum Reserve (SPR) at the State of the Union address, the upward momentum seems relentless; Brent hitting 130 USD/Bpb and WTI reaching a 125 USD/Bpb. This move, in our view, is rather short-sighted and does not address any of the underlying issues at hand while acting as a reprieve in the run up to the November midterms. The rhetoric by governments across the world, including Asia, has been similar. While the short-term price action may be a little overdone given that the US only imports approximately 700,000 barrels of Russian oil per day and the EU continues to import (30% of her consumption coming from Russia). We are seeing credible supply constraints, something we suggested was likely to be the case given the lack of appetite for investment in new supply. 

In a perverse manner, should central banks take a more hawkish approach to tackling inflation, this may get worse. The US shale boom has ultimately been financed via cheap credit from the Federal Reserve rather than technological breakthrough. Turn off the taps and you have a spate of bankruptcies. However, one alternative that is now being talked about is rethinking sanctions on Venezuela and speeding up the Iran nuclear deal which, it is assumed, should bring on additional supply. The impact of this, however, remains up for debate. It is entirely plausible that Iranian supply is already online (i.e. it is simply a paper trick that roundtrips it through Iraq, making it look like Iraqi exports). Venezuela, on the other hand, still has to build out her infrastructure after years of disuse and disrepair. But what of OPEC and specifically the Saudis?

We don’t see the Saudis reneging on commitments made during the OPEC summit as pertaining to production targets. As mentioned previously, the Budgetary Breakeven price per barrel for the Kingdom (i.e. the price needed to bring about a balanced budget) is 80 USD/Barrell. We see it as likely that the Kingdom will use the current prices to rebalance the budget. 

So, where to next for the black gold and what are the implications? 

Higher highs are likely with a base case (for us) now at 150 USD for Brent. This is in spite of optimistic scenarios bringing Iran and Venezuela online. This has tremendous implications for a market (still recovering from a pandemic) and global growth. 

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Specific Implications

We see immensely consequential implications for global growth and inflation going forward. The last time we had a similar environment were the years between the invasion of Iraq and pre-GFC. The Reserve Bank of India, for example, estimates that for every 10 USD rise in the spot price of Brent, 0.5% is added to CPI in that country. We would posit a similar case for China and much of emerging Asia, which remain net importers of energy. A slowdown in growth across these engines will irrevocably impact global growth prospects. 

For the equities investor however, the implications are a little more uncertain. Remember that the mechanism through which valuations are impacted, all things equal in the short run, is monetary policy. In the past, one might have had a great degree of certainty that growth would take precedence over inflation thus resulting in what maybe credibly termed a central bank put. The indication so far has been a little more concerning. The Federal Reserve maybe forced to raise the economy into recession (a rather small risk but now within the realm of possibility). As we mentioned, easing in would in fact have the opposite effect with supply constraints further exacerbated. If inflation is the biggest issue, there is simply no other way but to ensure an adequate fall in demand. Anything less and stagflation may ensue.  On the other hand, and this continues to be the base case, Russia-Ukraine could very well be used as an excuse to take a more dovish tone.

Closer to home, we are of the view that Australian investors and the economy may be in a better place than would otherwise be the case. Inflation transmission occurs quite differently here. It must be remembered that this remains a commodities driven economy and one that is a net exporter of energy. This has two consequences; the first is that higher commodities prices globally, while creating inflationary pressures, are (at least relatively) felt less domestically; and two, this gives the RBA a lot more room and flexibility. 

Let’s untangle the above sentence. Consider the nature of our exports and imports. Higher commodities prices inevitably become a positive for the nation’s balance of payments and put upward pressure on the AUD (than would otherwise be the case when comparing relative cash rates). The higher currency increases purchasing power and many of the imports that make up the CPI basket. That's not to say we won’t have inflation, only that it would be less on a comparative basis. This in turn allows the RBA to remain dovish compared to her peers (good news for those of you that are property investors perhaps).

Where to allocate? 

Let’s begin with where we don’t want to allocate. The immediate thought that crosses our mind is traditional fixed income. Why? For one, lets assume our most likely scenario that central banks continue to prioritise growth even at the cost of what they may call transitory inflation. In this instance, it could very well be that the coupon value turns negative in real terms as inflation is exacerbated. On the other hand, let’s assume that they do take an aggressive stance on inflation at the cost of growth, the rise in credit risk given the quality of issuance in the decade and a half since GFC makes us rather cynical of the risk-reward payoff. 

Similarly, the higher PE stocks are not necessarily the place to be. This is not to say, they aren’t quality companies or that they don’t have secular growth stories. But buying what are effectively long-duration assets in a rising interest rate environment is not for the faint of heart. 

So, where to allocate? Equities remain the place to be. Our base case of preferencing growth over inflation implies that cash will be negative yielding in real terms. What do we mean by this? Let's say inflation stays around 4-5% p.a. and the cash rate, from its historic lows, normalises to 3% over the twelve months (a rather aggressive scenario), cash holders still lose 1-2% p.a. in real terms. 

Companies with reasonable valuations and earnings effectively indexed to inflation are, in our view, the best place to be. Within the Australian equities portfolios we continue to own the likes of EML Payments (EML.ASX) and OFX (OFX.ASX). Globally, companies like J&J (JNJ.NYSE) and Home Depot (HD.NYSE) remain high conviction.