Inflation: An Unpopular Opinion?

​This week we visit a topic that has been all the rage in 2022. Inflation. A word we perhaps hadn’t heard of in a couple of decades but has saturated every headline this year. As we write the ASX has given back around 14% from its peak in 2021 and the ASX Small Ordinaries down over 25%, officially entering a correction, and there seems to be no respite. With that context in mind, we take a step back as is always best in scenarios like this. 

​We will look to briefly address a few things in this article. First, what actually is inflation and how is it calculated? Second, why has this thrown the markets off to the extent it has? Third, has the market been rational in its reaction (here we focus on equity markets)? And finally, how do we allocate given the current environment?

Keeping with tradition, we begin with the conclusion. Despite the apparent conflict of interest here given we are a funds management firm, we fundamentally believe that equities remain the place to be. This with the caveat that a well diversified portfolio has never hurt investors.

Inflation: An Overview

​Let's begin with what inflation is. Simply put, it is the general (or overall) increase in the prices of goods and services in an economy. Sounds simple enough but the question then becomes how does one measure it? The most common method and one used by central banks when determining monetary policy is CPI or Consumer Price Index. This is the price index anchored to some base year (which would have a value of 100). From here we move onto another fundamental problem, how does one aggregate this given the complexity of an economy. For example, accounting for the addition of a new technology or the fact that not all goods or services have the same weighting in a consumer's overall expenditure (not to mention the changes that occur over time here). The easiest illustration of this is simply that something like rent accounts for a far larger portion of household expenditure than new shoes (we hope).

With the above simplistic explanation, we hope that you were able to pick up on the first point about these numbers. They are open to interpretation and by their very nature are estimates. Moreover, such ambiguity also allows some artistry, especially given the political nature of what the measure may imply. For example, the last major change Stateside came in 1990 when the federal government decided to move toward a chain-weighted measure with the intention of explicitly reducing cost of living adjustments to social security recipients and allowing for significant reductions to the deficit. Another is the accounting for so called utility. In this scenario an example may be nominal increases in the price of mobile phones but, given the increase in functionality of said devices over time, prices can in fact be adjusted and revised downwards. To give some context into how much this can impact the headline figures, if one were to use 1980 measures in terms of calculations, inflation should be averaging 4-6% over the past two decades and should be around 10.65% (as opposed to the US’ recent 8.6%, a forty year high). 

Why does this second aspect matter for the investor? Firstly, it pays to be a little more cynical towards what the figures represent. Second and perhaps more importantly, the same data can have real world consequences. This is primarily through monetary policy and, by extension, the real world cost of capital. Despite the flaws in actual methodologies, it is somewhat irrelevant as long as the bond markets continue to believe it and premise their pricing on said data. What we mean to say (rather controversial perhaps), using the 1980s methodology could imply that real yields have been negative for a lot longer than the years since the GFC. 

Which brings us to the now. The current (and here we are speaking of Australia) weights are as follows: Housing (23.24%), Food & Non-Alcoholic Beverages (16.76), Transport (10.58%), Alcohol & Tobacco (9.01%), Clothing & Footwear (3.3%), Furnishings Household Equipment (9.16%), Health (6.47%), Communication (2.41%), Recreation & Culture (8.64%), Education (4.63%), Insurance & Financial Services (5.80%). 

You may wish to look to the ABS website to understand the methodology and the process of apportionment, you may find it interesting. However for the sake of brevity, let’s take a look at these categories.

You may notice that some of the biggest weightings are tilted towards those that have a great degree of reliance on supply chains and energy prices. While it is easy to presume that the effect of energy is limited to transport, food prices in and of themselves are uniquely exposed (i.e. fertilisers). Similarly, housing will also be significantly impacted by the same vis-a-vis utilities bills. In one way or another, every single category with the exception of education, financial services, communication and recreation will have faced significant headwinds as a result of  Covid lockdowns, China’s ongoing zero Covid policy and the Russia-Ukraine conflict.

The point? As it’s currently calculated and given the weightings listed above, we would very much expect CPI to be high at the moment. The question that begs is how many of these outsized price movements are as the result of an extraordinary event versus being systemic? Just take a look at the YoY changes to some of the US’ CPI categories in the May 2022 CPI Report:

The Market Reaction

​As with many things, it’s often easier to be short-sighted. So, let’s put everything into a little context. Since the GFC and the resulting advent of unconventional policy (i.e. QE) as a tool kit, we have been beneficiaries of what can only be termed asset price inflation of epic proportions. What we mean by this is we have seen a rise in the price of financial assets without a corresponding increase in goods and services inflation for over a decade (at least by the current methodology used to measure). We have effectively seen equity returns driven primarily by multiple expansion (as opposed to earnings growth). What appears to be occurring now is an increased awareness that the latter may not be a possibility going forward.

Why? 

It seems that inflation, with some significant help from Covid and fiscal expansion, has now seeped through into the real economy. This significantly limits the ability of central banks to maintain status quo arrangements and increases the possibility of significant tightening. This is the simple explanation of the selloff. Growth via multiple expansion is no longer a viable option, hence the carnage of highflying tech stocks and the NASDAQ.

Was/is the reaction rational?

In some ways, yes. But, looking through the noise, we see an alternative perspective. We base this perspective on two key notions:

1 - Assuming that the goods and services inflation is here to stay, can policy makers actually be that aggressive given the demographics across the developed world and the significant debt burden undertaken by governments since 2008 and coming to a head with Covid? The debt servicing burden and implications are significant. We say no, it may seem aggressive given the low base we are coming from but nominal rates are still likely to be below inflation. By the way, this has been a trend ever since the GFC, the below graph shows the effective Fed Funds Rate against CPI.

Source: Federal Reserve Bank of St Louis

(Given the changes to consumption patterns, excluding Food and Energy gives a better comparison. This chart shows that the effective Fed Funds Rate has been kept below rate of inflation since GFC.) 

2 - Given that this is a supply shock as opposed a demand driven inflationary pressure, we see very little room for manoeuvre unless central bankers wish to hike their way into a recession. After the effort put in to avoid one over the course of the last two years, we find this implausible. That said, there is always a possibility of policy error so we cant totally rule it out. 

​So, here is an alternative perspective. If nominal rates continue to remain below headline inflation, real yields are in fact negative. In that environment it would be a error to go toward traditional fixed income, which leaves cash but if the underlying thesis is secular inflation then that is a surefire way to guarantee negative returns. This leaves us to consider two asset classes, equities and real assets. Equities may not see the same degree of multiple expansion but earnings (contingent on where one is looking) should be able to keep up with inflation though wage pressures may dent overall profitability. Real assets, here we are thinking commercial or agricultural property (not residential as this is one that is incredibly sensitive to even small rises in nominal rates), that have cash flows able to move in line with CPI should put investors in good stead.

So there is our perspective, its not particularly popular at the moment but it may be that the indiscriminate selling is a little overdone. The high P/E market darlings to date, warranted. But days like those we have seen recently make us think that opportunities could be just around the corner. 

Does that mean we are against holding cash?

Definitely not. But one way to look at it is to view cash as a put option against the market with the decline in value in real terms as the premia. Bargains are popping up.