Why is everyone talking about inflation?

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Inflation was a hot topic for investors throughout 2021 and looks set to continue in 2022. But why?

To most people, inflation is simply something that means prices of the things we buy increase each year… and if you are lucky, your salary increases in line with it, so you aren’t left short changed!

However, inflation is much more than that. Things such as consumer spending, business investment, employment rates, government policies and interest rates are all linked to inflation.

Examples of how inflation works are:

  • When an economy slows, demand eases and the supply of goods increases, putting downward pressure on the prices of goods. Inflation will typically then begin to fall.
  • As an economy grows, businesses and consumers spend more money on goods and services, demand therefore overtakes supply, and prices rise. This will typically cause inflation to go up.

A quick history lesson

The Global Financial Crisis (GFC), and more recently the COVID-19 pandemic, have changed the inflation conversation. Since the GFC, developed economies have battled with persistently low inflation and stagnating wage growth.

Policymakers in developed markets generally target inflation at around 2-3% per annum – a level that’s low enough to encourage stable prices and investment by businesses, but not low enough to discourage consumer spending or cause low/negative wage growth. Central banks use interest rates to manage this, adjusting the nominal interest rate at which it lends and borrows cash to their domestic banks.

How is inflation measured and what does it mean?

Central banks use a range of measures to assess inflation but the most common is the Consumer Price Index (CPI). This measures the average change in the price of a representative basket of consumer goods and services over time and is used to set and adjust the cost-of-living based eligibility levels for social welfare, wage increases and poverty measures.

Although the basket of goods and services in a CPI differs between countries, it’s grouped into common categories (see chart below). Unsurprisingly, Australia’s largest expenditure comes in the Housing sector, followed by Food and Beverage, Transport and Household furnishings/equipment.

CPI weights by group 2021
CPI weights (by group) - 2021 - Source: Australian Bureau of Statistics https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/annual-weight-update-cpi-and-living-cost-indexes/2021#response-to-the-change-in-household-spending-patterns

With the news of interest rate increases coming, we believe we’re likely heading into a period of higher inflation due to this and some other key factors, including:

  • Increasing post-pandemic demand for goods and services, including housing and utilities.
  • Strong economic growth as a result of government spending and interest rate stimulus measures.
  • Supply chain delays continuing due to weather, regulatory and pandemic restrictions.
  • Increasing supply costs, including labour and commodities.

How inflation impacts fixed interest and share markets

Investors need to understand inflation because it has such a significant impact on the value of investment returns.

In the case of the traditional fixed interest market, we’re seeing negative real yield (the return after it’s adjusted for inflation or a loss in future purchasing power). This is partly due to the interest rate cuts applied by central banks at the vast sums of financial stimulus that supported economies and financial markets during the pandemic and avoided recessions.

Inflation also has repercussions for share markets. In particular, we have seen a marked difference in the performance of ‘growth’ (eg Technology stocks) and ‘value’ (eg Bank stocks) companies that behave differently in different markets.

A low inflation and interest rate environment favours growth companies that have seen them outperform since 2018. More recently we have seen value companies that have strong cash flows but are ‘unloved’ by the market, begin to come back into favour. While raising interest rates could mute some of this outperformance, overall, we still expect shares to broadly deliver positive returns given the improving global growth outlook.

What’s ahead?

As economies continue to recover and interest rates gradually rise, we’re likely to experience higher inflation as a result. As financial markets adjust to these new conditions, there will be periods of share market volatility. But overall, the shorter-term inflation dynamics will be felt through a dampening of economic activity and increases in the cost of goods, while the longer-term implications will be more subtly balanced and will result in a more modest increase in market valuations when compared to the recent economic cycle.

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