Flares and inflation: Are we headed back to the 1970s?
After decades of decline, some leading investors are now taking steps to protect investments from rising inflation.
- Some investors are warning of an impending surge in prices due to inflation.
- US President Donald Trump’s 2016 tax cut triggered concerns for a fresh outbreak of inflation.
- Investors should consider how their portfolios would perform in an inflationary environment.
The 1970s were famous for flares, fondue and inflation.
After 30 years of decline, some leading investors are now warning of a return to 1970s-style inflation, which means investors need to begin to take steps to protect their wealth and investment portfolios from the devastating impact of a price surge.
It seems like a distant memory, but higher oil prices and wages pushed inflation sharply higher during the 1970s. In Australia, inflation peaked at 17.5% in 1973. So if a product cost A$100 at the start of the year, you’d have to pay A$117.50 for the same product 12 months later.
Related: How to construct a winning investment portfolio
Financial planner Claire Mackay CA shares her approach to creating a great investment portfolio for you and your family.READ NOW.
After the 1970s spike, inflation began a long downward trend as central banks such as the Reserve Bank of Australia (RBA) succeeded in bringing price rises down. The rise of globalisation, technology and China as a manufacturing powerhouse also helped push the price of consumer goods down.
A benign outlook
Inflation is now relatively benign, though our measure of inflation (the Consumer Price Index, (CPI) rose 0.5% in the March 2017 quarter. This moved the annual CPI rate to 2.1%, which for the first time in nearly three years put it back in the RBA’s goal of 2% to 3% over time.
Some commentators and economists, such as Craig Swanger from FIIG Securities, argue that with low wages growth in Australia inflation won’t be a threat for some time. The supermarket and food industry, a major source of household costs, is also facing deflation due to the popularity of discount retailers such as Aldi and Costco.
Rising commodity prices and US President Donald Trump’s tax cut, infrastructure and defence spending policies triggered concerns about inflation. But with Trump’s agenda stalling those fears have receded.
Some commentators and economists argue that with low wages growth in Australia inflation won’t be a threat for some time.
In the developed world there seems to be a similar story of rising but relatively benign inflation.
According to the International Monetary Fund (IMF), inflation in advanced economies in 2016 was just 0.8%. That figure is forecast to rise to 2% in 2017 and stabilise at 1.9% in 2018. In the US, inflation is forecast to jump from 1.2% in 2016 to 2.7% in 2017 and then stabilise at 2.4% in 2018, and 2.3% by 2022.
Dormant, not dead
But others argue against complacency. In 2014 Harvard University Professor of Economics and Public Policy Ken Rogoff said inflation is dormant but not dead.
Rogoff noted that inflation was still alive in emerging markets, and that remains the case in 2017. According to the IMF’s 2017 World Economic Outlook, inflation is running at 7% in Russia, 8.7% in Brazil and 7.8% in Turkey. Venezuela is in the grip of rampant hyperinflation, with prices expected to rise more than 700%.
Scott Kelly, portfolio manager at independent Australian investment management company DNR Capital, told Acuity that independent of Trump’s agenda, lead indicators around the world are supportive of higher inflation, bond yields and interest rates. He says a “Goldilocks” scenario is a gentle trickle up. However, he says that inflation is a risk.
Related: Is stock picking dead?
Will there be a role for professional investors, stock pickers and investment advisers in the future?READ NOW.
“How quickly could bond yields and inflation rise from here? It could happen more quickly than investors might be anticipating,” Kelly says.
Paul Moore of fund manager PM Capital believes after 30 years of falling inflation and yields the cycle has bottomed out. Inflation is not going to return overnight, but the “seeds are being sown”.
Moore says the inflation threat means investors need to think differently about their investment ideas. Inflation means rising interest rates and bond yields, bucking the trend of the past three decades.
Unfortunately this generation of investor hasn’t had to guide their portfolios through an inflationary environment.
Predicting inflation is difficult, but inflation has such a hideous impact on portfolios and wealth that investors should at least be performing a risk assessment on their portfolios. Inflation is the termite of the financial world, eating away at assets and undetected.
Elizabeth Moran from FIIG Securities says, “investors should have inflation protection no matter where we are in the cycle”. That protection would function like insurance, particularly for those near or in retirement who don’t earn wages that would rise with inflation.
Identifying winners and losers in the equity market during an inflationary environment is tricky. As a general rule, commodities and those who service commodity producers do well during high inflation, as do growth companies and companies that have market power to pass on rising prices to customers.
Banks are also traditionally seen as beneficiaries of an inflationary environment, but Kelly argues that the banks have too many other issues. He prefers diversified financials and insurers such as Henderson Group, QBE and Macquarie Group.
Guarding against losers
Rather than picking relative winners, investors would be better served by focusing on inflationary losers such as cash and bonds.
Inflation eats away at the value of cash and fixed rate bonds, but it also cuts returns. If you are earning 2% on an account and inflation is running at 3%, you have actually suffered a negative return of 1% after taking inflation into account.
Rather than picking relative winners, investors would be better served by focusing on inflationary losers.
Fixed rate bonds suffer a double whammy. Higher inflation usually means higher interest rates. The value of bonds usually falls when interest rates go up, delivering capital losses for investors.
Large investors are currently reviewing their bond portfolios. They are preparing for rising rates by implementing strategies such as shortening the duration of their portfolios so they are more resilient in the face of rising rates, and favouring floating rate bonds. They are also wary of bond proxies such as utilities and real estate investment trusts that tend to suffer when rates and yields rise.
Moran from FIIG Securities says the only way to completely hedge against inflation is inflation-linked bonds, which increase both the principal (the amount you get back when the bond matures) and the coupon (the amount you’re paid) in line with inflation.
Moran prefers inflation-linked bonds issued by investment-grade corporates such as Sydney Airport, which offer higher yields than government issued bonds. Retail investors can now access government issued inflation-linked bonds via the Australian Securities Exchange.
Using the above example, Moran says that if inflation surged to 10% investors would be protected and the return in investment from the Sydney Airport inflation-linked bond would rise to around 13.2%.
In 2017 fondue parties seem to be making a comeback, however a return to rampant 1970s-style inflation is unlikely. But there are risks and it’s worth investors considering how their portfolios would perform in an inflationary environment.
This article is part of a regular Wealth Management column offering tips on personal wealth management and analysis of issues within the wealth management profession. Have something you’d like this column to cover? Email the Acuity team now.
Related: Would you take Warren Buffett's wager?
In 2005 legendary investor Warren Buffett made a ten-year wager with investment professionals. Would you have taken it?READ NOW.