How long can we expect this inflation to last for?

Portfolio Manager Oliver Gordon Rivkin in Australian Business Executive

With equities making up a large portion of total wealth in Australia, particularly within Super and retirement savings, the current trend and outlook for stock prices is always a topical one. Are recent gains the start of a recovery back to new highs, or merely a ‘bear market’ rally? To better understand this question, a look at the main economic drivers is required.

With Rivkin offering general advice and model stock portfolios across both Australian and US equities, this article aims to examine the current lay of the land across both markets, the major macro drivers at present, as well as our views for stock market performance into the end of the year. Having just celebrated our 25 years in business, we have invested through multiple market cycles since the late 1990s, and it’s this experience which we can draw on.

Looking at the year so far, 2022 has been a challenging year for investors, with higher inflation, increasing interest rates, and global geopolitical instability, with the Russian invasion of Ukraine all contributing to investor pessimism, and an overall bias to weaker equity prices. In the US, the performance of the benchmark S&P500 for the first half was the worst since 1962, and the fourth weakest on record since 1928. The Nasdaq100 has performed worse still, down 29.5% over the same period. In Australia, the falls have been less severe, with the ASX200 Accumulation Index declining 9.9% to June 30.

Portfolio Manager Oliver Gordon Rivkin in Executive America
Chart 1 – AU and US Index Performance

It hasn’t all been bad news however, with a decent bounce in equity prices unfolding during July and into August. More so, certain parts of the market have been attracting buyers and performing strongly. Since the beginning of the year, up until the end of July, two sectors from the ASX200 achieved positive returns, that being Energy (+29.6%) and Utilities (+17.0%). It has been a similar story in the US, with S&P500 Energy and Utilities sectors rallying by 41.6% and 3.3% respectively. Energy stocks have benefitted from higher oil, gas, and coal prices, while utility stocks are often a ‘go-to’ sector during times of broader market volatility, due to their lower-risk, more predictable business models, combined with regular payment of cash dividends. The lesson here is that even during times of overall market declines, there is typically always certain parts of the market where gains can be made.

Inflation

Inflation has been a major story of 2022, and one with major implications for equities via the link to interest rates. The latest CPI figure, released for the June quarter, showed that inflation is currently running at 6.1% in Australia, the highest since June 2001. The most recent CPI data for the United States was released on August 10th, and came in at an annualised rate of 8.5%, below the peak from last month of 9.1%. While this decline is encouraging, it remains well above the Federal Reserve’s target of 2%. Based on the average of surveyed economists by Bloomberg, inflation is currently forecast to reduce to 7.3% by the end of the year, and 2.65% by the end of 2023.

While inflation may well have peaked in the US, Australia appears to be lagging some months behind. According to the August Statement on Monetary Policy, the RBA said that “inflation in Australia is expected to increase further over the course of this year, reaching around 7.75% in headline terms around the end of the year.” A return to 3%, being the top of the RBA’s target band is not expected until the fourth quarter 2023.

Chart 2 places these recent figures in context, with both AU and US inflation at multi-decade highs.

Portfolio Manager Oliver Gordon Rivkin in The Australian Business Executive
Chart 2 – AU and US Consumer Price Index (CPI)

The cause of this high inflation is multi-faceted. Supply-side constraints have been a major factor, impacted firstly due to economic shutdowns in response to Covid-19, and secondly, the sanctions imposed on Russia by western governments in response to their invasion of Ukraine. The latter is more a localised issue for Europe, particularly as it relates to energy. And while these supply side issues are the ones cited by Government officials as the major factors, governments have also had an impact on the demand side. We can’t forget the significant monetary and fiscal stimulus that was used to soften the blow of Covid-19 economic shutdowns, with stimulus cheques and cheap loans resulting in artificially boosted demand. In summary, inflation is being fuelled from both the supply and demand side, thus with more money chasing fewer goods, higher prices are an inevitable result.

Interest rates

Higher inflation not only hurts consumers directly via higher prices for groceries, fuel, and other necessities, but also via the corresponding higher interest rates that typically accompany an inflationary environment.

Interest rates have always been an important component in business and equity markets. The commonly explained relationship is that that lower interest rates impact equity prices in two positive ways, being cheaper funding conditions for those raising capital via debt issuance, and two, increased equity price valuations. To explain the second, analysts typically use the current level of interest rates to discount future cash flows to generate a present valuation of a business. This means that the same forecasted cash flows will equate to a higher current valuation by simply plugging in a lower interest/discount rate.

Using bond yields as a proxy for interest rates, the link between rates and equity prices can be seen in the chart below, which plots the yield for the Australian 10-year bond yield (right-hand axis), against the ASX200 Index (left-hand axis). As yields increased from around 1.5% at the start of the year, to a peak of 4.2% in mid-June, equity prices traded sideways initially, before a selloff into the June lows, at which point prices were some 9.9% off the peak. More so, the subsequent reversal, being lower rates since June, has coincided with a sizable recovering in equity prices.  Put simply, lower rates tend to be supportive for equity prices.

Portfolio Manager Oliver Gordon Rivkin in Australian Business Executive
Chart 3 – ASX200 and Aust Gov’t 10 yr. bond yields – Year to Date

In the US, the last time inflation rates were at current levels was back in the early 1980s. One of the most significant differences between now and then is the total level of debt within the economy. Looking at just US government debt, as a percentage of GDP, levels during the late 1970s to early 1980s ranged between 30% and 35%, reaching levels above 40% in late 1984. This is considerably lower the current level of 124%, as registered in the March quarter this year. Higher levels of debt mean that total interest expenses are much more sensitive to increasing interest rates, meaning that the economy can only sustain interest rate levels much lower than in the past. This has the potential to put the Federal Reserve between a rock and a hard place. If inflation proved to remain stubbornly higher, the US Central Bank may be forced to either recalibrate their target band higher, to say 4-5%, or risk severely crimping economic growth if rates continue to go up, given the large amount of debt in the economy.

The US Central Bank is not due to meet again until the 22nd of September, however we expect to receive an update to the outlook from Jerome Powell at the Jackson Hole Economic Symposium, to be held towards the end of August. Given that a large component of Central Bank monetary policy is providing guidance of future policy, comments around what the Federal Reserve’s plans to do can often carry more weight than the actual policy decisions themselves.

In Australia, futures markets are currently pricing in at least a 0.25% increase in September and a total of a further 1.5% by the end of the year, meaning a rate of 3.35%.

Growth outlook

Let’s look at economic growth. Over the long run, equity prices will track economic growth, however the biggest consideration is that growth data is backwards looking while equity prices are always forward looking, thus the correlation between the two tends to be low over shorter-time periods.

In Australia, and as measured by real GDP, Australia’s economy grew 0.8% in the March quarter. While figures for the June quarter are not available until early September, economists are forecasting growth of 0.9%- no signs of a contracting economy just yet. While slowing growth is yet to show up in official figures in Australia, in the US, the slowing growth outlook is more prominent, highlighted by a second consecutive quarter of GDP contraction in the U.S. which declined -0.9% on an annualized basis following a -1.6% decline in the first quarter, meeting the technical definition of a recession. As it relates to equities, slowing growth will show up in company earnings.

Providing some solace has been the outlook for jobs, where in the US, jobs growth remains strong, and it is a similar story in Australia. Returning to the RBA’s Statement on Monetary Policy, “Employment growth has been strong, and the unemployment rate has declined faster than earlier expected, to be 3.5 per cent in June – its lowest level in almost 50 years.”

Conclusion

Looking forward, much of the current outlook for equities markets, both locally and in the US, hinges on inflationary pressures. If inflation eases, like we are starting to see in the US, Central Banks will be given breathing room to pause on rate hikes, which will both lessen the impact on economic growth and company earnings, as well as the negative impact on valuations. One real time pricing mechanism to keep an eye on is the price of crude oil, given energy makes up a large component of total costs in the economy. Oil prices have eased quite a bit over recent weeks, which is a good sign that future inflation will follow. We place a higher probability on this view. As such, our overall bias is for higher equity prices into year end, with a focus on those stocks that benefit from an easing in interest rates. These are typically your ‘growth-style’ names, including many from the information technology and consumer discretionary sectors. On the other hand, sectors that did well during the first half of the year, being energy and utilities, are now likely to under-perform. In terms of risks, higher for longer inflation remains the major one, meaning investors should pay close attention to any data that suggests costs pressure are remaining sticky.

Oliver Gordon is Portfolio Manager for Rivkin, www.rivkin.com.au.

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