In an era of central-bank inflation targeting, what matters most is arguably not inflation, but inflationary pressures. If actual core inflation is contained through tighter monetary policy (as the US Federal Reserve is attempting to do now in the US), it means higher real policy rates and also higher real discount rates for all asset classes, potentially leading to significant implications for returns.
As we know, inflation, or the general rise in the price of goods and services over time, erodes the purchasing power of a fixed dollar amount over time. This can have a significant impact on the real returns we can expect over our investing lives: just like nominal returns and interest, inflation also has a compounding effect. This was evident during the 70s and 80s, where global shocks propelled the consumer price index (CPI) growth over 15 per cent year-on-year in this country and other developed economies. In response, interest rates and bond yields also surged to keep pace and to maintain the purchasing power of savers, resulting in significant equity and bond market turbulence.
The damaging effects of high inflation and the risks of inflation getting out of control once it reaches particular levels cannot be understated as it undermines broader economic confidence and the ability of firms and households to plan for the future. In addition, deflation, or the fall in overall prices (usually stemming from recessions) can also have insidious effects due to incentivising the economy to defer expenditure on goods and services if they are expected to get cheaper in the future, spurring further economic contraction i.e. a negative growth spiral. As a result, policy makers view low levels of inflation as manageable and ideal for stability and overall economic incentives.
Chart 1: Australian Consumer Price Index and introduction of inflation targeting.
*Excludes interest charges prior to September quarter 1998 and adjusted for the tax changes of 1999-2000
Sources: ABS; RBA
Inflation, inflation expectations and inflationary pressures… what really matters?
Generally speaking, inflation is the CPI change we observe, inflation expectations (as opposed to economist forecasts) are what’s implied by financial markets, such as the yield spread between nominal and inflation-indexed bonds (known as breakevens), while inflation pressures are the underlying economic drivers of inflation (which could be wage growth, commodity prices, changes in government spending, etc).
Chart 2: Australian 10-year ‘breakeven’ inflation expectations
Source: Bloomberg; straight lines denote breaks in 10-year bond or linker issuance
Over the past 25 years, inflationary pressures arguably have mattered more than actual inflation or even inflation expectations, with central banks generally having been successful in containing actual inflation levels and managing expectations through monetary policy – tightening policy as inflationary pressures build and easing policy as disinflationary pressures emerge. Largely in response to the inflation shocks of the 70s and 80, the early 90s saw many central banks institute explicit inflation targets and CPI numbers have been fairly benign across developed markets. The RBA, for example aims to keep core inflation (which excludes naturally volatile components like food and energy prices) between 2-3 per cent, on average, over time. Similarly, the Fed implements monetary policy with an objective to maintain inflation of 2 per cent over the medium term, while the ECB has an objective of keeping Euro area inflation rates below, but close to, 2 per cent over the medium term. The short-term policy rates (overnight cash rate in Australia; Fed Funds rate in the US; Main Refinance and Deposit rates in the Euro area) are the main levers for central banks. This is not to be confused with asset purchases or ‘quantitative easing’ (‘unconventional policy’), which involves large bond buying programs to inject liquidity into the system.
The “real risk free rate”
For investors, policy rates are seen as the short term “risk free” rates, with the spread between these rates and inflation giving the real risk free rates: a key determinant of real returns and prices for all assets. If inflationary pressures build over the cycle and central bankers tighten policy and manage to contain inflation, real risk free rates will rise. Conversely, deflationary or disinflationary pressures are countered by lower policy rates, resulting in falling real risk free rates.
Chart 3: Australian Real Cash Rate
Sources: RBA; Betashares Capital
Since the GFC, pressures in developed economies have largely been disinflationary due to a number of factors. Increased globalisation, lower commodity prices and technological innovations (with more people now consuming very low cost or even free digital content) are all potential drivers for the disinflationary trend. As policymakers want to avoid deflation at all costs, they have generally countered these disinflationary forces through accommodative monetary policy via lower cash rates and asset purchases, placing downward pressure on short term interest rates and long term bond yields. The impact on real returns in recent years has been dramatic, with interest on cash barely keeping pace with inflation in Australia and falling well below inflation in the US. With returns on cash so low, investors have been incentivised by the higher returns on equities and bonds, sending asset prices much higher, and arguably driving future returns lower.
Inflationary pressures, tighter monetary policy and the impact on asset prices
Assets, whether bonds, equities or property, are simply rights to future cash flow streams and valuations are those streams discounted back by an appropriate discount rate. The cash flow streams may themselves be fixed or indexed to inflation or some other floating benchmark. This discount rate should ultimately reflect a risk-free component and a risk premium relevant to that particular asset class. Generally speaking, $1 today is worth more than $1 next year and a guaranteed $1 should be worth more than a risky bet with an expected value of $1.
Fixed coupon bonds, by definition, pay a fixed dollar amount over time as interest payments and so should see their values fall if both nominal and real discount rates (yields) increase. An unwinding of asset purchases programs can also have a negative impact on bonds as net supply is increased. Furthermore, inflationary pressures may also increase inflation risk, which will also increase the discount rate (via the term premium) on fixed future cash flows, adding further pressure on bond prices.
For stocks it gets more complicated. Dividends and earnings should generally grow with inflation if corporate revenues reflect broader economic trends, so modest increases in inflation should not negatively affect real future earnings too much. However, for a given risk premium, greater inflationary pressures and higher discount rates mean lower present values assuming unchanged real future cash flows. As a result, tighter monetary policy and higher short and long term discount rates may drive contractions in valuation multiples (such as the P/E ratio), all else equal.
Portfolio construction and higher policy rates
It’s important to understand inflationary pressures and central bank policy cycles are not necessarily synchronised across countries. Just because the Fed is tightening policy (as it has been doing since December 2015), doesn’t mean higher policy rates are imminent in Australia, the Euro Area or Japan. However, inflationary pressures can potentially spread from one country to another over time. If inflationary pressures build in Australia over time (they currently remain subdued, with the RBA expected to remain on-hold this year at the time of writing), it’s important to be prepared for higher interest rates and also higher bond yields.
A good starting point for asset allocation in a rising rate environment is to assess expected real returns on cash, floating rate credit, property, fixed rate bonds and equities over the tightening cycle. In general, higher real cash rates and bond yields will generally affect cash and floating rate debt in a positive way compared to fixed rate debt and equities, at least in the short term. Over longer horizons, however, returns on riskier assets should adjust to higher real rates, and risk premia for equities, long-term bonds and credit, should be broadly preserved over the investment horizon to ensure long term investors are compensated for the short term risk they endure.