How quickly can you boil a frog? Why we should still think about inflation.

1. In a low interest rate world, inflation expectations as measured by inflation linked securities are dramatically below long-term historical norms. This creates a risk that even small spikes in inflation can have an outsized negative impact on investors’ portfolios given record low interest rates amplify volatility.
2. Inflation, when measured as a proportion of investors’ total expected returns, is enormously hard to predict.
3. Low recent inflation releases have been heavily influenced by cyclical factors which could rebound quickly.

Why is inflation volatility relevant in a world of benign inflation?

With inflation hitting its lowest rolling year end point of 1.0% since September 1998, a contributor to the Reserve Bank cutting interest rates to a record low of 1.5% in August 2016, it appears many investors are unconcerned with the impact of inflation on their portfolios. Current market expectations of inflation are remarkably naïve when viewed in a historical context, with the Australian inflation linked bond market expecting average inflation over the next 10 years to be just 1.68%[1]¹  p.a. compared with typical realised inflation rates over 2.5% in decades past. This is largely informed by the recent inflation data releases.

Source: RBA, Bloomberg, Ardea Investment Management

The fact is that inflation for the quarter ending in March 2016 was -0.2% and in the subsequent June quarter rebounded to a positive 0.4% result, illustrating how inflation can change quite substantially in the short-term, which in turn influences expectations over the long term.

To many, this seems inconsequential, but what this highlights to us at Ardea is that we are entering into a new period of volatility. Small differences in expectations versus realised outcomes can have larger impacts than periods where global interest rates were much higher and investors had more yield ‘cushion’.

Furthermore, what many investors fail to appreciate is whilst the absolute level of inflation is low, it is very hard to predict what your real return (i.e. your return over and above inflation) will be on money invested in yield-producing investments for a given period, particularly on new money being invested in markets at current low yields.

The following graph shows historical 1 year term deposit rates every quarter over the last 10 years (the shaded part) and then the % of the return of that term deposit rate that was absorbed by inflation over the next 12 months. As you can see, this varies significantly, with some years seeing nearly 90% of average term deposit returns absorbed by inflation, and this was in periods where interest rates were much higher than they are now. This highlights just how unpredictable real returns over and above inflation can be.

Source: RBA, Ardea Investment Management

Finally, when we drill down into the component parts of inflation, we observe that the downward pressures on prices over the last two years have been due to a few core areas, which could quite easily and quickly increase:

• Petrol prices and transport costs have fallen on the back of the crash in oil prices due to oversupply from the OPEC producers in an attempt to drive marginal US shale oil producers out of the market. This market is slowly returning to more balanced global demand and supply and as such, oil prices are creeping up.
• Communication costs are being driven ever lower by free communication products like social media and messaging apps.
• Clothing and grocery costs have fallen due to the entry of large foreign competitors like Aldi and Zara, which have put considerable pricing pressure on domestic competitors.

Source: RBA, Ardea Investment Management

These headwinds have resulted in substantial downward pressure on the prices of many common household ‘basket items’ but like all cyclical factors, they can rebound quickly. The headline inflation figure also hides the fact many large household expenditure groups such as housing costs (i.e. rent), health care, education, alcohol and tobacco, as well as financial services and insurance continue to appreciate steadily in price.

Conclusion

Like the parable of the frog being boiled alive slowly and not noticing until it is too late, investors need to be constantly wary of the continuous impact of inflation on the spending power of their portfolio returns. We challenge investors to think about the risks of inflation volatility on their broader portfolios, despite the long-term cyclical down-trend in current and expected future inflation in markets. Inflation outcomes are very hard to predict year to year, have the potential to change quickly, and can consume a large part of returns in a low-yielding world. We haven’t yet seen the tail risk inflation shock potential of all of the stimulatory monetary policy over the past few years either.

Don’t write off inflation just yet, it still has the potential to cook investor returns.

The information in this article has been prepared on the basis that the Client is a wholesale client within the meaning of the Corporations Act 2001 (Cth), is general in nature and is not intended to constitute advice or a securities recommendation. It should be regarded as general information only rather than advice. Because of that, the Client should, before acting on any such information, consider its appropriateness, having regard to the Client’s objectives, financial situation and needs. Any information provided or conclusions made in this article, whether express or implied, including the case studies, do not take into account the investment objectives, financial situation and particular needs of the Client. Past performance is not a guide to future performance. Neither Ardea Investment Management (“Ardea”) (ABN 50 132 902 722, AFSL 329 828), Fidante Partners Limited (“FPL”)(ABN 94 002 835 592, AFSL 234668) nor any other person guarantees the repayment of capital or any particular rate of return of the Client portfolio. Except to the extent prohibited by statute, neither Ardea nor FPL nor any of their directors, officers, employees or agents accepts any liability (whether in negligence or otherwise) for any errors or omissions contained in this article.