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Managing the risk of inflation shock

Samuel Morris
— 1 minute read

Low interest rates and ongoing volatility are contributing to increasingly sensitive portfolios and the rising risk of ‘inflation shock’, writes Ardea Investment Management’s Samuel Morris.

Samuel Morris

During the 19th century, several German and American scientists undertook experiments to observe the reaction of frogs to slowly heated water.

Without exploring the detail of the experiments – or the debate over their scientific validity – these experiments spawned the parable about a frog being boiled alive if cold water were heated at a sufficiently slow rate that the frog failed to adjust to its changing circumstances.

Inflation is somewhat like the frog parable – it is that persistent and gradual feature of the fiat money system that ‘melts’ the purchasing power of our money over time. But that’s not the end of the story.

We believe inflation still presents a risk, for three reasons:

  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.

Let’s explore these in more detail.

With inflation hitting its lowest rolling year-end point of 1.0 per cent since September 1998, a contributor to the Reserve Bank cutting interest rates to a record low of 1.5 per cent 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 per cent per annum compared with typical realised inflation rates of over 2.5 per cent in decades past.

This is largely informed by the recent inflation data releases.

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

To many, this seems inconsequential, but what it highlights is that we are entering 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, many investors fail to appreciate that 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.

For example, a saver putting money into a 1-year term deposit in June 2015, when average term deposit rates were about 2.5 per cent, would have lost over 50 per cent of that return to inflation over the past 12 months.

You only have to look back to September 2013, when the average term deposit was paying about 3.5 per cent, to find that nearly 90 per cent of those returns were lost to inflation over the subsequent year, illustrating just how unpredictable returns can be once inflation is taken into consideration.

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.

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.

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.

Samuel Morris is an investment specialist representing Ardea Investment Management

 

Managing the risk of inflation shock
Samuel Morris
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