Will inflation ever come back to Developed Economies?

In July 2020, investors are starting to position themselves for inflation. We know this because specific asset classes have been rising without many noticing. 

Inflation price rises have been non-existent in developed economies since the Global Financial Crisis (GFC) started in 2007. Although the amount of fiscal and monetary stimulus which is being ploughed into economies is meant to bring rampant inflation – or so the theory goes.  

Key trading point:

In the last week, Australian bonds have increased, which often happens when interest rates are discussed. Importantly this week, inflation bonds suddenly took off in comparison to the rest of the bonds. This indicates that investors are suddenly concerned about inflation.

What is inflation?

Inflation is the general rise in price and fall in the purchasing value of money.

If a litre of milk costs $2.50, but a few years later it costs $5, and we’ve seen a similar rise in most other groceries, then we’d say that it was inflation that drove the prices higher, not the farmer or supermarket.

Why does it matter?

Inflation is important for many reasons, but from an investment perspective, this is the greatest reason - the impact on investment assets. 

Property example:

With high inflation, the price of property can go up disproportionately to the rest of the economy.

Take a house that cost $1m and rented out for $50k a year. 

If inflation takes off so do the prices of milk, bread, electricity, furniture etc. and the same house now costs $1.5m to keep pace with groceries and other costs in the country. 

Now the tenant is paying rent of $75k.

If the tenant has not had a similar increase in their wages, then they now have less money to spend on food etc. or need to move out.

If the tenant moves out, they could look to buy their own house, although their wage has not increased, but the cost of a house has. The bank will not lend the tenant money to buy a house, as their income is not high enough and the tenant is now even further away from home ownership.

Who wins with inflation? There are winners from inflation. In general, the winners are:

• Asset owners (property, shares etc.)

• Leveraged investors; those who borrowed money to buy assets (investment properties etc)

• Those in debt (credit cards through to governments)

Those who spent money to buy items that go up in price, such as property and shares, benefit. As the price rises, the value of the asset (property etc.) increases, but their loan does not. The loan shrinks as a percentage of the value of the asset to the point where the loan is insignificant  - just ask anyone who borrowed to buy a house in Sydney in the 1980s, with a mortgage of $50k.

Who are the losers when it comes to inflation? The inflation losers are the savers and lenders. For example:

• Retirees who have worked hard to save for their nest egg. They conservatively put the money in the bank to avoid risks in property and shares. This nest egg buys less and less as inflation rises

• Lenders - rather than buying assets, the loan the lenders provided has enabled someone else to buy assets and benefit from the price rises. When the money is given back to the lender, that same money now buys less today than it did before. 

What the markets tell us about inflation in July 2020: When looking at markets we can separate the investments into groups of those which benefit from inflation and those which are hurt by inflation.

In Australia we look at:

1. Commodity prices 

2. Gold prices 

3. inflation linked bonds 

The first two groups are hard assets which work in a similar way to property prices, albeit more volatile and exposed to their own global market dynamics. Nonetheless, the overarching theme is that when they go up, inflation can be a cause.

Trading insight:

We have seen gold miners increase faster than the gold prices in Australia. Part of this is explained by the AUD/USD exchange rate, although this has also been an early indicator, or hedge, of inflation.

Inflation-linked bonds are effectively loans to the government, like a term deposit. The interest though, is paid with the bonus of whatever the inflation rate is. When inflation is low, these inflation-linked bonds (IFLs) have low demand – such as the last few years.

Although, when inflation looks to be a concern, then IFLs are in high demand and their price skyrockets – just like the last week or so in Australia.

Summary:

Gold miners have been rising for months, iron ore prices and other commodities have too. Inflation-linked bonds have risen sharply. This implies that inflation is a risk that early investors are positioning themselves for in the years ahead. The positioning is to prevent being left behind as inflation lifts the prices of some assets more than others.