FYI | Jun 14 2022
Inflation can turn into a major negative for financial assets at a time when most investors have no recent experience.
-Inflation hasn’t been this high in decades
-How will politicians and central bankers respond if tightening creates systemic risk?
-Bringing inflation down to 2% might no longer be a realistic option
By Danielle Ecuyer
The bias factor of recent experience
For those of you who haven’t lived through inflation, and I mean the kind of price rises you genuinely notice, you may honestly be querying: why is everyone making such a song and dance about exogenous supply chain shocks causing price rises?
Fair enough when your own recent experience post the 2008 GFC has been a period of benign to declining inflation and ultra-accommodative monetary policy, known as quantitative easing (QE).
There’s no debating the resulting tailwinds for financial asset prices and the ‘buy-the-dip’ mantra have delivered a boon for investors.
However, the Professor of Finance at the NYU’s Stern School of Business, Aswath Damodaran disagrees.
In the recent Colossus podcast “Making Sense of the Market” (link below), Damodaran opined the proposition in words to the effect, “the fact the question is being posed at all implies these individuals have not lived through a period of inflation”.
While explaining many aspects of inflation, interest rates, companies, and stock prices, all through the lens of life/financial experience in the 1970’s, early 1980’s to present day, Damodaran highlights the negative implications, including jobs were hard to come by, as were favourable investment options.
High inflation caused financial pain in both the equity and bond markets.
High inflation eroded the viability of financial assets. PEs were in single digits with small caps outperforming, relatively speaking. Hard assets, like property, did well and contrary to recent history, cash was king.
Damodaran highlights investors, including himself, are often too swayed by recent experience.
Damodaran admits he, like many of us, had over-estimated the longevity of the ‘covid’ tailwinds on company earnings.
The example served to highlight the potential cognitive bias for younger investors/experts who are potentially prone to the same biases when it comes to assessing the impacts of inflation and higher interest rates on financial assets.
What’s the new neutral rate?
At the Morgan Stanley, Australia Summit 2022, the former Governor of the Reserve Bank of Australia (RBA), Ian Macfarlane offered his thoughts on what the new neutral rate would be for Australia and the US.
Not unlike the thoughts of Professor Damodaran, Macfarlane stressed two points.
1) In an historical context the period from 2010 until 2022 was unique: negative to low interest rates and QE.
2) On the pandemic impact on supply chains: the fiscal and monetary responses had been appropriate, but the demand response had well exceeded expectations.
The $64,000 question is where to now for inflation and interest rates?
MacFarlane stressed the measurement for inflation as a backward-looking indicator, year-on-year for the US and quarter-on-quarter for Australia, means there is potential for inflation to come down by the end of 2022, due to the high benchmark of comparison.
Equally, MacFarlane pointed out if the oil price stabilises at current level of around US$120bbl, the inflationary impact will ease.
The former head of the RBA believes inflation will not go back to 2%. Try 3%, 4% or even 5% as most likely outcomes.
To accommodate for higher inflation, the cash rate needs to rise.
Damodaran’s main concern is that the inflation genie has been let out of the bottle. Central banks are left with limited tools and influence.
The only way to pop the proverbial genie back in the bottle is via the unpalatable proposition of creating a recession; possibly a long, deep recession to squash demand and thus inflation.
Damodaran refers to the Volcker era which consisted of two back-to-back recessions in the early 1980’s to combat and defeat run-away inflation.
Macfarlane shares the view the RBA has limited powers, except to raise the cash rate to a neutral level, that theoretically could be as high as 5% depending on where inflation settles.
Times have changed since the 1970’s
Both Macfarlane and Damodaran are at pains to communicate times have changed since the 1970’s.
Direct comparisons are not by definition valid or accurate.
Macfarlane highlighted union strength and wage bargaining powers have subsided. He also suggested that as interest rates rise, Australians, historically, have placed mortgage repayments at the top of their expenditure list.
In Australia, Macfarlane believes the Achilles heel of the tightening process is in the property market, more specifically the vulnerability of the marginal borrower to undermine the balance sheets and earnings of the big banks (think rising bad debts).
Regarding the US, the complexity and financial gearing of Wall Street has left financial markets vulnerable to a financial shock, such as the 2019 repo market calamity when overnight rates soured from 1.6% to 9% overnight.
At that time, the Fed was forced to intervene in its role as central banker to maintain financial stability and operate for the US Treasury.
The potential for a repeat of other such systemic financial crises cannot be discounted in a tightening environment.
Macfarlane indicated the level of influence the global financial sector has on global economies is considerably more significant in the 21st century.
Whilst he offered no clear outcomes, the point for investors to ponder, which was also raised by the NYU professor is "how much resolve will the politicians and the central bankers have if the tightening process creates systemic risk?"
No central banker would want to revisit the calamitous bank runs of 2008.
Discretionary versus non-discretionary expenditure unknown
Inflation erodes spending power, so the challenge for companies will be in providing a discretionary must-have product or service for the retail consumer.
Damodaran highlights there are so many new products and services today that didn’t exist in the 1970’s, and thus it remains yet to be seen as to how the consumer will respond to sharply higher inflation.
Does the consumer suffer from subscription fatigue? Will the Netflix service be culled along with other streaming services?
How will eCommerce platforms perform? Will the consumer pay up for a new iPhone?
Large discretionary US retailers are already eating humble pie because of over-stocked inventories and pricing pressure.
Damodaran also highlighted high inflation brought forth volatile inflation. In turn, infrastructure and capital-intensive companies struggle to budget and work with volatile inflation.
Companies with agility and flexible pricing power will manage better, such as the small caps during the 1970s.
Companies with sticky earnings in the enterprise sector, think Microsoft and the Software-as-a-Service (SaaS) model should perform relatively better.
Equally; companies with the ability to offer smart digital solutions to businesses at reasonable prices will be well supported, predicts Scott Farquhar, Co-founder and Co-CEO of Atlassian, who also presented at the Morgan Stanley Summit.
Farquhar noted Atlassian had been through two recessions with the company’s low-cost pricing model offering a competitive advantage.
The stickiness of inflation, the extent of rate rises and the resulting impact on companies is for now at best a process of data watching and risk adjusting portfolios.
To be forewarned, is to be forearmed, so whilst history doesn’t necessarily repeat, both Damodaran and Macfarlane highlighted the risk high inflation represents for the valuation of financial assets, were it to stick around for longer.
Link to the Colossus podcast: https://bit.ly/3NK9lbL (Be prepared. It's nearly 2 hours long).
Danielle Ecuyer has been involved in share investing in Australia and Internationally for over three decades, both professionally and personally and is the author of ‘Shareplicity. A simple approach to investing’ and ‘Shareplicity 2. A guide to investing in US stock markets’.
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