Global inflationary pressures are starting to abate. This adds to confidence that volatility will remain relatively low and provides a favourable backdrop for returns from risky assets, including shares.
Introduction
A major concern around mid-year was that global inflation would get out of hand leading to much higher interest rates and eventually a hard landing for economic growth. Such concerns culminated in a sharp correction in share markets, a rise in measured volatility and higher risk premiums for some assets. Since then the inflation threat has receded allowing bond yields to fall and share markets to rebound. More fundamentally, as long as inflation remains relatively benign financial market volatility is likely to remain relatively low and returns should be reasonable.
Recent news on inflation has been good
Recent news on inflation worldwide has been extremely positive:
· The fall in oil prices has led to a sharp fall in headline inflation rates. Of 36 countries worldwide to have reported October inflation data so far, 30 have reported a fall. US inflation has fallen from a peak of 4.3% year on year in June to just 1.3% in October. Inflation in the Euro-zone has fallen back to 1.6%, in China it is 1.4% and in Japan it is just 0.6%.
· Just as headline inflation led the rise in core inflation (ie, inflation excluding food and energy), its decline is likely to lead to a fall core inflation. See the next chart.
· There are signs that core inflation is starting to slow. For example, monthly readings for core inflation in the US have dropped back to just 0.1% a month.
· Slowing growth in the US and elsewhere is also likely to lead to a fall in core inflation rates around the world.
· Finally, it is likely that inflation is in the process of topping out in Australia as well. Just as inflation in the US led Australian inflation on the way up it is likely that it will lead it on the way down.
An abatement of global inflation concerns is good news because it heads off the need for sharply higher interest rates. In fact, the global interest rate cycle is already turning with US rates likely having topped out and some central banks around the world already cutting interest rates, eg, in some Asian countries. This in turn adds confidence to the view that global growth will have a soft landing. Put simply, interest rates have not been raised enough to bring on a global recession.
More fundamentally the abatement of inflationary worries adds to confidence that the world remains in a low inflation environment. Key drivers of the low inflationary environment remain firmly in place:
· The last six months has demonstrated that central banks are as focused on keeping inflation down as ever. Not a day goes buy without a central banker in the US, Europe, Japan or Australia warning of the need to keep inflation down and alluding to the possibility of higher interest rates to make sure that it does.
· The big disinflationary trends of globalisation, competition and new technology are alive and well:
– the integration of China, former eastern bloc countries and India into the global economy has substantially increased the global labour market;
– this in turn is continuing to see functions shifted to cheaper producers – whether it’s the production of car parts shifting from Victoria to China or call centre and research functions moving to India; &
– the increase in competition and new technology is maintaining pressure on companies to boost productivity and cut costs.
The importance of low inflation for investors
Uncontrolled and/or high levels of inflation distort economic decision making and have been associated with slower economic growth and higher unemployment. Low inflation is critical to the performance of investment markets. Confirmation that we remain in a low inflation world has the following implications:
· The interest rate cycle is likely to remain relatively mild, in particular the current tightening cycle won’t see interest rates rise enough to cause major debt servicing problems or bring on a profit crunching recession.
· Similarly, interest rates are unlikely to rise enough to curtail relatively easy liquidity conditions globally.
· Volatility in financial markets is likely to remain relatively low. The last few years have seen relatively low volatility in investment markets – to a large extent this reflects reduced volatility in the economic cycle and a big driver of this has been low and stable inflation.
The last year has seen an increase in equity market volatility, but from a low base. See the next chart.
Volatility may move a little higher on the back of uncertainty associated with slowing global growth. However, the rise in volatility is likely to remain relatively modest and continued low inflation adds to confidence that volatility will stay low compared to the past. New financial instruments enabling investors to diversify and off load their risks to other investors that are more able to bear them (eg, banks securitising their housing loans) are also contributing to a reduction in financial market volatility. Similarly, volatility is likely to remain relatively low in other asset classes.
The impact of continued low inflation in terms of a relatively muted economic and interest rate cycle, relatively easy liquidity conditions and relatively low financial market volatility suggests that risk premiums can remain lower than they have in the past (a risk premium is the excess return that a risky asset must offer over a risk free asset to attract investors). Looking at key asset classes specifically:
· The historical record indicates that low and stable inflation enables shares to trade on higher price to earnings (PE) multiples. The logic is simple. Low inflation results in a lower interest rate and yield structure in the economy, tends to be associated with less uncertainty and tends to be associated with a higher quality of reported earnings from companies (because when inflation is high companies do not adequately allow for depreciation of plant and equipment) all of which enables shares to trade on a lower earnings yield or higher PE than when inflation is high. For these reasons it is not appropriate to compare today’s PE with that in 1970s and 1980s (when high inflation pushed PE’s down into single digits).
In a cyclical sense, fading inflation pressures will take pressure of interest rates which in turn should allow shares to re-rate via higher PEs, reversing the experience of the last few years where PEs have fallen or gone sideways because of rising interest rates.
· While the spread (or risk premium) between corporate debt and government bonds may face some upwards pressure in the short term as global growth slows, it is likely to remain relatively low as the economic cycle remains relatively muted.
· Continued low inflation means that yield curves will continue to fluctuate around a relatively flat level. Low inflation means low inflation uncertainty and this suggests that the risk premium investors require to hold long term bonds versus cash will stay low.
· Continued low interest rates and bond yields and low economic volatility mean that yields offered by assets such as non-residential property and infrastructure will continue to be pushed down.
While many fret that the global “chase for yield” by investors is solely due to a glut of savings (or excessive liquidity) looking for a home, it is also a logical consequence of continued low inflation and low economic volatility leading to lower risk premiums than might have been required in the past. This is being given an added push by private equity firms who can see the potential to unlock value in listed companies in a way that traditional shareholders can’t.
Conclusion
The global inflation threat is starting to abate adding to confidence that financial market volatility will remain relatively low and providing a favourable backdrop for returns from risky assets, including shares.
Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors*
