Inflation: Surely this can’t last?

By Jayson Forrest - Managing Editor  - IMAP Perspectives

Inflation is the talk of the town. The current spike in inflation has been driven by a number of factors - supply chain disruptions, QE, and geopolitical tensions. But just how long will inflation last and how is it impacting the portfolio management process? Alex Ventelon (Morgan Stanley), Aman Ramrahka (Morningstar), and David McDonald (IMAP) seek to answer these questions at the 2022 IMAP Portfolio Management Conference.

With inflation in the U.S. running at almost 8 per cent, and inflation in the U.K. at its highest level in over 20 years at over 6 per cent, it’s little wonder that the focus of portfolio managers has turned to high inflation across developed economies. And while inflation in Australia remains more subdued for now, pressures are rising.

Speaking at the 2022 IMAP Portfolio Management Conference, Alex Ventelon - Executive Director, Head of Research at Morgan Stanley Wealth Management Australia - says there are a number of things to consider in terms of the outlook for interest rates. Importantly, this includes geopolitical developments in Europe.

“The Russia/Ukraine conflict is creating a lot more inflationary pressure than we have previously had. This uncertainty creates prolonged market volatility and higher inflation,” says Alex.

“Federal Reserve chair, Jerome Powell, has recently commented that inflation is running too hot in the United States. Back in November 2021, he qualified inflation as being transitory. Since then, we have headline CPI running at nearly 8 per cent.

“The world has changed. The crisis in Eastern Europe is having an effect on inflation via commodity prices. It has been pushing commodity prices up.”

And while the current geopolitical developments in Europe carry relatively low earnings risk for Australian and U.S. companies, if the crisis is prolonged, Alex believes it could have three key implications:

• Higher energy prices for longer;
• Heightened volatility; and
• Slower economic growth.

“With this in consideration, Morgan Stanley has downgraded 2022 growth forecasts across most regions but still expects above trend growth both this year and next in Australia (4.5 per cent and 3.5 per cent respectively), as well as globally (4.4 per cent and 3.8 per cent).”

And what about inflation?

According to Alex, Morgan Stanley is expecting six rate hikes from the Fed this year, but this will still not get inflation back to target. Instead, the manager sees U.S. 12-month core PCE inflation at 3.4 per cent in Q4 2022, meaning even if inflation falls throughout 2022, a return to ‘normal’ (i.e. Fed target) will most likely be a 2023 story.

“Australia is also witnessing an acceleration in inflation,” says Alex. “The December quarter headline inflation (1.3 per cent quarter-on-quarter) was the strongest quarterly figure since 2008, and we are forecasting 3.6 per cent year-on-year for Q4 2022. Similarly, we expect inflation in Australia to normalise into 2023 towards the top of the RBA target. In fact, we believe inflation will peak at 4.4 per cent in Q3, so it will take us a bit longer to get inflation back into the 2-3 per cent range.”

Alex also believes the only way inflation can really come down is if there is a resolution to the Ukraine conflict. Inflation is forcing key central banks to abandon their ‘lower for longer’ stance on interest rates and move towards hiking rates much faster and more strongly than previously expected.

“As well as six hikes this year, he expects the Fed to have another four hikes next year, with a cash rate of 2.625 in the U.S. in 2023, which is about neutral. Jerome Powell recently said the Fed wants to go above the neutral rate of 2.5 per cent, which is where the economy could start to contract. So, the cure for inflation is probably more inflation, where it destroys demand.”

But Alex warns that if there is too much demand destruction by tightening excessively, the economy will slow down too much, resulting in a hard landing and the prospect of a recession in the U.S. next year. 

Despite inflationary concerns, Morgan Stanley still expects to see global GDP growth of 4.5 per cent this year and 3.5 per cent in 2023, with global growth continuing at 4.4 per cent in 2022 and 3.8 per cent next year.

“The geopolitical developments in Europe are impacting inflation, as well as sentiment, so we have downgraded our GDP outlook in most regions,” says Alex.

And what about Australia?

Alex believes Australia is well placed to outperform most developed markets this year and the next, given its strong economic momentum, the nation’s position as a commodities exporter, lower inflationary pressures, as well as a more accommodative RBA.

“We are predicting three interest rate hikes this year and four rate hikes next year. That’s because there are not as many inflation pressures in Australia compared to other countries, and our growth remains very strong. Australia is a net commodity exporter, which is good for the bottom line and budget. And in an election year, there will be more fiscal stimulus coming through.”

While agreeing with some of Morgan Stanley’s forecasting, Aman Ramrahka - Director, Manager Selection at Morningstar - warns that we may be understating some of the dangers of the current inflationary environment. One of these dangers is a perceived ‘soft landing’.

“This idea of a magical soft landing is a conundrum,” says Aman. “You can look back on history and see instances where rising rate environments have caused recessions, particularly in the United States. So, I won’t discount the possibility that perhaps the U.S. does go into recession, maybe not this year, but it could be something we have to worry about.”

Also worrying Aman is the possibility of stagflation.

“We’re heading towards a higher inflation environment, with GDP growth being tested. So, as economies recover from the COVID pandemic, the anticipated post pandemic bounce to markets for this year and next, is under question now. However, in terms of the argument against stagflation, we can look at the employment numbers, with the unemployment rate still low,” he says.

“I don’t believe inflation will runaway, but I think there is more to the story. We’ve already seen supply chains impacted by the pandemic. Companies and countries will now have to think more closely about their own supply chains, including the security of their supply chains, and that comes at a cost. Companies will either absorb that cost or pass it onto the customer, which makes me a little more bearish.” 

While there is general consensus that the Fed’s Jerome Powell is now listening to the market in terms of inflation and interest rates, back home, the RBA seems to have taken a more dovish approach than the local market over the last 12 months, adamantly saying it wasn’t going to raise interest rates until 2024.

“The market bought that story and it provided a needed boost to confidence. However, the RBA is now scaling back that story, and as a result, has lost some credibility,” says Alex.

“The state of capital markets for the last 15 years has been tied to the credibility of central banks. Therefore, it is very important they don’t lose credibility. The RBA has been generally good in providing confidence to the market, but withdrawing its statement on interest rate hikes has opened it up to criticism.” 

It’s a view that Aman supports, adding that the March resignation of RBA Deputy Governor, Guy Debelle, to go to Fortescue has interesting ramifications for the RBA.

“There is a widely held expectation that RBA Governor, Philip Lowe, would not be around for much longer and probably would not be extending his term, passing the baton onto Debelle. We’ve had the luxury in Australia of a long 10-year series of Governors, which have held the confidence of the market. The question now is who succeeds Lowe? This creates uncertainty and doesn’t inject confidence in the local market.”

When it comes to inflation, the key question is to what extent is it temporary or locked-in, particularly with respect to wages? For example, there are some industries with CPI+ wage contracts, which means if we get to 5 per cent inflation, does inflation then start to feed on itself through wages?

Alex concedes it’s an interesting question. He highlights the Ukraine conflict, which is significantly affecting the global supply of commodities, like wheat, oil, gas and aluminium.

“The impact on markets is enormous. History shows that often where there is a shock to energy prices, they spike, come down, and then normalise after that. Currently, we are fairly advanced in the inflation cycle,” says Alex. “The issue is when it’s supply-driven inflation, there’s not a lot you can do as a central banker, apart from destroying demand. That’s the risk when you apply the economic brakes too hard.”

In relation to the normalisation of inflation, while Morgan Stanley believes that much of the disruption with supply chains will ease this year - as countries progressively come out of COVID, with more investment returning across the board - China’s zero COVID policy has again affected the supply chain outlook, which is something Morgan Stanley wasn’t expecting.

“So, when headline inflation starts feeding into core inflation, that’s when things can really get bad. That’s why the Fed got more alarmed recently, because wages in the U.S. are growing at more than 3 per cent year-on-year, with an expectation of this increasing to 5 per cent this year. That’s what is making the Fed act today, because there is contagion between the headline and core factors, and it needs to reduce this pressure,” says Alex.

“As for Australia, there are many award agreements that will start kicking in, which will impact inflation. Add to this the fact that Australia is only expecting to receive half the number of skilled migrants back this year, compared to previous years, which will add pressure to wages. However, this number of skilled migrants is expected to return to normal next year, which will help to offset wages growth. That’s why we’re expecting 2023 to see a normalisation of inflation.”

Unlike Western economies, China has been cutting interest rates to stimulate its economy. In fact, if you look at what’s been happening in China over the last 10-12 years, the county has been countercyclical to the rest of the world. When the rest of the world was easing, China was tightening, and it has been easing when Western economies were tightening.

So, what’s the outlook for China and what does this outlook mean for Australia?

Due to its centralised economy, Aman believes China is well placed to closely watch and respond to the issues that many developed economies are currently grappling with - including wealth inequality, housing prices, and wage pressures.

“China has a lot more levers it can pull to curb some of those issues,” says Aman. This includes deleveraging the property sector.

In terms of what this will mean for Australia, it will depend largely on the continuation of China’s appetite for Australian resources, which is somewhat tied to its willingness to continue to expand westwards with its ‘belt and road’ infrastructure initiative. The war in Eastern Europe may also curb China’s ability to expand.

“I don’t think China is immune to some of these issues,” says Aman. “It may not be going into an inflationary cycle, but China is trying to get its domestic economy under control, and that’s causing a number of issues. However, as for Australia, the inflation story in the U.S. is much more of a connection to this country right now than perhaps some of the things that are happening in China.”

Morgan Stanley has downgraded growth for China, expecting the country to grow at about 5.1 per cent this year. And even with this downgrade in growth, Alex remains confident that China’s appetite for Australian resources, particularly iron ore, remains healthy.

“And that’s a good thing for both economies,” says Alex.

Alexandre Ventelon is Executive Director, Head of Research at Morgan Stanley Wealth Management Australia; and Aman Ramrahka is Director, Manager Selection at Morningstar.

The session was moderated by David McDonald - an Investment Specialist at IMAP and Conference MC.