By Hugh Giddy – Senior Portfolio Manager and Head of Research
As you sip your morning coffee and read this, consider the following questions:
- Have central banks, including the Reserve Bank of Australia (RBA), accurately anticipated inflation historically?
- Do you believe the RBA’s modelling of inflation outcomes will be correct now?
- Are their actions in raising the cash rate slowly to the current low level (including the latest small increase), consistent with their commentary that inflation is very damaging to an economy and must be reduced, despite Australia experiencing higher core inflation than other developed countries, with unemployment continuing to be very low?
- Is the RBA not focussed on house prices as they publicly profess? Do they not care about the favourable wealth and consumption effects of rising house prices and feel no need to intervene or act to cushion weaker house prices?
If you are shaking your head to the questions, you are probably fretting about how monetary policy and inflation are eroding your spending power and possibly your wealth. If you are nodding your head and place your faith in the Reserve Bank, it is likely you have not considered the record closely, or are simply a happy beneficiary of the unsustainable asset price bubbles central banks have fostered with loose monetary policy over more than a decade.
Despite inflation falling modestly to 7% in the latest figures, economists think the Reserve Bank will not raise rates much further even though the cash rate at 3.85% is well below headline and other measures of inflation, either because they have done enough or are simply too dovish to really care about inflation.
A recent Resolve Political Monitor poll showed that two thirds of people believe young Australians will never be able to buy a house. In the short term that may have favourable economic effects as young people might spend freely rather than saving towards an unattainable goal, supporting retail sales in the economy. However, the inequality resulting from asset prices rising much faster than incomes is nothing to celebrate.
Common sense should have dictated that inflation would rise significantly at some point. Crazy theories were floated that the governments should spend freely to stimulate the economy, financed by effective money printing by central banks. It is fair to say that modern monetary theory, “MMT”, or more aptly, “the magic money tree”, has already been disproved. While central banks like to point to Covid impacts on the supply and transport of goods as the cause of higher prices, it is disingenuous to not also point to the massive surge in demand as money poured into the economy with easy money and massive government deficits.
If central banks are unlikely to preserve the purchasing power of your savings and wealth, what are your best options? If you believe house prices will continue their heady progress despite poor affordability, that may be an option. However, net yields on investment properties are generally below funding costs, despite surging rents. Cryptocurrencies so far have not performed well in the face of inflation and the reality check of rising rates. Bonds have been terrible performers since the days when markets believed inflation and interest rates would stay down almost indefinitely. Term deposits are less unattractive than they were with zero rates, but the post tax income still trails core inflation by a significant margin.
The outlook for company shares essentially depends on two factors: profits or earnings (overall these depend on the economy) and valuation (which is influenced by interest rates and sentiment). Higher interest rates are putting some pressure on both the economy and valuations, but the stockmarket is never homogenous. We believe there are appealing avenues for protecting your wealth and purchasing power if you are selective in the current market, despite the index being close to record levels. Features to look for in companies are pricing power or the ability to recover cost increases without significantly impacting sales volumes; providing an essential good or service; and a strong balance sheet; but not at any price of course. A few examples are below.
Aurizon has inflation indexation on its rail haulage contracts with miners and other customers. Volumes have suffered with La Nina’s widespread flooding, but are likely to normalise as El Nino reasserts itself. Earnings on the regulated rail tracks or “below rail” rise as the asset base is adjusted for inflation and the regulated return rises as interest rates increase with inflation. Finally, the company’s recent purchase of the Adelaide to Darwin rail line (OneRail) is likely to favourably surprise the market if it is successful in signing up new mining customers in the centre of Australia. The longer term vision of moving containerised imports around the country more cost effectively could really change profits and perceptions of the business.
Telstra is finally able to benefit from its extraordinarily strong market position and historical investment in its network. After years of losing fixed line customers to the NBN and facing a price war in mobile services, the company has delivered strong earnings and a higher dividend. Telstra put through mobile plan price increases, telling customers who are becoming conditioned to price increases generally, that plans will go up in price annually with some linkage to inflation. The annuity cash flow from the NBN, which is renting Telstra’s ducts and exchanges, is indexed to inflation.
The Lottery Corporation enjoys long-dated licences and a monopoly position. Prices have been increased on various games with players largely accepting the increases. Rule changes on games like Powerball have increased jackpot frequency and hence interest in the games. Increased digital uptake by customers increases the margin for the company, which combined with rising revenues has created a favourable profit trajectory. Although lottery tickets are a discretionary purchase, history has demonstrated that lottery revenues are remarkably resilient in economic downturns.
A portfolio of quality businesses such as these could be a key pillar in defending your wealth against the ravages of inflation. It remains unclear how much central banks are aiding in the fight.
