Sent: 03-08-2010 13:50:43
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Inflation Decision Making
There are many types of inflation. The inflation measured by the CPI or wages growth that we were worried about in the 1980s might be less relevant. Investors will have to decide whether they are seeking protection or looking to take advantage.
The Australian consumer price index for the June quarter rose by only 0.6% rather than the higher 1.0% rise widely expected by market economists. Consequently, according to the pundits, an interest rate rise is unlikely to come from the next meeting of the Reserve Bank.
The reaction to CPI movements in Australia implies that everything we know about inflation is embedded in this index of the prices encountered by households.
Higher consumer prices, everything else kept the same, mean eroding living standards. People with lower incomes suffer the most. Social dislocation may result if there is a persistent and prolonged erosion of spending power.
As an investor, the source of inflation needs to be taken into account in coming to a judgement about whether it is disadvantageous.
Since the early 1990s, there have been four important sources of downward price pressure globally.
- The adoption of new technologies boosted productivity worldwide in the manufacturing and services industries.
- The declining price of technology greatly expanded its accessibility with businesses of all sizes able to capitalise on the new opportunities and compete more aggressively.
- There was a dramatic shift in global manufacturing capacity toward China which altered the global cost structure of manufactured goods.
- The Chinese manufacturing boom was abetted by the widespread adoption of lower trade barriers which allowed the potentially beneficial effect of spare Chinese manufacturing capacity to flow across national boundaries.
In Australia, adoption of more decentralised wage fixing arrangements through the 1990s magnified the advantages flowing from these changes.
Chinese manufacturers in the eastern part of the country are beginning to feel the pinch from cost pressures that could lead to a reappraisal of their production economics. The first steps to shift operations to western China, Vietnam, India and, in the longer term, Africa have begun. As long as there are no impediments to the trade in goods, manufacturing relocation could help contain goods inflation for several decades.
Having said that, one of the challenges for China in the years ahead will be to embrace foreign produced goods as readily as the rest of the world has embraced Chinese production. If not, other countries will be unable to maximise their productivity potential and costs will rise.
Two other components of the consumer price index are facing a less benign outlook. Government utility prices are set in a less competitive environment than global manufactures. Infrastructure shortages and taxes and levies to conserve energy and water will almost certainly lead to higher prices over the next 15-20 years.
Services that are unable to benefit from technology or free trade will become more susceptible to inflation pressures. Education and health care might be two examples.
Beyond the markets for goods and services, asset prices will be subject to disparate forces. In freer global capital markets, changes to financial policies flow through more readily to asset prices than to the goods markets. This has typified most of the last decade.
US monetary policies might have little impact on the price of a widget being made in a factory outside Hanoi but a far more significant effect on assets whose prices are set in markets with a high proportion of speculative content reliant on cheap money.
Whether an investor needs protection against inflation, and how that can be achieved, depends on what type of price rise is important.
Asset price inflation might be just as destabilising as goods inflation, as we saw in 2008. However, a 30% rise in equity values for no apparent reason will never be greeted with as much hostility, if any, as a 30% rise in education charges.
Investors might not want to protect themselves against asset price inflation as much as try to take advantage of it.
If, on the other hand, the concern was over CPI type inflation, the appropriate investment reaction needs to be different. In any event, there are marked differences in the pressures within the traditional CPI model.
If the inflation of concern is higher fuel costs or school fees, for example, action needs to be taken to hedge against the damage from those sources. These prices may be rising without regard to macroeconomic circumstances so that traditional recommendations such as buying gold to counter inflation may not be relevant in this context. Gold prices could be falling as Australian school fees are rising.
For many investors, fuel costs and education fees might not be of any great moment given their lifestyles. For them, rising utility bills might be far more important. One logical hedge against this source of inflation might be investment in utility companies, for example. Food price inflation, on the other hand, might force a move into fertiliser producers or companies with innovative ways to more economically produce usable water.
A more complex inflation environment might require investment advisers to consider what type of inflation is of most concern to the individual and build an investment framework appropriate to his needs. The inflation sources of primary concern might vary through his life cycle.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.