Is the inflation genie stirring?

Rate cuts actually undermine national confidence … now as the cutting cycle comes to an end, inflation emerges as the key risk.

Summary: Digging beneath the headline figures, there simply isn’t a lot to be relaxed about. The drivers of the latest low inflation result are only temporary.
Key takeout: If food prices continue to normalise, and the $A unwinds, inflation will move back above target.
Key beneficiaries: General investors. Category: Economics and strategy.

Many market observers have been hoping in recent times the rapidly changing global economic consensus might force a rethink on domestic economic prospects.

For the most part, there does seem to be this budding national optimism – due largely to the rebounding iron ore price and perhaps the fact that Aussie stocks are up some 12% over the year.

Also playing no small part is the fact that the unemployment rate remains low at 5.4% and has so far defied expectations of a rise to 6%. Jobs growth more broadly is roughly at trend, which is consistent with other data – it’s what we would expect. 

So we start 2013 with broad-based growth about where I thought it would be, an unemployment rate that is actually lower – and a resurgent iron ore price. It’s a good place to be, and taking stock my view is unfolding as planned. All the while (and there is no way I would have forecast this given it is inconsistent with the economic data), the RBA’s cash rate has been slashed to the lowest rate on record – lending rates more broadly are at their lowest since the 1960s. A better set of economic metrics would be hard to find, notwithstanding ongoing weakness or even recessionary conditions in the housing and manufacturing space (12% or so of the economy).

With all that in mind, investors are probably wondering whether now is time to be overweight Australia, following a couple of years underperformance. The fact is, many major global stock indices in Europe and the US are approaching their 2007 highs – Australia with its stronger metrics is still some 40% below. Last year’s 12% gain doesn’t even take us back to the most recent All Ords peak of 5033 set in March 2011.

However, this week’s inflation numbers suggest a domestic rethink may not be in order yet. Why? Because it will help sustain the interest rate debate, or rather the discussion as to why we need further rate reductions. Note that it didn’t take long for the Treasurer and RBA board member Heather Ridout to come out cheerleading for lower rates -and with inflation notionally at the bottom of the band, such calls will garner considerable support. Even prior to the figures, the consensus of economist’s expectations was for at least one more rate cut at some point this year.

That being the case, I don’t think the time is quite right to be overweight Australia. Take a look at the confidence destroying impact the rate debate has had – it’s very clear to see in the data, although I acknowledge it isn’t what economic theory predicts should happen.

Chart 1 shows that confidence was higher when we were talking about rate hikes – and indeed the slump in confidence occurred after the rate cut debate took off in earnest. Think consumer spending restraint, the East Coast recession, non-mining recession, mining recession, investment boom bust, jobs slump etc. So the discussion didn’t occur in response to a fall in confidence – the discussion concerning rate cuts created the fall. Also more than just a coincidence, Australian equities started underperforming global benchmarks soon after.  Note that each time there is the call for further rate cuts, confidence took another hit. Indeed confidence really only ever bounced (apart from a relief rally after the initial rate cut) when the RBA left rates unchanged, citing more upbeat data.

Adding further support to this thesis, note that in 2011 we saw new home loan growth of something like 10%. In the 12 months post the RBA’s rate cuts, loan growth has stalled (ex refinances), falling just over 1% over 2012.

The second unfortunate aspect is that the December quarter CPI (which came in at 0.2%, against expectations of 0.5%) has done little to make me think my broader inflation thesis (underlying pressures are rising and inflation is on the march) is wrong. And I would dearly like it to be wrong – it would be the perfect environment for a stockmarket surge.

Headline numbers offer no support for my view and I freely acknowledge this to be the case - so I can understand if you’re a little bit sceptical. Unfortunately when you dig beneath the headline figures there simply isn’t a lot to be relaxed about. The drivers of the low inflation result were again temporary this quarter - for the same reasons as last year: The strong $A driving tradable inflation down ...

and less well known – food price deflation. Well stagnation.

Chart 3 shows food price stagnation is not normal – it is highly unusual when you consider that food prices are up over 50% for the previous decade and 160% in the two decades prior to that. Moreover, I’m not aware of any structural change as to why, all of a sudden, food prices would ease off. Competition can dampen food price moves, but not offset generalised pressures.  It flies in the face of everything we know going on globally – emerging markets, urbanisation in China and India, Brazil etc. I suspect it has something to do with all the rain we had in 2011 – the bumper crop in 2012. Feed is cheaper than what it was, livestock inventories have been rebuilt.  But that is seasonal and temporary – indeed it’s all unwinding now.

Consequently, I maintain my call that investors shouldn’t be lulled into a false sense of complacency. It is still the case that if food prices continue to normalise, and as the impact of the strong $A unwinds, we will see inflation back above target, on a sustained basis, by the middle of the year.