While inflation is expected to begin to ease from next year, it is likely to remain higher than before the pandemic in the medium term, according to AMP chief economist, Dr Shane Oliver.
As a result, Dr Oliver believes that investment returns will likely be constrained in the coming period as a number of structural trends keep inflation above pre-pandemic levels.
“The collapse in inflation from the 1980s provided a tailwind for investment returns relative to what nominal growth and investment yields would normally indicate,” he said.
This, Dr Oliver explained, led to lower interest rates, reduced economic volatility and uncertainty, and a higher quality of company earnings.
“For growth assets, it meant a valuation boost as shares traded on higher price-to-earnings multiples and real assets like property traded on lower income yields,” he added.
However, Dr Oliver said that higher medium-term inflation would remove this tailwind and threaten its reversal. He highlighted five key structural trends that may drive this outcome.
1. Shift away from economic rationalist policies
While economic rationalist policies were used by Margaret Thatcher, Ronald Reagan, Bob Hawke and Paul Keating against the 1970s inflation, Dr Oliver noted there is now a backlash against these policies and more support for government intervention in the economy.
“The risk is that greater government involvement in the economy leads to lower productivity growth which will hamper the supply side of the economy and add to inflationary pressure.”
2. Reversal of globalisation
Dr Oliver stated that the pandemic and rising political tensions are accelerating the reversal of globalisation, as countries seek onshore production to reduce threats to supply chains, spurred on by resurgent nationalist sentiment and a return to scepticism of free trade.
“The reversal of globalisation looks like it has a way to play out yet. Inevitably, it will lead to higher costs and hence inflationary pressure,” he said.
3. Rising defence spending
With military spending on the rise again amid the war in Ukraine and China tensions, Dr Oliver noted that this means more demand for metals and more government spending, which will again add to inflationary pressure.
4. Climate change and decarbonisation
Even though the shift to sustainable energy may lead to lower costs, Dr Oliver argued that the transition to net zero will likely add to costs and inflation in a variety of ways. These include increased extreme weather damage, the costs associated with mitigation, increased demand for metals, increased energy costs and increased pollution regulation.
5. A fall in workers versus consumers
Dr Oliver suggested that a decrease in workers and an increase in consumers due to global demographic shifts will also likely add to inflationary pressures.
Implications for investors
Due to the potential for higher inflation over the medium term, Dr Oliver said that higher interest rates will make cash and fixed-interest investments relatively more attractive to investors.
Additionally, price-to-earnings ratios on shares are likely to settle at lower levels and income yields on real assets at higher levels.
“If inflation averages around central bank targets, which is our base case, returns will be constrained but still reasonable,” he predicted.
“If alternatively, inflation turns out much higher, then returns risk being weak. Which makes it very important central banks are successful in keeping inflation down; it’s just that the structural backdrop means it will likely be harder going forward.”
Jon Bragg
Jon Bragg is a journalist for Momentum Media's Investor Daily, nestegg and ifa. He enjoys writing about a wide variety of financial topics and issues and exploring the many implications they have on all aspects of life.
