The prospect of an increase in inflation has started to excite the imaginations of economists and market commentators, citing stimulus from expanding fiscal deficits and continued low interest rates across the yield curve. By contrast the US treasury bond market has increased its implied 10-year inflation rate from 2.43% per annum last month to 2.47% per annum this month.
There is some anecdotal evidence of a tightness of supply of labour in Australia, the USA, the UK and Europe which may point to accelerating wage inflation. It may, however, have as much to do with the shutdown of global migration and a reconsideration by workers of how they want to work, rather than being an indication wages are about to surge.
While there is some prospect of an increase in inflation, we think the US bond market is closer to the likely outcome than the opinions of many economic commentators. A modest increase in inflation over the next three to five years (to somewhere below 4% per annum) is much more likely than a sharp increase to above 5% p.a. The main reason for this is that there is not yet evidence of inflation expectations of consumers or bond investors having shifted upwards. In this circumstance returns on bonds would be adversely affected but returns on equities may well be improved by mild inflation that adds some lubricant to the economy and stimulates higher revenues and higher profits for many companies.
In Australia in the last month we have seen a significant change in long-term fiscal policy from the Coalition government which now envisages up to ten years of budget deficits, providing significant stimulus to the economy. This may add fuel to the speculation about higher inflation. Equally it implies a strong vested interest on the part of the government and the central bank in keeping any rise in interest rates to modest proportions.
The Australian federal government is conservatively predicating its budget strategy on a modest level of prices for Australia’s major export iron ore, at USD 55 per tonne (versus recent prices of over USD 150 per tonne). Most of the iron ore is exported to China. It may turn out that the modest price assumption for iron ore is insufficiently conservative to cater for a major drop in the volumes that will actually be exported to China, particularly in the latter part of the next ten years. Both the Commonwealth finances and the GDP growth of Australia depend significantly on such iron ore exports and any significant further cutback in imports by China would also impact many businesses within the country.
The level and the shape of the yield curve for bond markets in Australia, the USA and elsewhere is indicating:
- Low inflation over the next ten years
- Modest real GDP growth over the next three to five years; and
- No relapse into recession within the next two years
The valuation of a number of major equity markets has improved significantly over the last month reflecting mainly an improvement in the earnings base of companies. There has been little change in the level of short-term interest rates or long-term bond yields, so future profits and cash flows are not being discounted more severely.
Extracted from Purvis Investment Market Conditions Report – 1 June 2021