OPINION

For the past 40 years, inflation in the western world has not triggered any emotion…until now. Naturally, the question we must ask is: What exactly has caused the sudden panic, fear, and obsession with the subject of inflation?

In central banks’ pursuit of taming inflation, we have seen the blunt instrument of raising interest rates being applied worldwide. This has negatively impacted most asset classes, especially property and shares.

Since 1990, the general trajectory of interest rates has been downward, ultimately reaching the floor of a 0.1% p.a. official cash rate in Australia. In other words, “free money”. This led to an unprecedented demand for almost any time type of asset that can store wealth.

It is no surprise that with the onset of rate hikes, as well as wild predictions of the share market and property market falling in excess of 60% and 30% respectively, all types of investors have their eyes and ears fixated on what will happen next in the global economy.

On the topic of interest rates, it must be noted that if rates are raised too quickly, they could trigger a recession. On the other hand, if inflation is unchecked this could lead to deeper and more damaging recessions worldwide. It may take decades to return to normality.

This is undoubtedly the most pressing economic issue of our time.

To understand the origins of inflation and to arrive at possible antidotes, one needs to dust off their economics textbooks from an era that experienced this phenomenon firsthand – the 70s.

As one of my favourite sayings goes – “History doesn’t repeat itself, but it often rhymes.”

What is the True Origin of Inflation?

Milton Friedman is one of the most highly regarded economists of modern times, reinforced by his receiving of the 1976 Nobel Memorial Prize in Economics for his work on the study of inflation. He is the principal architect of modern monetary policies applied by western central banks.

The words Friedman uttered during his era are all the more relevant to today’s economic climate. As he put so simply: “Inflation is a monetary phenomenon. It is made and stopped by central banks.”

In other words, it is the volume of money being printed, which can be economically summarised as an increase in the money supply, that is relevant to the question of inflation.

Increase In The Money Supply

Since the onset of COVID, the increase in money supply has never been more significant in our economic history. We have been paid a raft of various government benefits to sit at home and disrupt normal business and spending habits. At the same time, the RBA increased the money supply to counterbalance the loss of productivity. Central banks were essentially “printing more money” at a rapid pace, while lowering interest rates and allowing the bank to issue more credit.

Also, let us not forget quantitative easing, where the government buys and issues debt, reducing the cost of capital and creating massive liquidity in the financial markets.

According to Friedman, once a rapid increase in money supply occurs, it takes anywhere between 6 to 18 months for inflation to work through the economy. We are seeing this phenomenon firsthand here in Australia and around the world, with inflation rates not seen since the 70s.

Friedman also noted that inflation is not a global phenomenon but a home-grown problem that is caused by central banks and can be remedied by central banks.

Supply/Demand for Goods And Services

In the normal free-market economic system, prices of goods and services adjust according to demand, with businesses either increasing or decreasing production. Over time, this results in new business entrants increasing supply, or businesses leaving the market and decreasing supply.

Counterintuitively, these disruptions do not cause persistent inflation. From the onset of COVID, the stop-and-start nature of the global economy has resulted in supply chain issues and overnight demand for certain services, with employers needing to re-skill and re-tool their businesses to cope with unexpectedly high demand.

Once again, using free-market logic, these issues will eventually resolve themselves over time. Economists often refer to these impacts being ‘transitionary’ impacts of inflation; that is, temporary.

Looking back at the ’70s inflation crisis, many governments around the globe tried to lay blame on the 1973 war in the Middle East that disrupted oil production and increased its price by as much as 400%. Comparisons can be drawn to the Russian-Ukraine War and its effects to supply chains and commodities globally.

Despite this, the teachings of Milton Freidman tell us that these supply shocks provide short-term inflationary pressure. In the long-term, free-market economics will find a way to adjust the demand and supply of these goods.

Future Price Expectations

Perhaps the most ignored and least discussed aspect of inflation is future price expectations.

In the US, Australia and most western economies during the ‘60s, inflation had been unchecked for many years, rising from 1.5% to 5% during the ’60s, and reaching more than 14% in the ‘70s. In addition, wage inflation in Australia for the five years during 1969-1974 went up by 98%.

If businesses and employees are accustomed to long periods of persistent, rising inflation, a natural response to the rising cost of living will be employees demanding an adjustment to their wages, leading to higher prices and higher inflation. In such a situation, inflation becomes embedded in expectation and becomes a self-perpetuating inflationary issue that is commonly referred to as the ‘wage-price inflationary spiral’.

The main lesson to be learnt from the 70s is that we cannot allow unanchored inflation expectations. Central banks must act swiftly to tackle inflation and maintain the status quo of people having anchored expectations of inflation so as to maintain faith in our financial system. This is to avoid inflation becoming uncontrollable and inflicting unnecessary harsher pain to the economy.

This is precisely why despite Labor’s promises to support the market with 5.5% wage inflation, the RBA recommends that it remains capped at 3.5%. Lower wage inflation guards against a wage-price inflationary spiral.

Thus, we reach a conclusion that a short recession is better than losing control of inflation and letting loose future price expectations.

Looking back at our central bank, the current actions taken by the RBA are taken right out of pages in Milton Freidman’s economic textbook. They are acting swiftly and assertively.

We believe the next 6 months will have a heightened level of volatility in both the property and share market until there is evidence that the inflation beast has been tamed. We anticipate that this will only occur towards the end of the year once we receive data reflecting lower inflation.

Investors should expect a short and fast series of interest rate rises over the next four months.

Hopefully, this will be followed by stability with minimal changes to the official cash rate during 2023. This would enable the economy to re-adjust to the psychology of normalised interest rates.

The RBA Governor, Philip Lowe, indicated that an official rate of 2.5% is the correct setting for a neutral monetary policy and money supply. Investors and borrowers should brace for this setting sooner rather than later and prepare for the fact that we will have higher interest rates and softening asset prices.

Australia’s present economic strength is significant with a low base of unemployment, plentiful natural resources and a food-rich economy. Despite this, the sudden increase in interest rates will pose an additional risk. As mortgage managers, we appreciate our risk assessment and are completely cognisant to the downward risk of depreciating property prices.

We assess the risk of properties depreciating by perhaps between 15-20% – maybe even more for some specialised properties as well as regional properties and vacant land. Additionally, some construction projects have a significant risk of delays and cost blowouts that continue to be the predominant risk factor for this type of debt over the next 12 months.

However, with the lack of supply, wage inflation, migration, low levels of unemployment, rental growth and times of inflation, property is naturally seen as an inflation hedge. Thus, property will remain relatively resilient through these inflationary times.

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Paul Miron has more than 20 years experience in banking and commercial finance. After rising to senior positions for various Big Four banks, he started his own financial services business in 2004.

MSQ Capital

msqcapital.com

For years, global companies showcased their Chinese operations as a source of robust growth. A burgeoning middle class, a stream of people moving to cities, and the creation of new services to cater to them—along with the promise of the further opening of the world’s second-largest economy—drew companies eager to tap into the action.

Then Covid hit, isolating China from much of the world. Chinese leader Xi Jinping tightened control of the economy, and U.S.-China relations hit a nadir. After decades of rapid growth, China’s economy is stuck in a rut, with increasing concerns about what will drive the next phase of its growth.

Though Chinese officials have acknowledged the sputtering economy, they have been reluctant to take more than incremental steps to reverse the trend. Making matters worse, government crackdowns on internet companies and measures to burst the country’s property bubble left households and businesses scarred.

Lowered Expectations

Now, multinational companies are taking a hard look at their Chinese operations and tempering their outlooks. Marriott International narrowed its global revenue per available room growth rate to 3% to 4%, citing continued weakness in China and expectations that demand could weaken further in the third quarter. Paris-based Kering , home to brands Gucci and Saint Laurent, posted a 22% decline in sales in the Asia-Pacific region, excluding Japan, in the first half amid weaker demand in Greater China, which includes Hong Kong and Macau.

Pricing pressure and deflation were common themes in quarterly results. Starbucks , which helped build a coffee culture in China over the past 25 years, described it as one of its most notable international challenges as it posted a 14% decline in sales from that business. As Chinese consumers reconsidered whether to spend money on Starbucks lattes, competitors such as Luckin Coffee increased pressure on the Seattle company. Starbucks executives said in their quarterly earnings call that “unprecedented store expansion” by rivals and a price war hurt profits and caused “significant disruptions” to the operating environment.

Executive anxiety extends beyond consumer companies. Elevator maker Otis Worldwide saw new-equipment orders in China fall by double digits in the second quarter, forcing it to cut its outlook for growth out of Asia. CEO Judy Marks told analysts on a quarterly earnings call that prices in China were down roughly 10% year over year, and she doesn’t see the pricing pressure abating. The company is turning to productivity improvements and cost cutting to blunt the hit.

Add in the uncertainty created by deteriorating U.S.-China relations, and many investors are steering clear. The iShares MSCI China exchange-traded fund has lost half its value since March 2021. Recovery attempts have been short-lived. undefined undefined And now some of those concerns are creeping into the U.S. market. “A decade ago China exposure [for a global company] was a way to add revenue growth to our portfolio,” says Margaret Vitrano, co-manager of large-cap growth strategies at ClearBridge Investments in New York. Today, she notes, “we now want to manage the risk of the China exposure.”

Vitrano expects improvement in 2025, but cautions it will be slow. Uncertainty over who will win the U.S. presidential election and the prospect of higher tariffs pose additional risks for global companies.

Behind the Malaise

For now, China is inching along at roughly 5% economic growth—down from a peak of 14% in 2007 and an average of about 8% in the 10 years before the pandemic. Chinese consumers hit by job losses and continued declines in property values are rethinking spending habits. Businesses worried about policy uncertainty are reluctant to invest and hire.

The trouble goes beyond frugal consumers. Xi is changing the economy’s growth model, relying less on the infrastructure and real estate market that fueled earlier growth. That means investing aggressively in manufacturing and exports as China looks to become more self-reliant and guard against geopolitical tensions.

The shift is hurting western multinationals, with deflationary forces amid burgeoning production capacity. “We have seen the investment community mark down expectations for these companies because they will have to change tack with lower-cost products and services,” says Joseph Quinlan, head of market strategy for the chief investment office at Merrill and Bank of America Private Bank.

Another challenge for multinationals outside of China is stiffened competition as Chinese companies innovate and expand—often with the backing of the government. Local rivals are upping the ante across sectors by building on their knowledge of local consumer preferences and the ability to produce higher-quality products.

Some global multinationals are having a hard time keeping up with homegrown innovation. Auto makers including General Motors have seen sales tumble and struggled to turn profitable as Chinese car shoppers increasingly opt for electric vehicles from BYD or NIO that are similar in price to internal-combustion-engine cars from foreign auto makers.

“China’s electric-vehicle makers have by leaps and bounds surpassed the capabilities of foreign brands who have a tie to the profit pool of internal combustible engines that they don’t want to disrupt,” says Christine Phillpotts, a fund manager for Ariel Investments’ emerging markets strategies.

Chinese companies are often faster than global rivals to market with new products or tweaks. “The cycle can be half of what it is for a global multinational with subsidiaries that need to check with headquarters, do an analysis, and then refresh,” Phillpotts says.

For many companies and investors, next year remains a question mark. Ashland CEO Guillermo Novo said in an August call with analysts that the chemical company was seeing a “big change” in China, with activity slowing and competition on pricing becoming more aggressive. The company, he said, was still trying to grasp the repercussions as it has created uncertainty in its 2025 outlook.

Sticking Around

Few companies are giving up. Executives at big global consumer and retail companies show no signs of reducing investment, with most still describing China as a long-term growth market, says Dana Telsey, CEO of Telsey Advisory Group.

Starbucks executives described the long-term opportunity as “significant,” with higher growth and margin opportunities in the future as China’s population continues to move from rural to suburban areas. But they also noted that their approach is evolving and they are in the early stages of exploring strategic partnerships.

Walmart sold its stake in August in Chinese e-commerce giant JD.com for $3.6 billion after an eight-year noncompete agreement expired. Analysts expect it to pump the money into its own Sam’s Club and Walmart China operation, which have benefited from the trend toward trading down in China.

“The story isn’t over for the global companies,” Phillpotts says. “It just means the effort and investment will be greater to compete.”

Corrections & Amplifications

Joseph Quinlan is head of market strategy for the chief investment office at Merrill and Bank of America Private Bank. An earlier version of this article incorrectly used his old title.

HAS THE INFLATION GENIE ESCAPED THE BOTTLE?

MSQ Capital’s Managing Director Paul Miron thinks a small recession could be the key to economic control.