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.
By Paul Miron
Wed, Jul 13, 2022 4:17pm
5 min
5 min
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.
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U.S. investors’ enthusiasm over Japanese stocks at this time last year turned out to be misplaced, but the market is again on the list of potential ways to diversify. Corporate shake-ups, hints of inflation after years of declining prices, and a trade battle could work in its favor.
Japanese stocks started 2024 off strong, but an unexpected interest-rate increase in August by the Bank of Japan triggered a sharp decline that the market has spent the rest of the year clawing back. Weakness in the yen has cut into returns in dollar terms. The iShares MSCI Japan ETF , which isn’t hedged, barely returned 7% last year, compared with 30% for the WisdomTree Japan Hedged Equity Fund .
The market is relatively cheap, trading at 15 times forward earnings, about where it was a decade ago, and events on the horizon could give it a boost. Masakazu Takeda, who runs the Hennessy Japan fund, expects earnings growth of mid-single digits—2% after inflation and an additional 2% to 3% as companies return more to shareholders through dividends and buybacks.
“We can easily get 10% plus returns if there’s no exogenous risks,” Takeda told Barron’s in December.
The first couple months of the year could be volatile as investors assess potential spoilers, such as whether the new Trump administration limits its tariff battle to China or goes wider, which would hurt Japan’s export-dependent market. The size of the wage increases labor unions secure in spring negotiations is another risk.
But beyond the headlines, fund managers and strategists see potential positive factors. First, 2024 will likely turn out to have been a record year for corporate earnings because some companies have benefited from rising prices and increasing demand, as well as better capital allocation.
In a note to clients, BofA strategist Masashi Akutsu said the market may again focus on a shift in corporate behavior that has begun to take place in recent years. For years, corporate culture has been resistant to change but recent developments—a battle over Seven & i Holdings that pits the founding family and investors against a bid from Canada’s Alimentation Couche-Tard , and Honda and Nissan ’s merger are examples—have been a wake-up call for Japanese companies to pursue overhauls. He expects a pickup in share buybacks as companies begin to think about shareholder returns more.
A record number of companies have also delisted, often through management buyouts, in another indication that corporate behavior is changing in favor of shareholders.
“Japan is attracting a lot of activist interest in a lot of different guises, says Donald Farquharson, head of the Japanese equities team for Baillie Gifford. “While shareholder proposals are usually unsuccessful, they do start in motion a process behind the scenes about the capital structure.”
For years, money-losing businesses were left alone in large corporations, but the recent spate of activism and focus on shareholder returns has pushed companies to jettison such divisions or take measures to improve them.
That isn‘t to say it is going to be an easy year. A more protectionist world could be problematic for sentiment.
But Japan’s approach could become a model for others in this new world. “Japan has spent the last 30 to 40 years investing in business overseas, with the automotive industry, for example, manufacturing a lot of the cars in the geographies it sells in,” Farquharson said. “That’s true of a lot of what Japan is selling overseas.”
Trade volatility that hits Japanese stocks broadly could offer opportunities. Concerns about tariffs could drag down companies such as Tokio Marine Holdings, which gets half its earnings by selling insurance in the U.S., but wouldn’t be affected by duties. Similarly, Shin-Etsu Chemicals , a silicon wafer behemoth that sells critical materials, including to the chip industry, is another potential winner, Takeda says.
If other companies follow the lead of Japanese exporters and set up shop in the markets they sell in, Japanese automation makers like Nidec and Keyence might benefit as a way to control costs in countries where wages are higher, Farquharson says.
And as Japanese workers get real wage growth and settle into living in an economy no longer in a deflationary rut, companies focused on domestic consumers such as Rakuten Group should benefit. The internet company offers retail and travel, both of which should benefit, but also is home to an online banking and investment platform.
Rakuten’s enterprise value—its market capitalization plus debt—is still less than its annual sales, in part because the company had been investing heavily in its mobile network. But that division is about to hit break even, Farquharson says.
A stock that stands to benefit from consumer spending and the waves or tourists the weak yen is attracting is Orix , a conglomerate whose businesses include an international airport serving Osaka. The company’s aircraft-leasing business also benefits from the production snags and supply-chain disruptions at Airbus and Boeing , Takeda says.
An added benefit: Its financial businesses stand to get a boost as the Bank of Japan slowly normalizes interest rates. The stock trades at about nine times earnings and about par for book value, while paying a 4% dividend yield.
Corrections & Amplifications: The past year is expected to turn out to have been a record one for corporate earnings in Japan. An earlier version of this article incorrectly gave the time frame as the 12 months through March. Separately, Masashi Akutsu is a strategist at BofA. An earlier version incorrectly identified his employer as UBS.
