Inflation can be your friend

Inflation is a hot and controversial economic topic both locally and internationally. This is because the entire global economic recovery hinges on the ability of central banks to keep interest rates low for an extended period to give the economy a push to full recovery.

The most recent Australian inflation figures have come in lower than anticipated at 1.1% per annum. This reaffirms the Reserve Bank of Australia’s carefully articulated argument about maintaining low interest rates until the economy reaches full employment. Unemployment is now down to 5.6%, consumer spending is fast returning to pre-Covid-19 levels, and trade figures are strong due to high iron ore prices, all of which contributed to a $30b windfall in the current budget figures.

It seems the Achilles’ heel to all this good news is the inflation uncertainty. Inflation has not been part of the discussion since 1980s, when Paul Keating was the treasurer and we experienced “the recession we had to have”.

The right balance

An analogy that best describes the importance of inflation is that of watering a plant, in that both too little or too much water could kill a plant. The right balance of low constant inflation increases business profits over the long term, in turn increasing business productivity. Such a strategy helps in reducing unemployment, increasing tax revenue and it naturally erodes the real value of debt.

Too much inflation (hyperinflation) can have a complete opposite impact and lead to undesirable economic and social outcomes. The most powerful tool to control high levels of inflation is the RBA’s use of contractionary monetary policy (increasing interest rates). If done prematurely, it will have a negative price impact on assets such as shares and property, further stunting economic growth and possibly spiralling the economy into a recession.

Investors are now becoming acutely aware of these issues with leading economists, governments, companies, and media all weighing in on the topic, presenting diverse viewpoints, fuelling volatility and uncertainty which may impact markets over the next 12 months.

Governments and central banks will need to maintain confidence in their ability to steer the global economies through these tricky times.  A loss of confidence from consumers and businesses is enough of a catalyst for a self-fulfilling prophecy for inflation issues to emerge unfavourably.

This is thought-provoking as economic data and activity are not the only drivers of inflation. It is also driven by the future expectation of businesses and workers - that influence decisions about increase in prices of goods and services and employees hitting up their bosses for a pay rise.

To stay calm when internet is filled with clickbait content about economy and inflation, I suggest investors consider the following points:

Covid-19 has skewed economic data

A mathematical concept worth explaining when attempting to interpret economic data is the “base effect”. Covid-19 brought the economy to a standstill, with all the major economic indicators falling off a cliff. Following a reboot, the economic indicators are all being overly exacerbated during recovery. As an example, we have had two quarters of GDP growth at 3%, however, our economy is still nowhere near the same levels as it was pre-Covid-19 despite the data implying otherwise.

The next inflation figures will likely be an absolute whopper, as it will reflect the effects of people returning to work and spending money on normal items such as childcare, entertainment and transport. 

Classic demand-supply mechanism

As we all know, Covid-19 has disrupted supply chains worldwide. There is a real concern that inputs from raw materials will cause a flow-on effect, leading to higher prices for many goods and services. A prominent story in the US now is the possible impact of the sharp 30% cost increase of timber on the construction industry. After over a year since the onset of the pandemic, companies are still playing catch up in supply chain efficiencies.

However, these supply shocks are temporary as businesses will expand production to cater to rising demand, and the prices will stabilise in the long term.

Property market growth

Central banks are committed to intervening in the money market by buying 3-year bonds to maintain the cost of funds at a low level which is passed down to the banks and then onto both business and personal borrowers. As fund managers, we are often asked:

• Where do you think property prices are going?
• Why has the property market had phenomenal growth in recent months?
• Where do we see the market going in the next 12 months and finally what are the major risks?

A novel way to describe the property market is through a ripple effect. We all appreciate how low interest rates with years of pent-up demand have resulted in the fastest recorded property growth since property data was first recorded.

However, the property market consists of a range of segments spanning many property types, geographical areas and price points. The two most active property market segments that are driving the current property boom are:

Owner-occupiers in affluent suburbs

We have experienced overnight price growth of anywhere north of 30%. An additional driver has been a rising number of white-collar wealthy expats leaving Covid-19 stricken Europe and Asia to stay in their newly purchased waterfront mansions. As properties in these suburbs become out of reach, locals are being forced to consider buying in surrounding suburbs.

First-home buyers

Thanks to the generous government schemes of home builder being circa $2billion and other grants for first-time buyers, land and house packages and houses under $750k have never experienced stronger demand.

The above two segments are showing signs of normalisation with an increasing number of people listing their properties to take advantage of rising prices. This is also benefiting property investors, with more investors hoping to cash in on record prices. As a result, price increases are more evenly distributed across different property segments.

Importantly, the risks to the property market are still prevalent and are tied to inflation and interest rates. Additionally, the property market in Australia and the construction industry have been solid off the back of historic immigration figures. In the next six months, the government has to delicately navigate a path for managing inoculations and transition from a zero Covid-19 tolerance philosophy to an acceptance to living with the virus so that borders can stay open. 

*Paul Miron, Managing Director, Msquared Capital. Paul has over 20 years’ experience in banking and commercial finance. He started his career within the business bank of Colonial State Bank. After becoming a senior banker, he started his own financial services business over 16 years ago. Miron’s expertise is economic theory and market trends, which is pivotal to assessing which investments MSQ looks to provide to our investors. 

 Msquared Capital offers investors the opportunity to create a diversified portfolio of mortgage investments using appropriate tools and a proven platform to invest intelligently. Investors are paid consistently and on a monthly basis, whilst their investments are secured by registered first mortgages over quality real estate assets on the eastern seaboard of Australia. It has never been more important for investors to have the peace of mind that comes with first mortgages than during turbulent times as they have proven to withstand an unexpected economic shock. For more information, please contact Msquared Capital.