Inflation in focus for rates & shares
Focus on inflation

What happened? The Australian Bureau of Statistics (ABS) has released an information paper: “Measuring Non-Discretionary and Discretionary Inflation”. The ABS found that prices of non-discretionary goods and services grew at more than double the rate of discretionary goods (less tobacco) between 2005/06 and 2020. The measures will be contained in the Consumer Price Index (CPI) from the September quarter 2021.

Implications: Discussion about inflation is dominating financial markets at present, and represents a key driver of sharemarkets and bond markets.

What does it all mean?

• In broad terms, ‘discretionary’ spending is spending on non-essential goods and services. That is, spending on nice-to-have items rather than ‘must have’ goods and services. And again – in broad terms – if prices of discretionary items lift significantly, you are more likely to spend less on those items than if there were similar price gains for essential (or non-discretionary) items.

• The distinction between discretionary and non-discretionary goods and services can be quite arbitrary. But the ABS has waded into the discussion. The distinction is important because higher prices for non-discretionary items may have the most significant and lasting effects on consumer spending and inflationary expectations.

• In November 2020, the ABS produced experimental measures of non-discretionary and discretionary inflation. Today it has issued a paper extending the analysis back 16 years to 2005.

• The ABS found: “prices of non-discretionary goods and services increased faster than prices for discretionary goods and services. Over the period 2005/06 to December 2020, cumulative Non-discretionary inflation was 44 per cent, whereas cumulative Discretionary inflation was 32 per cent. Excluding the impact of tobacco (which saw prices increase by more than 400 per cent over the period) resulted in lower Discretionary inflation of 18 per cent.”

• The other key finding was that between 2005 and 2019 non-discretionary goods and services increased as a proportion of total spending, from 56.7 per cent to 59.3 per cent.

• Now it could be argued that the faster rate of inflation for more ‘essential’ goods and services has been applying downward pressure on both spending and inflation of more ‘optional’ goods and services. And, in turn, it could be further argued that the overall economy-wide rate of inflation may have been constrained, contributing to the under-shooting of the Reserve Bank’s 2-3 per cent inflation target.

• In the five years before the pandemic, prices of non-discretionary items grew on average at a 1.6 per cent annual rate – double the rate of discretionary items (less tobacco).

• Clearly inflation is very much flavour of the moment. Governments and central banks continue to apply maximum stimulus to economies. As a result, investors fear that inflation could follow. That is, investors fear that too much money may chase too few goods (demand exceeds supply), forcing up the price of the goods. These price pressures could start ‘upstream’ such as producer prices (higher cost of raw materials) or they could surface ‘downstream’ at the final level of sales, such as consumer prices.

• In the current environment, central banks are prepared to tolerate a higher rate of inflation. So stimulatory settings are being maintained to ensure that economic recovery is sustainable. The real validation that inflation is more likely to be permanent rather than temporary is if the job market is tightening markedly, forcing up wages and therefore lifting consumer prices.

• Inflation is a key issue on equity markets at present on the perception that some sectors perform poorly in a rising inflation/rising interest rate environment, such as technology. And conversely there is the perception that other sectors tend to perform more positively, like financials. There is a distinction being made between so-called ‘growth’ sectors (such as technology, smaller companies) and so-called ‘value’ sectors (such as financials, retail, resources and industrials).

• While generally value sectors are those where the dividend yield tends to be higher than the market average and price-earnings ratios are lower. But it is certainly possible to find ‘growth’ stocks in ‘value’ sectors are vice-versa.

• In practice, clearly there are more factors other than inflation expectations and the resulting change in interest rates that drive sectors of the sharemarket. But investors need to be mindful that investors and analysts have a fixation at present on the ‘growth’ versus ‘value’ distinction.

• Global ‘growth’ shares outperformed at the height of the pandemic with technology shares beneficiaries of strong earnings growth during lockdowns. But the re-opening of economies, higher vaccination rates, relative valuations, greater prospects for earnings upside and higher market interest rates are all encouraging investors to rotate towards ‘value’ companies.

• Since late October/early November 2020, the MSCI value index for Australia (gross index, US$ prices) has risen by about 50 per cent. Over the same period, Australian 10-year bond yields have risen from lows near 0.75 per cent to current levels near 1.70 per cent.

• Inflation in Australia has remained low and the Reserve Bank has consistently indicated that official cash rates are on hold until 2024. But also over the past six months, investors have become more confident about the sustainability of economic recovery. And, in turn, there has been a view that such an environment poses upside risks for inflation and official rates.

• Central banks are essentially disagreeing with financial markets at present on the risks to inflation and interest rates. And it is an argument that won’t get resolved in a hurry. So it is clear that inflation and inflation risks will have enduring effects on equity and government bond market pricing over the coming year.