Inflation insights from the Australian equities team

The risks of higher inflation have increased as larger government deficits and increased money supply take the place of interest rates and quantitative easing, which have dominantly driven asset prices. Whether inflation accelerates will depend significantly on whether the trust is lost in the intention of the government to ever shift away from significant deficits and the propensity of the central bank to fund this spending through intervention in markets. This trust has already been materially eroded through behaviour to date. Supply bottlenecks and output constraints have already seen significant inflation in some areas with increasing danger consumers begin to expect rising prices (inflation itself is a significant factor in impacting consumer behaviour), though it is not clear these constraints will sustain as pandemic impacts ease. We see significantly greater longer-term inflation risks in areas in which investment is being disincentivised, energy and raw materials being obvious candidates given the diversion of investment away from these sectors for ESG reasons.

Interest rates obviously have virtually no scope to further aid asset prices nor fall much further, creating a significantly skewed outcome going forward. We see limited scope for an increase due to the inability of a highly indebted financial system to bear any increases without severe debt crises. Interest rates are likely to remain highly manipulated by central banks to avoid crises, although the potential for loss of control and trust should not be underestimated. We remain wary of highly leveraged financial intermediaries due to this unfavourably skewed payoff.

Views on inflation and interest rates necessarily impact company valuations through revenue (price and volume) forecasts, margins and discount rates. Many valuations are also highly sensitive to the level of financial leverage employed, given this has been a major factor driving valuation increases for many years.

A few charts supporting our views:


Source: AOFM, MST Marquee


Source: Trading economics


Source: Credit Suisse (Output gap measure incorporates employment relative to labour force, NAB capacity utilization survey)

How is the portfolio positioned in light of the above views?

The portfolio remains well-diversified across sectors of the economy, albeit significantly underweight sectors such as banks and healthcare, given views on both the absolute size of exposure and high levels of stock correlation in the bank sector and extreme valuations in healthcare. Technology exposure is also extremely limited given highly extended valuations. The portfolio remains positioned across a range of real economy businesses at reasonable valuations rather than highly exposed to financial asset prices with overweight positions across a range of materials sectors (building, metals & mining, chemicals), food retailing and telecommunications. These are not premised on expectations of significantly higher selling prices as all valuations in materials are premised on long-run pricing, which has not changed across most commodities.

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