Inflation and interest rates

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By Ken Howard

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20 April 2022, 1:40 PM

Interest rates are rising. Why and what does it mean for your investment portfolio?

The central banks of the US, UK and Canada have each increased their target interest rate this year and it is possible that the Reserve Bank of Australia will do the same in May (although they may wait until after the Federal election).

For most OECD countries the interest rate on their respective 10-year government bond has been rising on an almost weekly basis, since the start of the year, with only one short pullback in late February when Russia invaded the Ukrainian, and most are now at 3-year highs, to illustrate;

The Australian 10-year Government bond rate (weekly data from 1^st of January 2005 to 14^th of April 2022)

It's anyone's guess how much higher interest rates will go, but; with record low levels of unemployment, mounting Government deficits, ongoing supply side disruptions from Covid in China (Shanghai is currently in lockdown) and sanctions against Russia impacting most of the World’s commodity supply chain, particularly energy, we could very well see a return to pre-GFC interest rates over the next couple of years.

There is no guarantee of course, but there is plenty of evidence of an inflationary feedback loop in many sectors of the global economy, and with record low levels of unemployment in much of the developed world, this will invariably translate to higher wages in the developed world and underpin higher inflation.

I am guessing, at some point, China will have to work out how to live with Covid (or maybe Covid will almost 'disappear' like SARS and H1N1), but until then, we will have to accept a disrupted supply chain out of China. That is at least until we can build substantial inventory buffers and or alternative production facilities.

Energy sector 

The energy sector is even more complex. Take Germany as an example, according to Eurostat (the official EU statistical service), Germany’s total energy is sourced; 36% from oil, 24% from gas, 20% from coal and 6% from nuclear, the balance is from wind, solar, hydro and biomass. So 86% of Germany’s energy is from conventional sources, which the Germans are increasingly reluctant to invest in and almost half of this is coming from Russia. Source.

On top of this the developing world is still very 'energy poor'. Close to 3 billion people⁽¹⁾ would use less than 10% of what the average German would use and of these almost 750 million have no access to electricity.

The current inflation is good evidence of two things (a) there is little spare capacity, whether that is for conventional energy, metals, minerals, fertiliser, food or manufactured parts & or finished goods and (b) those who have the financial resources are bidding up the price to gain access to the limited supply.

It will take considerable time and investment to create the buffers required to absorb the disruption to the supply of Russian commodities or Chinese manufactured goods and in the interim there will be inflation.

I know inflation erodes the value of savings, but in an era where the central banks of developed countries have been able to print money and their governments have run deficits; full employment, wages growth and inflation has been the path of least resistance.

The upside for the developing world, is that higher prices should encourage investment into alternative sources of energy, basic commodities and manufactured goods. It is also my guess, that the developed economies are unlikely to change their stance towards primary production and manufacturing and these investments will have to occur in developing countries.

Interest rates

Of course, nobody knows the future and there is always the chance a democracy will vote in a high taxing, low spending government, committed to paying down its debt and thereby reducing demand, but it is probably more likely to be left to a central bank to lift interest rates. Higher interest rates will reduce investment, which will reduce employment, which will reduce demand and consequently reduce inflation.

Ultra-low interest rates (circa 0%) stimulate investment, neutral interest rates (circa 2% to 3%, equivalent to low levels of inflation) neither add to nor detract from investment, while high interest rates (something well above the prevailing rate of inflation) curtail investment. Any move from ultra-low interest rates to high interest rates will take several years and it will require persistently high inflation which will only occur if there is a lack of innovation and investment.

A little bit of inflation is a good thing. It is evidence of a vibrant, healthy economy; (a) where there is not so much demand (or lack of supply) that people are going without the basic needs or (b) so much supply that there is waste. The price tension creates the feed back and incentive to innovate and invest, and it is why dynamic and innovative business do well and stale, constrained businesses struggle.

A little bit of inflation is certainly better than stagnation, deflation or high inflation, and it (a little bit of inflation) has been missing from many developed economies since the GFC.

In the real world there are limited resources, and while prices can change quickly (inflation), bringing on the additional supply through innovation and investment takes time. Ultra-low interest rates and government deficits (when spending exceeds tax revenue) work when there is plenty of spare capacity (unemployment at 10%) but when the spare capacity is gone (unemployment at 4%) ultra-low interest rates and government deficits drive up prices. To bring prices down you need to bring on supply, which requires innovation and investment, which requires time and money.

The return of inflation will be disruptive for business and for asset prices but if you own quality businesses, they will be able to absorb some of the inflation, through; innovation (often more for more, the consumer may pay more but they are actually getting a better product), efficiency (cost out) and eventually by passing on higher prices (for competitive industries – inflation is never a pass through cost for the consumer, maybe for governments and for monopolies but for competitive innovative businesses managing and defraying input price pressure is how they ultimately add value).

Strategy

So my immediate thought is that the supply side disruption should lead to increased investment, which will be a positive for the global economy and a positive for business. Consequently in the short term (that is the next couple of years) investors should remain invested in equities, but if, over the coming years, inflation persists and interest rates rise, there will be an increasingly compelling argument to rebalance a portfolio and re-introduce government bonds.

More Information

Ken Howard is a Private Client Adviser at Morgans. Ken's passion is in supporting and educating clients so they can attain and sustain financial independence.

If you have any questions about your financial plan or your share portfolio, your strategy, investments or would just like to catch up, please do not hesitate to give me a call on 07 3334 4856.

General Advice warning: This article is made without consideration of any specific client’s investment objectives, financial situation or needs. It is recommended that any persons who wish to act upon this report consult with their investment adviser before doing so. Morgans does not accept any liability for the results of any actions taken or not taken on the basis of information in this report, or for any negligent misstatements, errors or omissions.