Should investors prepare for a nasty inflation surprise? (Hint: It might not be that bad)
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Equity investors know inflation is rising.
But perhaps the real question is — how far does it have to rise until it becomes a problem for stock market returns?
CBA bond strategists Martin Whetton and Philip Brown had a think about that query in their appraisal of the RBA’s Statement on Monetary Policy (SoMP) last Friday.
In its latest forecasts, Australia’s central bank said it now expects inflation to rise (slightly) faster.
As for 2022 rate hikes, they are still not a thing (as far as RBA governor Phil Lowe is concerned).
2023 might be in play, but Lowe still prefers the RBA’s post-COVID mantra (2024).
All of that is based on the RBA’s base-case scenarios, but they did include some ‘upside’ projections as well.
In their analysis, Whetton and Brown took it a step further.
What if the key measure of core inflation jumps even higher than the RBA’s upside case?
The analysts presented two scenarios where inflation climbs to 3.5% and 4%, then stays there for two quarters (and elevated for longer).
In a nutshell — even the first scenario (3.5%) would be considered a success by the central bank, they said.
To argue their point, the analysis put those high-inflation scenarios in the context of a five-year moving average.
Following an extended period of historically low inflation — where nothing the RBA tried got inflation back into the target 2-3% range — those five-year moving averages still only result in a level of inflation near 3%.
In other words, inflation levels at or near the target range. And just as importantly, not merely for a brief stint — but over the medium term.
So even if core inflation jumps unexpectedly to 3.5%, “then the RBA will happily call that a success”, Whetton and Brown said.
CBA’s second scenario — inflation at 4% for a year –“would do some damage”, they said.
“But if it reset wage expectations and CPI expectations back up into the target band, it would also do a lot of good.”
So while inflation is rising, the flow through effect of higher wages and stronger consumer demand will also give rise to broader economic benefits.
It’s another point of view to consider for investors who are assessing how the prospect of higher inflation and tighter liquidity will affect their stock portfolios.