As emerging markets wages increase significantly, the core CPI of many developed world economies will rise, and potentially force some central banks to revisit interest rate settings.
Positioning portfolios for the prospect of rising inflation is therefore critical.
Globalisation delivered enormous productivity benefits over the past decade, as the world’s labour-intensive productive capacity shifted to lower cost developing nations.
These productivity gains have been a major contributor to moderate inflation outcomes in developed nations in recent times.
From December 1999 to March 2011, nominal gross domestic product in the US, UK, and Australia grew at 4.1 per cent, 4.2 per cent and 6.9 per cent per annum respectively, while CPI grew at just 2.3 per cent, 2.1 per cent, and 3.2 per cent per annum, respectively.
With global inflation highly likely to increase due to rising food prices, rising energy prices, and increasing costs of tradable goods, it is unlikely globalisation will continue to deliver global productivity gains over the next 10 to 15 years.
Drivers of global inflation
Rising food prices
Rising food prices are one of the most potent sources of current and prospective inflation. As people move up the wealth curve, calorie and protein intake rises from subsistence levels, and real food prices increase, unless there is an increase in the quantity of land under cultivation and/or an increase in agricultural productivity.
The shrinking availability of arable land as the world urbanises suggests that increasing land under cultivation will be extremely difficult.
Further, agricultural productivity gains have slowed from close to 3.5 per cent per year in the early 1970s to below 1.5 per cent in 2011, despite fertiliser use more than doubling.
Food prices have already risen significantly. After a flat period in the 1990s, food prices rose at 9.7 per cent per year in nominal returns and 7.7 per cent in real terms over the past decade.
Between 2005 and 2007, the world consumed 6.5 trillion calories per year and this is forecast to increase to 8.7 trillion calories per year by 2030, and 10.2 trillion calories per annum by 2050.
Much of this increase emanates from Brazil, Russia, India, and China (BRIC), which are forecast to increase annual calorie intake by close to 1 trillion calories per annum over the next 20 years.
The world’s already stretched agricultural capacity will be challenged to cope with a 35 per cent increase in demand for food over the next 20 years, let alone a 57 per cent increase in demand over the next 40 years.
The impact of higher food prices on wages in developing countries – and thus inflation on rich world imports – is dramatic, as food occupies such a high proportion of household consumption expenditure.
Consumers in the BRIC nations allocate 25 per cent, 28 per cent, 33 per cent and 35 per cent respectively of their household budget to food, compared to 7 per cent in the US, and 11 per cent in Australia.
Food price increases will result in wage stress in the developing world, and advanced economies should expect much higher inflation in import prices over coming years.
Rising energy costs
A 2010 study by ExxonMobile forecasts annual energy demand amongst non-OECD nations to grow by 46 per cent by 2020 and a further 17 per cent between 2020 and 2030, increasing annual global energy demand by 23 per cent and 11 per cent respectively, despite improved energy efficiency and government policy initiatives moderating future demand in the OECD countries.
The same study noted that these increased energy demands will grow annual oil and coal demand by close to 20 per cent and gas by over 60 per cent over the next 20 years.
Oil, coal and gas are finite resources. While alternative options are providing sources for meeting the world’s energy needs, these are less efficient with higher costs of production that must eventually be passed on to consumers.
And despite production expanding through alternative sources, oil and gas production is still well below 1970s production peaks. With these supply restraints, energy prices are highly likely to increase.
Increasing costs of tradable goods
According to an April 2011 IMF working paper, for every 1 per cent shock to food prices, there has been a 0.15 per cent increase in non-food prices in rich world areas, and a 0.30 per cent increase in non-food prices in poor countries.
The impact of inflation on portfolios
One of the major challenges is managing the impact of significant global inflationary pressures on portfolios. Inflation eats it way into real returns.
Investors must seek assets that will protect them from inflation. While it is clear that the returns of long-dated bonds with a fixed coupon will suffer when inflation increases, the impact on stock returns has been debated widely.
One theory that has received attention is the Fed model. It asserts that, in the long run, the forward earnings yield of a stock market should equal the yield on long-term government bonds.
The logic is simple – with stocks and bonds competing for a place in portfolios, any relative mispricing will be arbitraged away and thus, in the long-term, yields on stocks and bonds should be equal.
A more practical approach is to add a risk premium to the bond yield to arrive at an equilibrium stock market yield.
With inflation expectations the primary driver of long-term government bond yields (assuming the issuer carries zero default risk), an increase in inflationary expectations will cause the required earnings yield on the stock market to increase – or, for the inverse of the earnings yield, Price-Earnings ratio, to fall.
Empirically, there is strong support for the Fed model. Asness (2002) showed a significant negative relationship between inflation and PE ratios. Over the 1965 to 2001 period studied, E/P (the inverse of P/E) had a correlation with inflation of 0.81.
But there is one major flaw with the Fed model. Stocks are at least partially real assets, as their cashflows and dividends have the ability to grow with inflation.
It is the ability of companies to increase cashflows that govern their performance in inflationary times.
Investors should seek to invest into companies that have pricing power that allows them to at least maintain prices in real terms (even in inflationary environments), an ability to at least maintain volumes, and low capital intensity, thus reducing the impact of inflation on capital expenditures and working capital.
Such companies are extremely rare, as capitalism tends to compete away these desirable advantages. Hence, a passive index approach to equities is fraught with danger during inflationary times.
Yet a portfolio focusing on companies that exhibit these characteristics is one of the few ways an equity investor can be relatively confident that their investments will provide adequate defence in inflationary times.
This is an abridged extract from a paper presented at the 2011 PortfolioConstruction Forum Conference. The full paper is available at www.PortfolioConstruction.com.au.
Matthew Webb is an investment specialist at Magellan Asset Management.
