If you are to taking your cue from the market as to what will happen next with Australian interest rates, then you’d come to the conclusion that the RBA has reached the end of its rate cutting cycle, with the official cash rate set to rise toward 1.80% by the end of 2018.

This expectation of higher rates is not one we agree with personally, as we see a myriad of at best lukewarm economic data in Australia. This includes record low wage growth, and an imminent peak in housing construction, which will limit what was a primary pillar of support holding up the Australian economy in the last few years.

Source: Gerard Minack

Soft economy aside, inflation, or the lack of it (officially), is one of the key factors that those who are sceptical of the consensus view that the RBA is done cutting like to reference, as a sub 2% reading would no doubt be worrying the monetary mandarins of Martin Place.

Whilst we are in their camp when it comes to where local rates head next, we don’t necessarily share their view regarding inflation.

How Big an Issue is Inflation Anyway?

If you are willing to take the official statistics at face value, then inflation is incredibly low today, with the annual rise in consumer prices to end 2016 coming in at just 1.50%, with prices falling for footwear, clothing, transport, communication and recreation.

This continues a prolonged period of official low inflation rates, with the decline in the rate of CPI growth evident in the table below, which covers 2006 to 2016 inclusive.

Source: Australian Bureau of Statistics

As you can see, prices are rising at less than half the rate they were back in 2007/2008 when the GFC was getting underway.
The problem is of course that none of us actually purchase the inflation basket our statisticians’ use, with every Australian having different needs and wants, which influence their consumption patterns.

Given this, it should be no surprise that many Australians themselves don’t completely believe we are in such a benign inflationary environment.
Indeed a January 2017 ANZ Roy Morgan poll on consumer confidence and inflation expectations suggested that Australians expect the cost of goods and services rise by 4.3%, a level essentially triple that of the latest official CPI reading.

This Roy Morgan result should come as no surprise, for whilst its true that there are a number of goods and services that have seen very little inflation in the last decade, there are also many ‘big ticket’ items, such as healthcare, childcare and energy costs, which have spiralled higher.
This was a subject we covered in detail in our 2015 book; Dire Straits: Money for Nothing, Debt for Free, which looked at the root causes and unresolved challenges of the GFC, and the implications for investors going forward.

In that book, we observed that in our opinion, whilst “the official inflation story may well be dead…cost of living pressures for everyday Australians is very real”.
The book included the following chart, which showed the cumulative increase in prices between 2008 and 2014 for child care, utilities, education, healthcare, insurance, house prices, rents, as well as the official CPI rate, which you can see in red.

Source: Australian Bureau of Statistics, Dire Straits: Money for Nothing, Debt for Free

You can see how significant the price increases were in things like child care and utilities, which rose by close to 45% in that five years period, versus the official CPI figure, which rose by less than 15% in the same time period.

In the 2 years since the above graph was created, nothing has changed, with price increases between 2014 and 2016 in childcare, health care and education running at 3-4 times the rate of overall CPI growth.

“Essentials” are also getting more expensive relative to wages, not just the overall CPI basket, as this chart, which comes from a February 2017 article in the Guardian titled “The cost of living is easing. So why doesn’t it feel that way”, makes clear.

Given this backdrop, it should come as no surprise that the average Australian is now saving less, with the household savings ratio falling to just 5.2% today, down from 10.2% back in December 2011.

It should also come as no surprise that Australian households now have to dedicate an much larger percentage of their income to spending on “essentials” (compared to the late 1990s), leaving less money for “discretionary” spending.

This much is made clear in the following graph, which tracks the amount of money out of every $100 spent spent on “essentials”, and “discretionary” items, and how this has evolved over the last 15 plus years.

Source: Australian Bureau of Statistics, ABC Bullion

When looking at the graph above, it’s important to realise that the two lines are on different axis.

As you can see, back in 2000, Australians were spending $62 out of every $100 on “essentials”, leaving close to $38 for “discretionary” spending. Today, “essentials” are taking up closer to $67, leaving just $33 for discretionary spending.

That is a near 15% in reduction (from $38 to $33) in “discretionary” spending as a percentage of total spending in the last 15 years, despite the growth the economy has experienced over this time period.

No wonder discretionary retailers in Australia have been feeling the pinch over the last few years, or why companies like Aldi have had such success penetrating the Australian market.

What Happens Next

Whilst no one can be 100% certain what will happen with inflation (or GDP growth, retail sales, corporate profits, stock market performance etc.) in the coming years, the risk for inflation globally seems tilted to the upside.

In Australia, as we’ve already pointed out, true cost of living pressures are far higher than official CPI readings would indicate. We aren’t expecting it to explode higher (too many domestic headwinds), but we think it will trend higher, something that will be exacerbated should there be significant downside in the Australian dollar, which will act to increase tradable inflation.
It is worth remembering tradables make up close to 40% of the total inflation basket, and last time the AUD fell meaningfully (between 2011 and 2015), this component of the CPI basket went from -2% to +3%, which you can see on the chart below.

Source: Australian Bureau of Statistics, ABC Bullion

Globally, using the United States as a proxy, we can see that inflation rates look like they will break meaningfully higher, with the latest CPI result showing an annual increase of 3.30%, a rate not seen since just before the GFC hit.

Sticky price inflation, often seen as a more useful guide to future inflation rates than core CPI and the like, also portend higher rates of inflation in the United States, though interestingly for investors, this is not yet flowing through to the market.

As per a recent Livewire Markets update (see chart below) from fixed income investors Ardea, “market pricing for inflation is flat for the next 30 years”, which means that “markets are prepared to bet that US inflation will average 2%, each year and every year, for a very long time”.

This has potential implications for gold, as the lack of market concern regarding rising inflation means that inflation sensitive assets are likely undervalued. Or as Ardea put it, “protection against rising inflation can be accessed cheaply”.

That likely won’t last.

Until next time,
Jordan Eliseo
 

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