What rising inflation means for Australian investors

-- | 17/11/2021

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Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Today, joining us is Tim Murphy. He is the Director of our Manager Research team.

Tim, thanks so much for joining us.

Tim Murphy: Hi, Emma. Glad to be here.

Rapaport: Tim, I think it's quite fortuitous where we're recording on Thursday morning and the latest U.S. inflation numbers have come out a lot higher than anyone else expected them to. U.S. consumers have been seeing big increases in things like energy and housing and things at the supermarket, and surely investors are starting to see a little bit of that here. So, I thought it was a really good time to talk about inflation and how investors should think about inflation in their portfolios. So, let's just go back to basics very quickly. Why do investors pay attention to inflation and how impactful is it on portfolios.

Murphy: Yeah. So, from first principles, inflation is important because it obviously affects the cost of running and living our lives day-to-day. And so, we've obviously seen that in recent times through increases in things like energy prices, cost of goods – with lots of the backlog of shipping and distribution of goods at the moment, you're starting to see price inflation of day-to-day goods go up, and that's obviously therefore reflected in real numbers. So, living our lives is more expensive now than it was a year ago. So, in terms of thinking about your overall financial plan and household budgeting, that's clearly having an effect.

As it pertains to investments and how you then think about generating returns from that, or sort of protecting from downside from that, certainly, there's been lots of discussion around the bond market and the effects that inflation has there, and certainly, we have seen some negative returns in government bonds of late on the defensive side of client portfolios. But more broadly, in the equity sphere where most people have higher allocations of their assets, certainly, inflationary effects can and does have different effects on different sectors. So, having a good understanding of where your exposures and where your tilts lie in your own portfolio and how those sectors are exposed to inflation in differing ways is obviously an increasingly important consideration.

Rapaport: So, maybe if we just stick to the equity market, are there specific types of stocks or specific sectors that are more impacted by inflation than others?

Murphy: Well, certainly, anything that's interest rate sensitive, so whether it's sectors that have high loads of debt, or in particular, where we've seen the run up in valuations of some of the more growth oriented stocks in recent years where the market valued them on fairly high P/Es based off low discount rates, certainly if you think about an inflation environment and you're worried about interest rates increasing, and that's going to increase the discount rate you might be applying to value a company, and therefore companies trading on high P/Es potentially become at risk of a correction more so from (writing) discount rates in that sense.

Thinking about some of the traditional what's seen as more safer inflation plays, things like banks and financials tend to benefit from that because you'll see a rise in their net interest margins because what they're able to charge mortgage holders increases at a faster rate than what they're paying depositors. So, that's a good positive for banking margins. Other areas like real assets and property have historically been seen that way. Again, it does depend on how they're financed though, because while it might be a positive for the asset prices, the capital structure of that if they're exposed to floating rate debt and obviously interest charges going up against that. So, you think similarly along infrastructure along those lines as well.

Rapaport: And how about the bond or the defensive side of the portfolio? You said before that higher-quality bonds are more impacted. How come inflation affects those types of investments differently?

Murphy: So, certainly, if you think of traditional government bonds, they are – interest rate or duration risk is the key risk there. So, think about interest rates and bond prices are inversely related. So, as interest rates go up, bond prices go down. And so, that's what we've seen, certainly, in the month of October, one of the worst performing months in the history of the Australian bond market in that sense. So, you've seen negative returns from bonds more recently in Australia.

More broadly, depending on the style of bonds, if you're talking about credits, you generally have a higher income yield there that's offsetting some of that. And if you're using a fund to get that exposure, sometimes the fund managers are hedging out some of that interest rate risk as well. So, depending on how you're doing it, you are carrying different rates of exposure to interest rate risk.

Rapaport: We've talked about inflation for quite a while. We've been talking about this difference between transitory inflation or actual or happening inflation. Do you feel like at this point that there's been a shift in the market or a shift in sentiment, and is it a time that investors should really start paying attention to inflation?

Murphy: Yeah. Well, I mean, it's clearly front and center at the moment. And now, there's the big debate that is this inflationary spike transitory, or is it more structural, and I think that's a – the market is still having that debate, frankly, and I don't think there's a definitive answer one way or another. Certainly, things like, in more recent years, rising shipping costs and energy prices, you would like to hope some of those things are more transitory in nature, but more structural inflation potentially could become an issue and how that affects particularly the longer end of bond curves and therefore longer-term market pricing can become an issue.

Rapaport: Yeah. So, let's talk about some of the ways that investors can hedge against inflation or reposition their portfolio in an inflationary environment. I think Australian investors hear a lot about inflation-linked bonds or TIPS as they're called in U.S. And I understand that Australian investors can't really access these things, or they have to have a lot of money to do so. But can you explain why these sorts of products would be beneficial or potentially beneficial in an inflationary environment, and maybe why they haven't been in the last month or so?

Murphy: Yeah. So, I mean, yes, inflation-linked bonds, as you alluded to, are specific bonds issued to rise in line with forecast inflation. Now, there's a number of nuances that affect how they're priced. So, there is one ETF on the market here, the ticker ILB inflation-linked bond, that provides exposure to that sector domestically. One of the similar characteristics of inflation linked bonds are they have quite long duration and low running yields. And so, while they have an inflation mechanism within them, they are also exposed somewhat to rising interest rates. And so, despite the rise in inflation that we've seen this year, year-to-date inflation-linked bond ETF on the ASX has actually slightly lost money.

Rapaport: So, you wouldn't necessarily recommend that investors seek out these sorts of products?

Murphy: I think no – certainly, not in isolation. I mean, if you understand how inflation-linked bonds work, you're really looking at making a call on the implied breakeven rate of inflation. So, you will make money if inflation exceeds the implied breakeven rate within that inflation (indiscernible). Up until recently, it hasn't done so. Certainly, in the start of November there's some of these recent prints that the bond has gone up and made money as the inflation has surprised a bit on the upside. But certainly, over trailing one-year basis that hasn't been the case. So, inflation-linked bonds can certainly play a role as, one, inflation protection mechanism within a portfolio, but certainly by no means it should be the only one.

Rapaport: So, let's talk about some of the other areas that people use when they talk about trying to find an inflationary hedge. You spoke a little bit before about bank stocks. The other ones that people bring up are commodities. I know that's a really broad investment market, but are there any particular types of commodities that people try and seek out, and would you recommend that they do so?

Murphy: So, one of the most commonly cited and used one is gold. Lots of people use gold and talk about gold as an inflation hedge over time. And certainly, there's been some periods where there's been strong correlation between gold appreciation and inflation rises. Increasingly, recently, that hasn't been the case. So, there's certainly a case for how that can be part of an inflation hedge, but it's by no means a guarantee as the recent experience has shown.

Rapaport: So, I've got to ask as Bitcoin hits, I think, US$69,000 or something close to that, pretty ridiculous considering that I remember it was US$20,000. But do you think the case is growing for crypto currencies as a hedge to rising costs? Or have we just not seen enough evidence of that yet?

Murphy: I think the risks that you're bringing to a portfolio by investing in Bitcoin or any other crypto for that matter are I think probably far dwarf any possible inflationary protection you may or may not be getting from that. I think it is definitely too early to sort of conclude that crypto is a – or Bitcoin specifically is an inflation hedge. But one thing you're certainly getting when you look at crypto is some fairly intense volatility. So, I think if you had Bitcoin in your portfolio, the volatility – certainly, price rises have been very strong in the last few months as you say, but it's within the last 12 months that Bitcoin halved in price in a fairly short time period. So, I think the volatility of that that you'd be bringing to a portfolio from a Bitcoin investment probably dwarfs inflation hedge consideration, I would say, when thinking about overall portfolio risk.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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