Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 219

The unreliability of inflation forecasting

We are at a confluence of deflationary and inflationary forces. The deflationary forces of debt overhang and demography are considerable. The last 20 years in Japan illustrates that not even expansionary monetary policy can necessarily solve these problems. Yet, against that, we are in the midst of perhaps one of the greatest peacetime expansionary monetary policy experiments. This is applying significant inflationary forces to the economic environment.

When two such strong, opposing forces exist simultaneously, the net outcome is clearly uncertain but some observations can be made:

  • Inflationary policies (the monetising of deficit) are popular and austerity is unpopular. In fact, monetised deficit spending is the ultimate politician’s free lunch with the largesse bestowed upon voters without the need for unpopular taxes or increases in debt.
  • Deflation is not an acceptable outcome for monetary authorities. As the former US Fed Chair Ben Bernanke explained in his famous 2002 ‘helicopter’ speech, the Fed has the ability to prevent deflation, given that they have unlimited control over the money supply. Inflation is the only way indebted governments will be able to meet their obligations. This dynamic includes Australia, where government debt levels (albeit from relatively low levels) continue to rise and both major political parties have appeared to abandon serious fiscal discipline in the short-term.

These arguments imply that the final outcome of this global debt cycle should be inflationary, but it does not reveal the potential timing of this scenario. Inflation is not anticipated but prudent investors should prepare for a range of possible outcomes and interest rate scenarios.

Does inflation matter?

What would inflation mean for the Australian economy and the equity market? To answer, it helps to consider the starting point today:

Source: UBS, Goldman Sachs, Lazard Asset Management Pacific Co. *as at 31 March 2017.

Most of the world, including Australia, has negative real policy interest rates (cash rate minus inflation) and even more negative policy rates if considered in light of central bank inflation targets. Thus, if economic conditions were to ‘normalise’, we would experience rate rises, even without any rise in inflation. The bias is clearly on the side of rates rising from current levels.

The second observation relates to the valuations of the major asset classes. Which assets are priced on negative real spot interest rates and which ones are not?

We view equities as being on the expensive side of fair value, but not dramatically so. The pre-tax earnings yield of approximately 7.5% for the S&P/ASX200 index, as at 30 June 2017 is in-line with the average over the last 20 years.

In contrast, bonds, by definition are priced on the current spot rates, with bonds yielding around 2.35%, based on the Australian Government 10-year bond yield as at 30 June 2017.

From on our assessment, Australian residential property, also priced on current spot, appears to be overvalued and has a pre-tax yield of around 2.3% according to Residex Data, as at 31 March 2017. It is clear that there are signs of speculation, including very high investor participation, and widespread interest-only borrowing in this market. The price-to-income multiple in Sydney now stands slightly above that of Tokyo in late 1989 just before the property bubble burst.

Four inflation scenarios possible

For Australia, the size of the residential property market ($7.5 trillion) and its dominance in household balance sheets make it a critical factor in assessing possible outcomes from a rise in inflation.

One would normally consider four possible growth and inflation scenarios:


  • Stagflation – low growth, high inflation



  • Japanese experience – low growth, low inflation



  • It’s all OK – good growth, low inflation



  • QE wins – good growth, high inflation.



A rise in inflation and an associated rise in interest rates would most likely result in a significant price correction within the Australian residential property market. At a cash rate of only 2.5% (up from the current level of 1.5%) for example, households would be devoting about as much to mortgage payments as they did in the late 1980s when variable mortgage rates reached the high teens. A rise of the cash rate to 5%, which is a number broadly consistent with a 2.5% inflation target and nominal growth of about 2.5%, could lead to potential wide-spread mortgage defaults.

It is likely that a rise in inflation may be followed by a recession and a return to very low inflation or deflation. Australia’s high household debt levels make the economy vulnerable to high inflation, which should be a serious concern for investors.

Potential impact on Australian equities

An inflationary environment would mean different things for different areas of the economy, especially when current starting prices for sectors are taken into account.

Assuming a local rise in inflation and potential recession, the biggest risk in the S&P/ASX Index appears to be in the banks and domestic cyclicals. Both industries are heavily exposed to high consumer debt levels. We believe that the biggest beneficiaries would be global exporters, who would theoretically become more competitive from a lower exchange rate and reduced wage pressures in a recession. It should be stressed that not every company in these broad groups would be affected to the same degree, as each company is different and importantly is trading on a different valuation. Security selection will remain critical, both in terms of sectors and the companies within these sectors.

High inflation: potential winners and losers

Of course, if the entire world experienced inflation, benefits to exporters would be eliminated. Yet given that Australia did not fully participate in the GFC and has much higher consumer debt levels, Australia would likely experience larger deflationary pressures. Thus, it is likely that the Australian dollar would be weak, partially offsetting the adverse impacts for global businesses and assisting exporters.

In an inflationary environment, we expect the Australian stock market to be negatively impacted, but given that it is a real asset class with a fairly reasonable starting valuation, at least in the medium term it may be a relatively better option compared with nominal bonds and residential property. While the bank and cyclical sectors together account for approximately 40% of the market, this is not a binding constraint on an active manager of equities.

Plan for inflation

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” John Kenneth Galbraith

Macroeconomic forecasts are notoriously unreliable, and what we have known about inflation has been upended in the last 20 years. So, we make no predictions about the timing of a return to inflation. Yet we still believe equity investors should consider inflation risk within an asset allocation framework. Our view is that inflation is a more a likely outcome than deflation over the long term.


Dr Phil Hofflin is Senior Analyst and Portfolio Manager at Lazard Asset Management. This content represents the views of the author. Lazard gives its investment professionals the autonomy to develop their own investment views, which may not be the same throughout the firm.



Leave a Comment:



Are we again crying wolf on inflation risk in pandemic response?

From deflation fears to inflation worries

Deflation is good


Most viewed in recent weeks

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Welcome to Firstlinks Edition 433 with weekend update

There’s this story about a group of US Air Force generals in World War II who try to figure out ways to protect fighter bombers (and their crew) by examining the location of bullet holes on returning planes. Mapping the location of these holes, the generals quickly come to the conclusion that the areas with the most holes should be prioritised for additional armour.

  • 11 November 2021

Welcome to Firstlinks Edition 431 with weekend update

House prices have risen at the fastest pace for 33 years, but what actually happened in 1988, and why is 2021 different? Here's a clue: the stockmarket crashed 50% between September and November 1987. Looking ahead, where did house prices head in the following years, 1989 to 1991?

  • 28 October 2021

Why has Australia slipped down the global super ranks?

Australia appears to be slipping from the pantheon of global superstar pension systems, with a recent report placing us sixth. A review of an earlier report, which had Australia in bronze position, points to some reasons why, and what might need to happen to regain our former glory.

How to help people with retirement spending decisions

Super funds will soon be required to offer retirement income strategies for members in decumulation. With uncertain returns, uncertain timelines, and different goals, it's possibly “the hardest, nastiest problem in finance".

Tips when taking large withdrawals from super

You want to take a lump sum from your super, but what's the best way? Should it come from you or your spouse, or the pension or accumulation account. There is a welcome flexibility to select the best outcome.

Latest Updates


John Woods on diversification using asset allocation

All fund managers now claim to take ESG factors into account, but a multi-asset ethical fund will look quite different from a mainstream fund. Faced with low fixed income returns, alternatives have a bigger role.

SMSF strategies

Don't believe the SMSF statistics on investment allocation

The ATO's data on SMSF asset allocation is as much as 27 months out-of-date and categories such as cash and global investments are reported incorrectly. We should question the motives of some who quote the numbers.

Investment strategies

Highlights of reader tips for young investors

In this second part on the reader responses with advice to younger people, we have selected a dozen highlights, but there are so many quality contributions that a full list of comments is also attached.

Investment strategies

Four climate themes offer investors the next big thing

Climate-related companies will experience exponential growth driven by consumer demand and government action. Investors who identify the right companies will benefit from four themes which will last decades.

Investment strategies

Inflation remains transitory due to strong long-term trends

There is momentum to stop calling inflation 'transitory' but this overlooks deep-seated trends. A longer-term view will see companies like ARB, Reece, Macquarie Telecom and CSL more valuable in a decade.


Infrastructure and the road to recovery

Infrastructure assets experienced varying fortunes during the pandemic, from less travel at airports to strong activity in communications. On the road to recovery, what role does infrastructure play in a portfolio?


The three prices that everyone should worry about

Among the myriad of numbers that bombard us every day, three prices matter greatly to the world economy. Recent changes in these prices help to understand the potential for a global recovery and interest rates.


Why green hydrogen is central to achieving net zero

Hundreds of green hydrogen projects show this energy opportunity is finally being taken seriously. While a cost disadvantage and technical challenges need to be overcome, it promises to deliver a path to net zero.



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.