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

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Latest Updates

SMSF strategies

30 years on, five charts show SMSF progress

On 1 July 1992, the Superannuation Guarantee created mandatory 3% contributions into super for employees. SMSFs were an after-thought but they are now the second-largest segment. How have they changed?

Investment strategies

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.


Tips and traps: a final check for your tax return this year

The end of the 2022 financial year is fast approaching and there are choices available to ensure you pay the right amount of tax. Watch for some pandemic-related changes worth understanding.

Financial planning

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.


Listed infrastructure: finding a port in a storm of rising prices

Given the current environment it’s easy to wonder if there are any safe ports in the investment storm. Investments in infrastructure assets show their worth in such times.

Financial planning

Power of attorney: six things you need to know

Whether you are appointing an attorney or have been appointed as an attorney, the full extent of this legal framework should be understood as more people will need to act in this capacity in future.

Interest rates

Rising interest rates and the impact on banks

One of the major questions confronting investors is the portfolio weighting towards Australian banks in an environment of rising rates. Do the recent price falls represent value or are too many bad debts coming?



© 2022 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.