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.

 

  •   14 September 2017
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

Why economic forecasts are rarely right (but we still need them)

Why a deflationary shock is near

Howard Marks on the best opportunities in 2024

banner

Most viewed in recent weeks

Australian stocks will crush housing over the next decade, 2025 edition

Two years ago, I wrote an article suggesting that the odds favoured ASX shares easily outperforming residential property over the next decade. Here’s an update on where things stand today.

Building a lazy ETF portfolio in 2026

What are the best ways to build a simple portfolio from scratch? I’ve addressed this issue before but think it’s worth revisiting given markets and the world have since changed, throwing up new challenges and things to consider.

Get set for a bumpy 2026

At this time last year, I forecast that 2025 would likely be a positive year given strong economic prospects and disinflation. The outlook for this year is less clear cut and here is what investors should do.

Meg on SMSFs: First glimpse of revised Division 296 tax

Treasury has released draft legislation for a new version of the controversial $3 million super tax. It's a significant improvement on the original proposal but there are some stings in the tail.

Property versus shares - a practical guide for investors

I’ve been comparing property and shares for decades and while both have their place, the differences are stark. When tax, costs, and liquidity are weighed, property looks less compelling than its reputation suggests.

10 fearless forecasts for 2026

The predictions include dividends will outstrip growth as a source of Australian equity returns, US market performance will be underwhelming, while US government bonds will beat gold.

Latest Updates

Economy

Ray Dalio on 2025’s real story, Trump, and what’s next

The renowned investor says 2025’s real story wasn’t AI or US stocks but the shift away from American assets and a collapse in the value of money. And he outlines how to best position portfolios for what’s ahead.

Superannuation

No, Division 296 does not tax franking credits twice

Claims that Division 296 double-taxes franking credits misunderstand imputation: franking credits are SMSF income, not company tax, and ensure earnings are taxed once at the correct rate.

Investment strategies

Who will get left holding the banks?

For the first time in decades, the Big 4 banks have real competition in home loans. Macquarie is quickly gain market share, which threatens both the earnings and dividends of the major banks in the years ahead.

Investment strategies

AI economic scenarios: revolutionary growth, or recessionary bubble?

Investor focus is turning increasingly to AI-related risks: is it a bubble about to burst, tipping the US into recession? Or is it the onset of a third industrial revolution? And what would either scenario mean for markets?

Investment strategies

The long-term case for compounders

Cyclical stocks surge in upswings but falter in downturns. Compounders - reliable, scalable, resilient businesses - offer smoother, superior returns over the full investment cycle for patient investors.

Property

AREITs are not as passive as you may think

A-REITs are often viewed as passive rental vehicles, but today’s index tells a different story. Development and funds management now dominate earnings, materially increasing volatility and risk for the sector.

Australia’s quiet dairy boom — and the investment opportunity

Dairy farming offers real asset exposure, steady income and long-term growth, yet remains overlooked by investors seeking diversification beyond traditional asset classes.

Sponsors

Alliances

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.