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10 October 2017

Is the deflation bugbear heading Down Under

Anthony Fensom

Australia's economy could be just one recession away from deflation, with inflation and interest rates seen staying lower for longer despite monetary tightening overseas.

For local investors, the "normalisation" of policy as seen in North America appears a world away.

At its latest board meeting, the Reserve Bank of Australia (RBA) left its official interest rate steady for the 13th consecutive month, at a record-low 1.5 per cent.

In his official statement, RBA Governor Philip Lowe noted that inflation and wages growth "remains low in most countries," although inflation in Australia is expected to "pick up gradually as the economy strengthens".

While ANZ and NAB are predicting the RBA will increase interest rates in 2018, others such as Westpac do not expect a hike until 2020, due to slow growth and weak inflation.

Although the central bank is currently targeting an inflation rate of 2 to 3 per cent "on average, over time," the latest consumer price index (CPI) showed just a 1.9 per cent rise in the 12 months to the June quarter 2017, led by medical and hospital services (up 4.1 per cent).

According to RBA data, domestic inflation has largely remained below 4 per cent since the introduction of inflation targeting in the 1990s. In the two decades prior, the CPI fluctuated from as high as 16 per cent to below 4 per cent, affected by such factors as the OPEC oil price shock and centralised wage hikes.

Yet central bank researchers now estimate that Australia's "neutral" interest rate--the rate required to achieve full employment and stable inflation over the medium term--is just 1 per cent, down 150 basis points since 2007.

This comes amid the gradual "normalisation" of the US Federal Reserve's balance sheet and expected higher interest rates in the world's biggest economy. As noted by Morningstar's head of equities research, Peter Warnes, "the easy part is easing; the hard part is tightening".

Structural forces
Capital Economics' Paul Dales, chief Australia and New Zealand economist, suggests the decline in inflation reflects structural forces, including globalisation, labour, and technological changes and inflation targeting by central banks.

The opening up of China and the former Soviet Union and the rise of globalisation "led to greater efficiencies, provided cheaper sources of labour, and opened up domestic markets to global competition," he said in a 15 August presentation.

At the same time, labour market reforms and technological innovation "led to lower wage growth, by reducing the bargaining power of workers and flattening cost curves".

This was followed by politicians granting independence to central banks, which put priority on curbing inflation instead of stimulating demand.

The global financial crisis helped dampen inflation expectations further, dragged down by weak demand, high unemployment, large output gaps, and plunging commodity prices.

According to Dales, structural factors are likely to continue weighing on inflation in the decade ahead. Despite the influence of the Trump administration in the United States and Britain's exit from the European Union, globalisation should continue, albeit at a slower pace, while automation and other innovations will likely restrict wages growth.

And while central banks' inflation targeting policies may be "tweaked" slightly, they are unlikely to lose their independence.

"Our analysis suggests that global inflation will probably fluctuate around 2 per cent over the next decade. But as the United States is less likely to participate in further global integration and as the central bank may be forced to focus more on growth, it is most susceptible to higher inflation," Dales said.

"In contrast, an increase in competition and a greater focus on financial stability means Australia and New Zealand are more susceptible to inflation edging lower."

These trends could result in Australia's inflation rate staying below the RBA's target "over the next 10 years".

In the worst-case scenario, "an average inflation rate of around 2 per cent or below could mean that many economies, including Australia, are just one recession away from deflation. In other words, the next economic shock might not need to be very large to push inflation below zero".

Weak inflation and low interest rates could see central banks run out of ammunition in the event of a crisis, potentially forcing ultra-easy money policies such as quantitative easing.

Investor implications
For Australian investors, low global inflation means a continuation of low global interest rates and bond yields. Rising US interest rates are also expected to exert downward pressure on the Australian dollar.

Importantly, the decline in the neutral interest rate means the risk-free rate of return sought by investors is lower than previously, resulting in lower earnings yields and higher price/earnings ratios.

"The message we are saying is, if you compare asset valuations to the historical average, due to the fall in the neutral interest rate the actual fair value level is much higher than it used to be," Dales said.

This suggests that bond yields will remain low and the prices of both equities and property will stay high by historical comparison.

In contrast, Morningstar's Warnes argues investors should lower their expectations as the new monetary tightening phase gets underway.

"With interest rates and central bank balance sheets now moving into the normalisation phase, it follows shareholder returns should also normalise ... While hard to quantify, I suggest elevated leverage was responsible for a large, perhaps up to 50 per cent, proportion of total shareholder returns during quantitative easing," he said.

Yet with debt levels at record highs worldwide, "this leverage driver of returns is now exhausted," while productivity growth has also stalled. Meanwhile, global competitive intensity, disrupters, and technology will continue dampening inflationary forces, slowing any central bank tightening.

"Studies show, over the long term, normal total shareholder returns average around 5 per cent to 6 per cent per annum. This is the level to which I believe investors should now recalibrate their expectations."