A wealth based economy in an inflationary world

By Dominic McDonald | More Articles by Dominic McDonald

After 15 years of exceptional global growth it is believed the global economy is heading into a more difficult decade of economic trade. It must be acknowledged that 15 years of economic prosperity has been accelerated through active government and central bank policy, stabilising markets and securing credit during the uncertainty of a post GFC world. Has the 'hands on' policy from global governments removed the dynamic effects of market based economics? We would argue that the historical over involvement of monetary and fiscal policy has prevented the natural function of the business cycle to occur, creating an artificial price action in global economics. Developed nations in particular have experienced substantial appreciation to asset valuations due to excess credit, a by-product of overreaching policy. The consequences of the money market imbalance have formed structurally unsupported demand levels and further embedded inflationary pressures. A world that has operated in a liquidity fuelled disequilibrium cannot properly allocate capital nor can it appropriately quantify risk. Seemingly a necessary pivot to ‘fair value’ under a normalisation of policy is proving a monumental task as confidence levels remain elevated and disconnected from the true value of the underlying assets. Central Banks have been forced to hike and hike rapidly as transitory inflation was debunked. Proving the global economy was not immune to the mania of pandemic spending and investment. The COVID hysteria may have passed, yet inflation appears to be stickier than expected, still market confidence remains with the 'soft landing' narrative.

The global economic risks of Central Bank's narrow path to either not tighten enough or too much is certainly not being acknowledged by market pricing. The risk loving sentiment of the last 15 years has not yet been extinguished by tighter credit. What is the market missing? Global recession risk is likely being understated, particularly with a lagging China and negative domestic household savings. More importantly, the overarching theme for this decade that is being overlooked – stagflation. If inflation persists and unemployment rises we would likely enter a period of stagflation. A period defined by an erosion of purchasing power and significant structural job losses, ultimately curtailing economic growth. We are shifting from a government protected market to a floating market set by ‘real’ demand, and doubts remain if the market has the dynamic capacity to pivot with government policy and function without central bank liquidity. For a dynamic demand driven market to return we must see consumer and investor behaviours align in the government policy pivot towards tighter credit. The continual push back on recession forecasts accompanied with more than expected rate rises, unable to rein in inflation, supports that developed economies have become dependent upon excess government credit and structural change is required to absorb excess liquidity.

In a world where market driven demand is skewed by government backed speculation, short run financial outcomes will be prioritised and market inefficiencies will remain. The disinflationary impacts of rate adjustments will be limited until investment behaviour changes. Investment strategy and market function need a dramatic shift towards long term economic goals, encouraging a more efficient alignment of economic issues and market function. Post pandemic economies must find transformative solutions to clear and systemic generational problems: climate change, the energy transition, deglobalisation and labour shortages. For the Australian market to allocate capital efficiently and operate effectively it requires more than the blunt instrument of rate rises. As changes in the cost of money will not shift investment to operate with a long term focus. Investment behaviour will remain on a per annum basis (short run) until governments adequately incentivise behavioural change, if investment activity is held constant stagflation will remain a risk. The structural change required to address environmental and generational economic issues is a ‘catch- 22’ to inflation, opportunities for innovation may increase productivity helping to ease inflation, yet the capital required for change is now substantially more expensive adding to inflationary pressures. Furthermore, the added cost of capital in an inflationary world is contributing to the choppiness of markets trying to compute the new normal of ‘true value’. When market dynamics may still be skewed to the globalisation model failing to price in the compounding stagflation risks of an increasingly multipolar world. A shift in the optimal duration point of investment is a necessary economic antidote to stagflation and economic stability.

We live in a precariously shifting economic climate, which intends to increase the cost of carbon whilst decreasing the cost of living. A contradictory world, enduring a cost of living crisis and yet luxury goods have proven to be some of the best defensive equities. The friction of changing macro trends will likely continue a preference towards defensive assets and future facing industries. Australia is uniquely positioned for the transformative decade ahead. We are a major producer of future facing commodities and have the potential to be a key player in the production of green energy. Our characteristics as a net exporter of hard and soft commodities for renewable solutions has the capacity to strengthen the Aussie dollar to the world’s commodity dollar. Our currency would become aligned with the long term economic goals of our trading partners. As demand for the Aussie dollar grows, our dollar will become a natural hedge against inflation, insulating us against stagflation risks in the long term. The Australian economy is well positioned for wealth based trade and development, however government policy must effectively incentivise the return of dynamic ‘long run’ market based activity, if we are to be sheltered from stagflation risks.

Global macro thematics are changing and individual investors need to be aware of change economics, ‘the great transition’.The inflationary risks that change, may pose to your portfolio and the unique opportunities of the Australian market. An inflationary environment exacerbates two inescapable economic constraints for the individual: time and budget restrictions. As they spend more, they work more and save less- purchasing power is eroded. Time value constraints are evidenced in wage growth not satisfying consumer needs due to inflation pressures. An individual must consider a wealth strategy that best addresses time and budget constraints, and therefore improving overall purchasing power. Real assets are an essential buffer to the pressures of income shortfalls. The antidote to structural friction and inflation are assets that provide capital stability and a rate of capital return. These assets give an investor ownership (equity) and a passive form of income, both characteristics are the best defence against the time value constraint in an inflationary world. For the Australian retail investor there are three main areas to improve overall individual wealth:

1) Property: capital conservation and rental income resistant to inflation

Property has a proven historical performance in Australia, a strong asset class for capital preservation. The housing crisis and supply/labour shortage is producing rental returns that far outweigh the rate of inflation. An emphasis should be placed on residential property, commercial property appears to be facing greater headwinds.

2) Passive Income: Interest and Dividends

Passive income increases an individual’s income without any further effort required. Interest and dividends derive income independent of a salary or hourly wage, improving an individual's overall productivity and time constraint. The supplementary income from passive investments can be an added shield against inflation.

3) Super: Future facing industries, commodities and infrastructure

The great Australian super is a hugely important toolkit in establishing a self funded retirement, and an underappreciated asset in accumulating individual wealth. Australian superannuation has performed strongly over a historical basis, it also gives retail investors exposure to own positions in more selective institutional offerings.

For people at all stages of their working life superannuation strategy must be considered, for two main reasons i) Tax advantages can create a greater accumulation of wealth ii) The duration of investment for most people has a significant time horizon, often making it their longest accumulating asset. Therefore plan accordingly, and optimise compounding future returns that can defend your portfolio against inflation. Superannuation is an effective vehicle for ownership in real assets and future facing industries that can generate concessionally taxed income greater than the rate of inflation, at a later date.

The global economy is facing a frictional decade of structural economic issues. Inflation is likely to remain present as the cost of a rapidly changing world. Australia is well placed to seize the opportunities of economic change. The individual must consider a capital security strategy in uncertain times, maximising wealth over the long term.