LBJ’s Great Society kicked off the Great Inflation, and the wage and price controls were disastrous. Blaming the Great Inflation on Arthur Burns is convenient, but also appears to be a pack of lies played on the dead. Barry Knapp -Ironsides Economics – Inflation Mythology, 11 February 2023

Welcome to 2023 - the opening two months of 2023 are in the books for investors and while the average portfolio is likely ahead of its starting point for the year, January (positive) and February (negative) were two completely different tales (and I use this word deliberately). 

We have chosen to quote Barry Knapp’s Inflation Mythology as he describes a situation where in the US in 1964/65, President Johnson (and subsequent promotion by following Presidents), kicked off his Great Society spending policy. Major policy initiatives in this area encompassed housing, health, education, transportation, labour and the environment. Unemployment during this period was stable until the mid-1970’s where it was as low as 4.6% in October 1973 and peaked at 9% in May 1975. The same period also was characterised by government policy that attempted to tax its way out of growing deficit. The situation he describes while not exactly the same, has some striking echoes with the current policy settings or proposals in both the United States and Australia. 

From an Australian perspective, it is useful to read the Essay published by our Treasurer, Dr Jim Chalmers (an economist by training) in “The New Daily”. From a literary perspective, it will not win any major awards (much like my own prose); however, it is useful to understand what shapes our Treasurer and his thinking. What is obvious is that his views on the world are coloured by his observations of disadvantage that he sees around him – particularly in his own electorate. It is also clear that he sees a place for increased government intervention in the economy – much like the 1960’s and early 1970’s US policy to right some of the wrongs according to his perception of the world. 

Similarly, to the political class of those bygone eras, he is successfully prosecuting an argument with the aid of an adoring and sympathetic media (for the most part) and dubious left wing “think tanks”; that cost inflation has been a construct of the Reserve Bank of Australia and greedy corporates. While there are certainly examples of the latter, including those that can thank the government for their current going concern status; it is simply inflation mythology, to borrow Barry Knapp’s term to apportion blame this way (The Territory term is simply to call it what it is… a blatant lie). 

Cost Inflation was caused by fiscal policy (government spending started by the Coalition during the pandemic and continued by both parties far longer than required) and supply chain disruption in part. Asset price inflation was created by the Reserve Bank lowering rates and creating an expectation (policy by press release) that rates would stay low until 2024… until they realised that they had made two mistakes 1. They expected that Political parties running governments would be responsible (cue laughing soundtrack) and 2. That the public would not take their 2024 pronouncement as policy.

So back to markets and what we observed during January, February and the first days of March is: 

• A market showing that things are not as bad as the pundits were professing from July through to December of 2022 (January was strongly positive);
• An assessment that Central Banks continue to be held accountable for cost inflation even though they were not responsible for it and that they are managing it through dubious, seasonal and highly unreliable datapoints that they refuse to budge from;
• Policy frameworks are emerging that are indicative of an era that led to a stagflationary environment and governments that sought to tame profligate spending of earlier years through destructive higher taxation policies. 

For 2023, we still believe that the 1995 analogy for market performance remains intact, however for latter parts of the decade, for the reasons above and some basic maths that characterise our demographic makeup, we expect a more difficult environment if the current policy path remains intact. 

• Inflation will be higher this decade, fuelled by peak spending in both millennials and baby boomers who represent higher percentages of the population than at any other time in our history (Millennials and Boomers both represent 1% more of the population each compared to previous decades and overall population is growing);
• Government policy will favour climate and social infrastructure that appeals to a good proportion of the demographics in peak spending rather than saving phase;
• Energy transition will continue – this cannot be linear (carbon intensive linearly replaced by green sources) and will lead to periods of high prices that will be exacerbated by government spending seeking to “ease the cost of living” (a different form of Harvey Norman dollars that we saw during the GFC);
• An increasingly interventionist government policy that will likely seek to tax away deficits and encourage malinvestment. Early evidence of this can be seen in Australia with the current superannuation tax proposals rather than government taking on the task of proper tax reform via the GST. 
• Central Banks will try to stick to their target inflation bands but (in our view) be forced to adjust them upwards once it becomes apparent that the basic arithmetic of the exercise cannot be achieved when considered against their core objectives of price stability and full employment. 

Earnings:
January was a solid month for markets as H1 and Q4 earnings rolled in.  The reporting calendar stretches for Q4 figures, so it takes longer than the other three quarters for reporting to finish on overseas indexes.  The S&P 500 companies reported profits 0.64% ahead of estimates, and sales 2.14% in front.  

Our ASX 200 is earlier in its reporting session (94% of companies) and trending at 2.57% ahead of sales estimates, and 4.79% behind earnings estimates.  AGL alone accounted for a $68m miss on earnings.  Financials reporting to date has been strong locally reflecting a resilient local economy despite nine RBA rate hikes.

The AUD continued to appreciate against its US counterpart as the RBA matched the US Fed on the rates front.  “Risk-on” sentiment helped investors like us that have been hedging non-AUD investments.
 
Inflation the path to 3.5%:
The RBA surprised at their first meeting of the year, not with a 25bps hike (that was already priced by the market) but with their rhetoric - that a pause wasn’t on the cards, essentially mirroring their overseas colleagues at the Fed.  The 3-month swap curve now estimates a terminal rate for the RBA at over 4% (currently 3.35%) as our central bank continues the fight against inflation. Previous estimates were for a peak rate of 3.6%.
Unemployment rose slightly in Australia in December to 3.5%, but inflation was still running quite hot at 7.8% (annualised and a lagging measure - high comparative numbers from the prior corresponding period should see inflation fall moving forward as it is a year over year measure).

Demand for big ticket items that are interest rate sensitive like automotives and housing will be very sensitive to employment and lending policy.  In Australia, APRA added its voice to the debate, reminding policy makers that it can support borrowing by adjusting the mortgage rate servicing buffer.   Changes here would be a targeted attempt to put a floor on housing falls, as current servicing buffers require borrowers needing to refinance or get new lending to qualify at a servicing rate over 7.5%.  This targeted approach means that the RBA has more scope than using the sledgehammer approach (continued rate increases followed by cuts to the cash rate once activity falls off a cliff). Instead, APRA can use the scalpel to try and revive real estate and construction if activity declines and real supply is not added to a property market that remains tight for a growing population. 

Wage growth trends in the US are positive for lower inflation as the peak in wage rises was in Q1FY23.  At home the RBA raised its estimates for CY23 wage growth from 3.9% to 4.2%, which is why the talking points were hawkish from RBA Gov. Lowe.  A reopening in China will be a deflationary help as supply chains declutter - the Baltic Dry Index which represents shipping costs is at 2019 lows. 
 
Old Economy and Under Investment:
Materials have been strong to start the year, energy is lagging though as local efforts to curb gas pricing have put a headwind on the sector at a time when global oil prices have also seen the effects of Russian sanctions.  Deflation is biting in energy in the short term as China benefits from cheap crude.  The sanctions are doing their job lowering Russian receipts and the limited number of buyers for Russian crude are seeking deeper pricing cuts.  

Lower pricing and similar output levels have seen inventories rise in the short term (deflationary again).  Even with the short-term rise, inventory levels in the US are at 1986 levels.  President Biden successfully opened the taps to suppress pricing through last year’s election year.  With a re-opening China and spring offensives expected in the Russia-Ukraine war energy prices could easily spike again.
 
Further than energy markets prices of all commodities remain vulnerable to increasing demand as years of under investment mean that supply cannot be increased quickly enough in many key commodities - particularly in the complex of commodities required to de-carbonise economies. 
 


1995 Analogue:
We cited 1994 as our analogue for the 2022 market correction led by the Federal Reserve tightening monetary conditions, with a melt up occurring in 1995 after the second last rate hike.  Quantitative Easing (printing money, QE) put the correction from the pandemic peak to trough at 25% down, compared to the 8.7% peak to trough decline in 1994.  The 1995 melt up retraced the declines of 1994, a similar scenario for 2023 puts the S&P500 at 4800 when the calendar year closes.



In understanding how this may come about, it is important always to look at the component parts of the market. 

• In US Terms, it is likely that the fall of technology has been over-stated. The US is a place of great innovation and belief. This will continue – the ability for private credit to be issued to fund innovation remains unimpaired (the debt sits on the Government balance sheet for the main part and the majority of mortgages have been locked in for extended terms). 
• Re-shoring of Manufacturing in the US and other jurisdictions continues apace. 
• Real Estate Investment Trusts were beaten up in 2022 – particularly in Australia. Look for yield hungry investors looking for longer term inflation hedges to buy these assets until the discounts narrow. 
• As discussed above, chronic underinvestment in Commodities is likely to spur an extended bull market cycle (with periodic declines within the cycle). Supply simply cannot be brought online quickly enough and demand particularly in battery minerals is under-pinned by Global Government policy. Australia is well served for quality companies in this space. 

Parting Words
The Essay written by Dr Jim Chalmers opened with a discussion of a quote from Heraclitis, sent to him by a Friend and Journalist: “We both step and do not step in the same rivers. We are and are not.” The quote implies that two different people cannot step in the same river at two different times – essentially it was a reminder for him to forge his own path based on his own beliefs. 

It is reasonable to assume that these core beliefs will shape Australia for the decade to come. They come from a good place (we truly believe that), but taking a dispassionate view, we also believe that government intervention in policy, the market and efforts to tax a population to remedy prior fiscal profligacy has and always will be a mistake. So while we speak of rivers, we are reminded that rivers are polluted upstream, the downstream effects are felt many years later and that rivers can rage in a torrent or dry up permanently. While we hope that Dr Chalmers vision is realised, hope is not a strategy that we employ in assessing the investment environment ahead and we will continue to distil the facts from the spin.