Inflation: The Untamed Beast

This story features AUSSIE BROADBAND LIMITED, and other companies. For more info SHARE ANALYSIS: ABB

The company is included in ASX300 and ALL-ORDS

By Greg Peel

Yesterday South Australia-based barley production specialist ABB Grain ((ABB)) blew analyst forecasts out of the water by reporting a 79% increase in first half profit. The result was, for example, 40% above JP Morgan’s estimate, and was accredited to a strong rise in global malt prices. While JPM decided to downgrade the stock from Overweight to Neutral on the back of a strong share price reaction, and because ABB has been forced to increase working capital to meet its expansion plans, the analysts suggest any price lower than here presents a good long term buying opportunity.

Why? Because while global grain prices may well bubble and burst, the reality is the longer term trend is up.

Macquarie Airports ((MAP)) has been a bit of an analysts’ darling in recent months as valuations have taken into account the promise of growing passenger numbers globally, increased capacity via brand new airliners, and increased revenue from sucking the airport visitor dry with parking fees, taxi surcharges and lavish retail outlets. Prior to this morning, eight out of ten brokers in the FNArena database called Mac Airports a Buy.

But this morning Merrill Lynch downgraded from Buy to Neutral. In short, the reality of US$135/bbl oil has suddenly hit home. As airlines across the world have been forced to bump up fuel surcharges on ticket pricing, passenger numbers have begun to drop. Smaller airlines, particularly in the US, have been forced to quickly talk possible mergers with each other, or go belly up. Some already have. Now the major carriers are talking about reducing fuel bills by reducing capacity – reducing the number of scheduled flights to any one destination.

Fewer passengers, fewer flights, lower terminal revenue, fewer people to fleece as they are forced to pass through one of Macquarie’s global airports. All up a good enough reason for Merrills analysts to decide airports are not so much of a potential winner anymore.

It took a simple move in the price of oil from US$125/bbl to US$135/bbl for the world to suddenly realise the oil price had been sneaking up all along. Hysterical forecasts of US$200/bbl ahead have meant oil is now the most hotly debated topic across the globe, with even our own parliamentarians boring us all rigid as they try to pretend they can actually do something about it. The Coalition now seems to be basing its entire re-election policy on 5c off a litre. Whoopee. If we’re paying $1.80 a litre soon are we really going to care?

Inflation is a beast that has been decisively kept in its cage ever since the oil embargoes and subsequent stagflation of the seventies alerted central banks to the fact that high inflation is more destructive than low economic growth. Back then we were talking double digit levels of inflation, which produced mortgage rates in the teens. Given the average Australian household has quadrupled its debt servicing to income ratio since that time, can you imagine what a 15% mortgage rate would do right now?

The oil price has crept up on everyone, just as increases in most commodity prices have been previously accepted with a shrug. From Australia’s point of view, one reason is that high commodity prices mean strong export incomes, and that is a good thing. But across the globe, higher commodity prices had not, until recently, rung any inflation alarm bells. That’s because China – the driving force behind higher commodity prices – was recycling those commodities back to the developed world in the form of ever lower-priced goods. That deflation offset commodity price inflation, and thus any increases in core inflation have been relatively modest.

Those days are over.

China’s export industry has now become a mere shadow of its former self, as an appreciating currency and those rising commodity prices themselves have stripped margins, not to mention a weaker US dollar driving demand reductions from the world’ greatest consumer. However, Chinese demand for commodities has not subsequently waned, but has surged ever higher as the world’s fastest growing economy turns its mind to domestic matters. Every day Chinese citizens are moving into their first real house, with their first access to electricity and their first phone. In their first fridge they are placing meat and other exotic Western delicacies for the first time. And in the driveway sits their first car.

As a response, grain prices have surged, rice prices have surged, fertiliser prices have tripled, coal prices have tripled, iron ore prices are set to double, and the oil price has risen 50% in 2008 alone. Without the offsetting effect of ever-diminishing prices for consumer goods coming back, the global inflation beast has broken out of its thirty-year cage.

While inflation has become an issue across the globe, Australia – the booming commodity-based economy – has suffered the greatest jump in headline inflation within the developed world. The Reserve Bank of Australia has been forced to raise the cash rate to 7.25% when Britain has a rate of 5%, Europe 4%, Canada (another commodity-based economy) 3%, the US 2% and Japan 0.5%.

However, recent leading economic data have shown that the Australian economy is indeed set to slow. Business and consumer confidence have collapsed. Credit growth has begun to slow. Before oil hit US$135/bbl, most economists were expecting that 7.25% was as high as the cash rate would reach in this cycle.

But with inflation creeping higher, more and more economists began to suggest that perhaps one more rate hike may yet be forthcoming. And then yesterday the economists at ANZ Bank shocked the nation by suggesting that there would not be one, but two more rate hikes of 25 basis points. The cash rate would reach 7.75% before the year was out. This would push variable mortgage rates into double digits. The ANZ report became a leading item on the six o’clock news.

Simply put, ANZ now expects Australia’s economic growth to be stronger (or at least its slowdown to be less pronounced) than the RBA most recently forecast. The economists also expect inflation to rise to a higher level than the RBA already fears. They suggest a rate rise in August, following the second quarter consumer price index (CPI) outcome, is as good as given. It may even come as soon as July. They then suggest another rate rise in November is also a strong, albeit less certain, possibility.

What has startled the economists is not just the strength of inflation pressure in Australia but the breadth. Okay – oil and food prices are obvious, and in Australia house price pressure is also an unusual factor from the global perspective. But over 75% of items used to calculate the CPI rose in price by more than 2.5% year-on-year in the March quarter. Physical input prices are one thing, but service prices rose 5% in the period. The rise in the producer price index (PPI) has been even more pronounced, suggesting, to date, that retailers are copping reduced margins in the short term, knowing that they would lose business otherwise and hoping that wholesale prices will come back down. But nothing is coming down at all.

ANZ notes the second quarter petrol prices could post a 5-7% rise if the oil price does not fall significantly from here. Airfares could rise by 5%. Rents continue to rise consistent with record low vacancy rates. Food prices will have to rise further on transport costs alone. Even the alcopop price rise will add to inflation, and health insurance premiums will also rise by an average 5%. The result is a higher rate of both core and headline inflation than we saw in the first quarter.

ANZ expects core inflation to peak at 4.9%.

The economists suggest headline inflation will reach 4.6% in the second quarter, pushing the annualised rate above 5.0%. And the risk is to the upside. Indicators such as the TD Securities-Melbourne Institute inflation gauge are signalling higher levels still. When the RBA last raised the cash rate, its peak inflation expectation was 3.75%. Consumer inflation expectation surveys are suggesting higher levels as well, as are financial markets, as evident in government bond prices.

The RBA is hoping, and logically so, that while inflation may not have yet peaked the lagged flow-through effect of the interest rate rises to date will ultimately tame the beast. It just might take a bit longer – perhaps even into 2010. But as much as this simple economic equation should work, there are still more inflationary pressures ahead, as ANZ notes.

One inevitable pressure is that the rising commodity prices which are so much responsible for the rise in Australian inflation will also be responsible for a much improved terms of trade. Australian commodity producers will be swimming in cash. At the same time, the credit crisis which has been as much responsible for increased inflation as Chinese commodity demand (it has resulted in a much lower US dollar) is showing signs of tentative easing. This means the panicked credit restrictions recently placed on Australian business borrowing will also ease. As businesses look to continued expansion to take advantage of the boom, they will be looking to borrow and spend what they can.

The Australian government will also chime in with its own infrastructure spending.

And while the Australian consumer has been hard hit by rising interest rates and rising costs for petrol and food, tax cuts will soon be forthcoming.

Even the beleaguered Australian farmer will be doing his bit for inflation, as rising global grain prices have been met with a breaking of the drought at least in some parts of the continent. Agricultural income will also jump.

In the US, the Federal Reserve has been able to respond to the credit crisis by slashing the cash rate from 5.25% to 2%. The effect on inflation has not been as dramatic as that felt in Australia, as a slumping housing market has been the root of the problem. As the US includes in its CPI measurement a consideration for equivalent rent of homeowners, falling house prices have helped to keep a lid on inflation. Not so in Australia.

In Australia, we still have a chronic housing shortage, and record low levels of housing affordability. While higher interest rates are serving to subdue house prices, and high raw material costs are dissuading builders from jumping into risky development projects, the shortage of accommodation will put a dampener on any real demand slowing stemming from higher mortgage rates, ANZ notes.

ANZ believes that given the ongoing stimuli for business investment, the responsibility will fall upon the humble Australian consumer to slow the economy down. The RBA sees it this way too, albeit knowing it is causing pain amongst those who may not really deserve it. However, despite higher rates and prices, the effect of the upcoming tax cuts will be to push the consumer pain barrier to a higher level. It has only been this last week that Australia has really started to whinge about the petrol price. And politicians from both sides of the fence have only now responded, trying to spin a belief that one or other can control global oil prices. With perhaps $1.80 per litre in sight, Australians are now thinking very seriously about their petrol consumption. The tax cuts will help relieve the burden.

Which means that if the RBA is really going to slow down the Australian consumer, it is going to have put rates up further still. This is the crux of ANZ’s argument. And yet there is still another problem looming.

The RBA’s greatest fear is wage price inflation. Governor Glenn Stevens once again laboured this point in his most recent statement, warning that any upward groundswell in wages would result in a quick monetary tightening response – higher interest rates. It has continued to surprise the RBA over the course of 12 months or more that Australian wages have remained well behaved despite record unemployment and a shortage of skilled workers.

But the unions have begun to growl. After eleven years of emasculation under the Coalition government the trade unions have seized on the opportunity presented by an electorate that rejected Howard’s Work Choices policy of enterprise bargaining. With a Labor government in place the door is now open for inflation-based wage claims – a destructive feature of the economically impotent seventies. Higher wages mean higher incomes, and greater spending power. This feeds consumer inflation. Thus begins  a classic wage-price spiral.

ANZ is predicting that economic growth in Australia will reach 2.0% in 2008 compared to the RBA’s forecast of 1.75%. For inflation, the economists’ prediction of 5% before year end may yet seem conservative.

The good news is that ANZ also sees inflation coming down in the future, as the above graph suggests, back into the RBA’s comfort zone perhaps by 2010. Ultimately the effect of higher interest rates will work, and the Australian economy will slow.

One contributing factor will be the strength of the Australian dollar. On the basis of two more interest rate rises, the ANZ economists are now predicting an Aussie of US$1.04 by the end of the year. While Australians may thus be able to draw great delight from thumbing their noses at the Yanks, the reality is an Aussie above parity will have its own direct effect on taming inflation. It will, however, be a lagged effect, which is why predictions of falling inflation have been pushed out to 2010.

A higher Aussie means less income for Australian businesses operating overseas, and for Australian commodity producers. The currency movements acts as a dampener on local revenue increases enjoyed via higher commodity prices. Fewer and fewer tourists will venture all the way downunder, given both higher airfares and a stronger currency. Australia’s once booming post-Olympic tourism industry will be decimated.

However, import prices will fall. Never will it be cheaper to own an iPhone, although the cost of flying an iPhone out to Australia will increase. It will thus be incumbent upon the RBA to make sure Australians are hurting enough in trying to overcome their debt burdens that they won’t be able to pay for new toys.

The ball is in the RBA’s court.

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