Australia’s rare plunge into deflation with a record drop in quarterly prices may not last, but fund managers nonetheless expect a sustained period of low price growth ahead, which will only reinforce the dominance of growth stocks.
Falling prices for childcare, rents and fuel contributed to a 1.9 percentage point fall in June quarter headline inflation from the March quarter for a negative 0.3 per cent outcome.
“It’s soft but that was to be expected and we understand the reasons why it is soft,” said Tamar Hamlyn, fixed income portfolio manager at Ardea Investment Management.
Inflationary outcomes can also be important for investment styles. The equity market’s interest in technology companies makes sense to John Birkhold at Origin Asset Management because when prices were lower, companies needed a mindset to either cut costs or deliver breakthrough products.
That’s a natural way of operating for technology companies.
“The tech space essentially has to deal with deflation on a regular basis,” the fund manager said. Technology, such as phones, degrade in terms of capability over time.
Macquarie speculated last week that as the information age brought marginal costs toward zero, and with it marginal pricing, any stock that had the ability to defy those gravitational forces “is rewarded with an almost infinite valuation, amplified by a near-zero cost of money”. The broker suggested that was why some growth stocks can go parabolic, but value stocks struggle.
The CPI slide took place in a quarter marked by the COVID-19 pandemic. The government’s response included slashing childcare costs to zero and introducing a rent moratorium to prevent tenant evictions. Petrol prices also fell.
Many of those factors are expected to be temporary. The government has already reversed its free childcare policy and petrol prices have recovered.
National Australia Bank expects CPI to bounce back in the third quarter given that free childcare ended on July 12 and it is looking for a 2 per cent rise in prices quarter-on-quarter.
The longer-term outlook for inflation remains subdued, NAB said. Elevated unemployment, weak housing rents and new dwellings costs, along with a “disinflationary impetus” from China’s factories were all likely to prevent large price rises.
Mr Hamlyn agreed: quarter-on-quarter changes to CPI are not too concerning for markets, he said.
“You can see that in today’s market reaction where 10-year yields barely moved after the most negative CPI that we have ever seen,” he said. The Australian 10-year government bond yield traded at 0.86 per cent on Wednesday afternoon.
“It is changes to long-term inflation expectations that are most concerning to investors and so far they seem both low and stable,” Mr Hamlyn said.
Equities can provide solid returns if inflation is not too strong, and equity markets have surged since March, with the S&P/ASX 200 Index climbing more than 30 per cent.
Investment strategist Giselle Roux said traditionally investors would go long equities, “particularly those with pricing power”, in a world where inflation is not expected to rise significantly.
Pricing power can come through market dominance, a unique offering, or a lower-cost business model than competitors. Scarcity due to intellectual property or research and development complexity is another way for companies to lift prices.
Not all equities qualify, she said. “They have to show the capacity to grow at a faster pace than either inflation or low overall economic growth.”
Investors have corralled themselves into these kinds of companies over the past six months. That group can include technology stocks, the strategist said, “but not all of them”.
“It would be wrong to assume that every technology company is necessarily going to do well,” she said. In some cases, a competitor can do better or is cheaper.
It’s not easy, Mr Birkhold argued. “To stay relevant in the tech space you have to bring new products to the table and bring innovation to the table to compete which is challenging. If you’re not investing in R&D and you don’t have an innovation mindset then you get left behind,” he said.
“That notion of bringing more capability to the table at the same price is ultimately what every company should be trying to do – effectively trying to make your client happy that they are receiving more bang for their buck and increasing productivity.”