Today’s investors are lucky (or cursed) by the pervasive availability of economic information. That’s great for informed decision making – or is it? Psychologists say too much information can lead to slower decision making. Sportspeople call it ‘paralysis by analysis.’
So let’s look at the big economic numbers and what they tell us – and what they don’t. And at a less accessible but potentially more important number.
Inflation: too much money chasing too few goods
|Measure||Headline inflation (RBA)|
|The number/s||5.1% for the year to March 2022|
|Direction of travel||High and going higher|
The story behind the number
The inflation beast is rearing its ugly head. According to the International Monetary Fund’s (IMF)’s March World Economic Outlook, Developed Country inflation in 2022 is projected to hit 5.7% - that’s 1.8% higher than projected just three months ago.
In Australia, prices went up 5.1% in the past year. But our hip-pockets were less impacted than our friends in the US (8.5%.) and the UK (7.0%).
Where has all this inflation come from? Keynesian economists call it ‘demand-pull’ inflation. To fight the economic shock caused by the pandemic and government-imposed lockdowns, policymakers around the world threw money at consumers and cut interest rates. With the pandemic panic easing (except in China), all that money is sloshing around looking for goods to buy. Those goods are in short supply, partly because China’s latest lockdowns have lengthened backlogs. So prices rise.
The new issue for policymakers is how to stop inflation getting baked into economic decision making. Or as the IMF puts it, “tighter monetary policy will be appropriate to check the cycle of higher prices driving up wages and inflation expectations, and wages and inflation expectations driving up prices.”
What it means for investors
Rising inflation changes the playbook:
- It makes holding cash problematic. Inflation will erode the value of your savings.
- It rewards companies with pricing power – those with unique products (including some luxury goods), those working in oligopolistic sectors where competition is less intense and companies who sell the goods which people need to buy, despite of price increases – like food and fuel.
- For more on how investors can adapt to inflation see this discussion with Perpetual Private’s Head of Investment Research, Kyle Lidbury.
Interest rates: They’re charging you more for their money
|The number||0.35 - still very low (as at 3/5/22)|
|Direction of travel||About to rise - and quickly|
With inflation surging, Central Banks in most of the big economies will be raising rates to curb demand. The recent 0.25% cash rate rise in Australia is the first since 2010. But some economists speculate the Australian cash rate could hit 2% by the end of the year. That’s not high by historical standards but for the one million or so Australians who have never had to hike their mortgage payments it could be a big shock – and enough to dry up their spending on other areas.
That highlights another big policy dilemma. Raise rates too slowly and inflation gets baked in. Raise them too fast and growth collapses. Events in Eastern Europe complicate the picture even more - “Even as the war reduces growth, it will add to inflation,” says the IMF.
What it means for investors
The obvious investment impacts of rising rates is what they do to demand and to costs. If rates are rising, companies must fight for their place in consumers’ shopping list. The debt they carry starts to cost more money. Both factors affect how companies perform.
But if you’re an investor, you may also need to think about how changes in interest rates affect the discount rate markets use to value assets. Let’s take a simplified look at how that works.
The price you pay for an asset – whether an office building or a parcel of shares – reflects not just its current value but the cashflows it may earn in the future. The question for investors is how to value that future return – how to know what that potential future return is worth as a price today.
Using a technique call Discounted Cash Flow (DCF) analysis, fund managers use the prevailing interest rate (often, but not always, the 10 year government bond rate) and their assessment of estimated future cashflows, to calculate what a company is worth today. In very simple terms they’re assessing whether the estimated future cashflows of the company are worth paying for given you can access a ‘risk-free’ income from government bonds. The rule of thumb: when rates are rising, the present value of assets will be declining.
GDP: Higher is better
|Measure||Gross domestic product (GDP)|
|The number||5% (end 2021) - very strong|
|Direction of travel||Moderating - but slowly|
While some economists see GDP as a clumsy number – it’s a calculation first used early in the Industrial Age and subject to frequent and often significant revisions - understanding the long-term trend is important. After all, economy-wide growth will feed into the growth trajectories of the companies you’re investing in.
Over the next year economists, fund managers and investors will be carefully watching how rising rates, geopolitics and policy decisions combine to affect our economic growth – and our jobs.
Unemployment: Head-hunters paradise
|Measure||National Unemployment Rate|
|The number||3.9% - very low (ABS figures, 19/05/2022)|
|Direction of travel||Going lower|
The RBA recently predicted that unemployment in Australia will hit 3.5% by early 2023 . That will be the lowest level in 50 years. As companies compete for staff, wages should rise. That should help local households cope with rising rates and rising inflation.
What it means for investors
Like every major Western economy, Australia now has rising inflation and rising rates and that presents a challenge to investors.
On a broader view, our inflation and interest rates are lower – and should stay lower – than those of many counterpart nations. Our unemployment and growth numbers are also broadly superior, thanks to a (relatively) well-managed pandemic and because our resources-heavy economy is less affected by the war between Ukraine and Russia. In short, as an investor, you’re still living in the lucky country.
The number you don’t see is the number that matters
Knowing your economic indicators can be handy. But according to Andrew Garrett, Investment Director at Perpetual Private, there’s a far more useful figure all investors should understand that’s rarely front page in the newspapers – standard deviation.
Put very simply, standard deviation measures the dispersion of a dataset relative to its average. In investment it measures how far a given return (say the annual return from Australian shares) diverges from its long term average. It’s often used as a measure of a relative riskiness of an asset. A start-up tech stock might have a high standard deviation. The standard deviation of a blue-chip stock like CBA would usually be meaningfully lower.
“Thinking about standard deviation helps you really understand your asset – both the return side and the risk side,” says Andrew Garrett.
On RBA numbers, the standard deviation of the Australian sharemarket between 1917 and 2019 was 18.6%. Given the average historical performance of the Australia market is around 10%, any year where the Australian market performs between negative 8.6% and positive 28.6% is a ‘normal’ year (an outcome expected in 68.2% of years).
By getting a feel for standard deviation, that is, knowing that stocks move should move within this range – most of the time - can help investors manage their attitude to risk. They’re less likely to bail out at the bottom of the market (and crystalise losses) in the face of short-term volatility. And that can make a big difference to the long-term return they achieve.
“Understanding average returns and standard deviation can make you a better investor,” says Andrew Garrett. “You can set your return expectation around the average return – and that will help with your asset allocation. But thinking about standard deviation can ensure you’ve got a clearer picture of how widely your return could vary. It’s investing with your eyes open. And it’s something you should talk to your adviser about.”
The numbers may not lie but they don’t tell all of the truth
What this small survey of the big numbers tells us is that investment metrics do matter. But investors can get too obsessed with knowing the latest numbers. There is no one number that can guide investment decisions in isolation.
Perhaps Mark Twain’s famous quote is useful here. “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
For Andrew Garrett, investing is all about intellectual humility. “Do we feel super confident because we have all the numbers at our fingertips?” he says. “No we don’t. Because we’re always thinking about which of our assumptions could be wrong. A constant scan of the horizon – and constant checking of our thinking - is what helps us protect and grow our clients’ money.”
 FactSet Economics Standardized Database, Feb 2022
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