Wednesday last week, Domino’s was the first major company here in Australia to flag seeing inflationary pressures such as rising food prices and labour shortages. The market reacted poorly to this news with the stock down 18% for the day. Domino’s is a great business, and while and a drop like that was probably an overreaction, it is the sort of re-rating we can expect if inflation takes hold.
Higher inflation has certainly arrived. The only question is how long it is here for. I’ve previously outlined my view that this bout of inflation is primarily a result of supply chain issues and that it will ease in due course. Overlay the slowdown from China and I believe inflation is most likely a 6-to-18-month issue. Ultimately, 1 of 3 scenarios will play out. I’ve listed these below with my view on their likely probability:
20% likely inflation subsides within 6 months and markets continue bull run.
60% likely inflation is a consistent theme for 6-18 months and causes a significant correction before inflation eases and markets continue their bull run.
20% likely inflation stays and causes a fall a permanent re-rating of all asset prices of 20% or more. The bull run is over, and we have an inflation problem.
If you look at the breakdown of the scenarios more deeply, you see the conundrum investors are faced with. When combining scenarios 1 and 2 my view is that it is 80% likely inflation is dealt with within 18 months. At the same time, if you combine scenarios 2 and 3, I also think there is an 80% chance that markets will see a significant correction due to markets re-rating on inflation concerns.
The reason this is my view is that unless there are signs that inflation will ease within the next 6 months, investors are going to start getting nervous. The prevailing view in equity markets seems to be that the inflationary pressures are going to be transitory. But 18 months is a long time. Once we enter the next phase at some point within that 6–18-month time frame, markets are going to lose their nerve on inflation, and we’ll see a correction.
I am also mindful that central banks and Governments around the world are typically not great at managing these situations and can make them worse. They are almost always reactionary and rarely brave enough to be proactive. They act too slowly, then too quickly. This is why interest rates are still at zero when they should be higher and why a massive stimulus package has been approved in the US when the global economic recovery is already well underway. It only adds fuel to the inflationary fire now.
The data in the year ahead is going to provide very mixed messages on both growth and inflation. Labour shortages and increasing wages are next and that just adds another layer of inflationary pressure. While equity markets are currently expecting inflation to be transitory, I think this sentiment will change over time as doubts creep in. We will see over the next 12 months more knee jerk reactions like that seen by Domino’s as concerns around inflation persist and are flagged more and more frequently by companies. This will be a buying opportunity in my view.
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