Investment markets have been in a Goldilocks period where low inflation has allowed central banks to keep interest rates low and buy government bonds to provide stimulus to economies. Low interest rates have been a major boost for share markets helping maintain growth but more importantly boosting valuations due to strong demand from investors. Low interest rates have meant that investors have had to look for alternatives to cash and fixed income. With inflation running above the return on cash and fixed income (negative real rates) this was the only rational investor response. Demand for shares has been further compounded by central bank bond buying – which effectively lowers long-term interest rates and creates more cash to invest. The size of this bond buying has been on a massive scale, approximately $NZ 2,000 billion each in the United States and Europe over the last year. This compares to the total value of New Zealand’s top 50 listed companies of approximately $NZ135 billion.

Inflation has returned with the latest annual growth in consumer prices of 4.9% in NZ and 5.3% in the United States. Central banks’ mandates include controlling inflation (typically around 2%) and therefore they are unlikely to continue with current extremely stimulative policy. Policy tightening has started in New Zealand with its recent 0.25% rise in the cash rate. Globally, major central banks in the United States and United Kingdom have started talking about reducing stimulus. There is much debate around whether the return of inflation is transitory, being caused by supply disruptions, or permanent, being caused by too much demand. There is likely an element of both – but either may be challenging for share markets.

If inflation is driven by supply pressures and growth slows this will be challenging for company margins (and therefore profits) with reduced ability to pass on costs given slower demand. If inflation is driven by too much demand, central banks will likely have to respond and reduce stimulus more aggressively by increasing interest rates. Higher rates will be challenging for share market valuations which in many cases are significantly above long run averages.

The challenge for central banks will be to tame inflation whilst at the same time maintaining a growth environment that is not too hot or too cold (Goldilocks). This could be a difficult balancing act and central banks may have already reacted too slowly with inflationary pressures starting to become ingrained. Given their importance for profits and market valuations the actions of central banks will be closely watched by markets. The good news for investors is that we believe parts of the market continue to have attractive valuations and some companies can benefit from rising inflation and interest rates.