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Raw material inflation surging but “nothing to see” yet as far as central banks are concerned

  • Australian inflation numbers were released this week. The RBA’s preferred measure (the trimmed mean) rose just 0.3% over the quarter or 1.1y% over the year, well below the target range or 2-3%, on average, over time. Key contributors to inflationary pressure were Transport +3.2% (assisted by automotive fuel +8.7%) and Health +2.0%, while there were falls in the Furnishings -0.2% and Recreation -0.2%.
  • The ABS noted the impact of the Federal Government’s Homebuilder grant and similar grants by the WA and Tasmanian state governments, emphasising that without these grants, the price of new dwellings would have risen (instead of falling 0.1%), reflecting increases in materials and labour prices due to strong demand
  • We are unsure whether the “normalisation” of prices affected by other stimulus measures is leading to the under-reporting of inflationary pressure.
  • Looking ahead, the pressure on construction materials is unlikely to ease any time soon. Enterprise Bargaining Agreements (EBAs) between builders and the unions are likely to result in pay rises for employees on major commercial real estate sites in Victoria of 4.1% annually over the coming 3 to 5 years, with even higher increases being negotiated in NSW.
  • Cost pressures more generally are also mounting as prices for a number of global commodities reach multi-year highs. In the US, lumbar prices have risen over 60% so far this year. Lumbar is wood that is processed into beams and planks and is a key building material, with 90% of newly built homes in the US wood framed. The increase is estimated to have increased the cost of building the average new single-family home in the US by ~8% (National Association of Home Builders).
  • Other commodities have reached multi-year highs including corn (8-year highs), copper (10-year highs) and iron ore (up 20% this year and at 10-year highs), while the current shortage of silicone chips – dubbed “chipageddon” – will lead to long wait times and increased prices for a variety of goods including televisions, computers and other electronics.
  • The Reserve Bank of Australia, along with other global central banks including the US Federal Reserve, has played down the risk of inflation, noting that there will be transient increases but that longer term price growth trends remain subdued. But the massive fiscal and monetary policy response from governments and central banks means that the oversupply of money relative to the level of productive output in the economy will be ongoing.
  • The impact of rising inflation and interest rates in the Partners Fund is considered as part of our investment and risk management process and includes consideration of
    • Interest rate risk – our loans are short duration and significantly higher returning than general fixed income. The value of the underlying loans will not be materially affected by a shift in real bond rates in any significant manner.
    • Sector Impact – higher inflation and interest rates would affect mortgage serviceability and the residential real estate sector would be the most vulnerable sector as wage increases are unlikely to rise as fast as mortgage repayments, while commercial real estate will be protected in the short term due to CPI-linked rental lease agreements and agricultural sector assets will benefit from higher commodity prices and income.
    • Portfolio Risk – higher asset prices in general lower risk within the portfolio, but higher building costs could put pressure on profitability or causes delay of some construction projects.
  • Our strategy is well suited to balance returns versus inflation risk as loans are modestly geared with a portfolio LVR below 60%, but conversely backed by hard assets which may appreciate in an inflationary environment.
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