The Reserve Bank may have its hands on the interest rate lever, but its eyes are focused on the inflation rate. This is bad news for equities and bonds, but private debt is becoming more attractive.

RBA is following its game plan

The RBA has a mandate to keep inflation between 2 to 3%. In Q3 2022, inflation was 6.1%, the highest level since the Howard government introduced the GST in July 2000.

Inflation started to accelerate throughout 2021. At first, the RBA, like most central banks, saw it as temporary: a blip caused by COVID-19 supply shocks. Then came the war in Ukraine, which pushed up global food and energy prices. Now the RBA is concerned about the impact of a tight labour market on wages and the danger of growing inflation expectations. The RBA had to get serious.

The RBA’s primary tool in fighting inflation is raising interest rates. Rising interest rates makes debt more expensive, this puts pressure on households and companies to cut back on spending. This lower demand takes pressure off prices.

So far, the RBA has raised interest rates six times in 2022 for a total of 250 bps. Will it raise interest rates even higher? Yes, so long as inflation remains high and keeps accelerating. 6.1% is a long way from 3%!

What’s really driving inflation?

The acceleration in inflation in 2021 can be explained by an external shock. There was a decrease in the supply of many goods during 2020 and 2021 because of an initial pullback in production by companies around the world in the early days of the pandemic.

More recently, inflation has been driven by a spike in world food and energy prices caused by the war in Ukraine. Both Russia and Ukraine are among the world’s top wheat exporters. Russia is also a major oil and gas exporter and the embargo on its oil and gas by the West has decreased global supply.

There is, however, one more driver of inflation and it is the most dangerous: increasing inflation expectations. If companies and consumers believe that inflation is going to keep increasing, they will take actions that will actually keep pushing inflation higher. This includes bringing forward purchase decisions, raising prices, and asking for higher wages - inflation becomes a self-fulfilling prophecy and can run out of control. This was last seen in the late 1970s and early 1980s and was only fixed with aggressive interest rate rises by central banks with Paul Volcker being the poster boy.

Are we heading for stagflation?

At the moment the RBA is forecasting a slow down but no recession. GDP is expected to grow 3.25% in 2022, 1.75% in 2023, and 1.75% in 2024.

So where to invest?

Rising interest rates are no good for growth stocks which are typically valued using a discounted cash flow model. It also pushes the price of bonds down. Slowing growth will also weigh on stocks. So where to invest?

Private debt is a growing niche in the Australian investment scene. Private debt AUM grew 144% in 2021. And the good news is that when interest rates rise, the return on private debt rises.

In recent years, the big banks have retreated from providing debt to SMEs because of structural and regulatory changes in the market. Thus, SMEs have been forced to look elsewhere for funding. Companies like FC Capital have filled this void by providing private senior and junior debt. SMEs will also increasingly turn to private debt as they look for greater flexibility during this tighter economic period. Private debt could be an attractive investment option over the next few years.

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