Is Inflation Just Around the Corner?

Inflation is a tricky beast to control. The central bankers around the world do not want it rampaging and destroying the masses in its path. They want to rein it in and control it without killing it. Ever since the financial crisis of 2008-2009, the US Fed has slashed the interest rates and has been on a bond buying spree. The central bankers of the developed economies have followed suit with slashing their interest rates, whilst keeping an eye on the inflation rate. Cutting the interest rate was supposed to be a temporary measure to spur the economies and inflation for now, remains dormant. On the contrary, the International Monetary Fund (IMF) recently warned of deflationary risks. Deflation would be the biggest nightmare for the economies – something that occurred during the Great Depression of 1930s, a repeat of which Ben Bernanke wanted to avoid by any measure while he was the Fed chair.

The Fed decided to cut the interest rates for an extended period of time (at the risk of rising inflation, even though it hasn’t happened so far) and the bond buying route, which has resulted in additional trillions of dollars of deficit to the US national debt. The insurmountable debt may seem daunting, but there are some tweaks that are at their disposal. Recently, the the government has changed the way inflation is calculated – which leaves out essential parts such as food and energy costs; and the government has also changed the way the GDP is calculated to make the economy look better than it really is.

How does the central bank and the government dig itself out of these problems? Normally, governments have three tools to fix their books: (a) Taxation – which is an unpopular option and raising taxes could result in political suicide, (b) Borrowing – by issuing bonds and (c) Devaluation of currency – which results in inflation.

The debt can be more manageable by devaluing currency, the US$, since all the debt is issued in local currency. This is great for the debt issuer, i.e. the US, and hurts the debt holders. But how can they spur it on and inflate their way out of this problem? One way to spice up the economy and the spending is to raise the wages, more importantly the floor – the minimum wage. As wages rise, more money in the economic system should results in inflation. If wages are rising, fixed amount of debt can be paid off more easily using cheaper dollars. Normally, its the other way round – where wages rise due to inflation. But we could be witnessing the government trying to approach the problem the other way round. The media is abuzz (see the Google Trends chart below) with wage increase talk over the last few months across N. America.

In the US, a number of states including Kentucky, Connecticut, NY, NJ, California have started debating about increasing the minimum wage, if not already started passing the bills. Some of the states have proposed raising the minimum to $10.10 per hour. In Canada, Ontario recently announced raising its minimum wage to $11.00 per hour. Quebec has followed that with increasing its minimum wage to $10.35 per hour. More money in everyone’s pocket should result in more spending to spur the economy and we could finally start seeing some of the inflation that the central bankers want to see.
As an investor, you want to strategically position yourself to, not only protect yourself but take advantage of these shifts. There are many ways to protect your portfolio against inflation such as – inflation-indexed bonds, owning commodities, real estate etc. A more detailed account of this can be found on my earlier post – How to Fight Inflation.
Are your investments positioned to protect you from inflation? My full list of holdings can be found here
Acknowledgement: A special thanks to Bryan from Fast Weekly for reviewing and providing feedback for this article before publishing.

Impact of Interest Rates

Changes in interest rates can have a huge impact on your portfolio. With interest rates at historical lows (in US and Canada), it is only a matter of time before they start rising. This post discusses how the rise in interest rates affects each sector.

Rising Interest Rates

When interest rates rise, credit becomes more expensive and the equity market will tend to falter a bit as a first reaction, but as the economy improves, the equities will recover.

  • Bonds: Bonds are the most sensitive asset class to changes in interest rates. Bond prices fall effectively increasing the bond yields.
  • REIT: REITs fall (initially). REITs become an alternative for income investors during low interest periods. The more interest rates rise, the less REITs make because they have to pay higher borrowing costs. REITs may later perform well after the initial fall if inflation picks up – see ‘Inflation’ below for details. Click here to read more about impact of interest rates on REITs.
  • Financial sector: The financial sector will produce winners and losers. The banks that are well capitalized perform better than others. Banks with a heavy focus heavily on mortgages could benefit from the increased earnings from mortgage payments.
  • Energy infrastructure: This sector tends to fall. The increase of debt on the companies puts a downward pressure. Exceptions include companies with high growth potential or long term contracts.
  • Utilities: Utilities fall. When interest rates are low, bond investors turn to utilities as next-best alternative for yield. With rising interest rates, investor return to the safe haven of bonds driving stock prices in the utilities sector lower.
  • Inflation: One of the motivations for the central bank to rise interest rates is the threat of inflation. If inflation is high, sectors such as REITs, commodities (gold, oil), inflation-indexed bonds etc will do well after the initial jitter in the markets.
What are your thoughts on the impact of interest rates?
Disclaimer: The information provided here is for educational purposes only. All opinions here are my personal opinions and should not be taken as financial advice. I am not qualified to be a financial advisor. Always consult with your financial advisor before investing in any of the companies mentioned on this blog.

How to Fight Inflation

What is Inflation?

Inflation is the rate at which your money loses value. When you have positive inflation, the same goods and services costs more in subsequent years due to falling purchasing power. The inflation rate is dictated by the interest rates set by the central bank of the country.

Why Address Inflation?

Every investor needs to address the issue of inflation when dealing with returns. If your investment returns do not beat inflation, then, the investment has actually lost value over the time. A little bit of inflation is desirable by the government since it keeps the money moving and the economy growing. The inflation rates for United States and Canada are shown in the charts (source: inflation.eu).
As you can see from the chart, we are currently at extremely low levels of inflation, historically speaking. Another way to look at this is that we also have the potential of higher inflation in the future.

How to Fight Inflation?

There are a few investments that are good at combating inflation, simply due to their nature. The best inflation hedges are:

  1. Inflation Indexed Bonds: These are bonds that are tied to a country’s inflation index. They go by different names in different countries. In Canada, they are called Real Return Bond and in the United States they called Treasury Inflation Protected Securities, or TIPS for short.
  2. Commodities: Commodities are generally a good hedge for inflation protection.
    • Gold is considered one of the best inflation hedges.
    • Oil can also be a good hedge against inflation.
    • Food products – food prices are one of the quickest responses that companies can manipulate in case of higher inflation.
    • Everyday consumer staple items such as toothpaste, razors etc.
  3. Real Estate: This could be either in the form of your personal home value or owning REITs to get real estate exposure.

My Portfolio Holdings

  1. I do not own any Inflation-Indexed bonds.
  2. Commodities exposure:
    • Gold: I own IAMGold (IMG), a gold mining company instead of owning gold bullion.
    • Oil: I own Husky Energy (HSE) instead of holding/trading oil futures contracts.
    • Food related: I own agriculture/farming related companies/organizations such as Archer Daniels Midland (ADM) and CHS Inc (CHSCP)
    • Everyday consumer staples: I own Consumer Staples Select Sect. SPDR ETF (XLP) that holds most major companies in this sector.
  3. I own REITs which can quickly raise their rent in case of high inflation. I own RioCan REIT (REI.UN) and Omega Healthcare Investors Inc (OHI).

Have I missed anything? What are your thoughts on inflation hedges?

Disclosure: All the stocks/ETF mentioned above.

Disclaimer: The information provided here is for educational purposes only. All opinions here are my personal opinions and should not be taken as financial advice. I am not qualified to be a financial advisor. Always consult with your financial advisor before investing in any of the companies mentioned on this blog.