Rising inflation fears: fact check
June 10, 2013 by Editor, InvestingForMe
The dire inflation warnings from our friends in the stock market industry are becoming tiresome. Normally, they like to use an investor’s own innate greed to get them to buy - using lines like "if you’re not in this market, you’re going to miss out big time!" But this time around they’re also playing the "fear" card.
As stock markets reach new highs, investment professionals are concerned that investors are not buying stocks as they have in the past. In fact, despite the good stock markets, investors continue to shy away from stocks and are still buying bonds. This is historically unusual. Normally when stock markets are setting new highs, the economy is strong and investors regain their confidence to invest a greater portion of their savings in stocks. It appears this time is different. This may be the result of a number of factors:
- Baby boomers, seeing their retirement on the horizon, are simply investing more conservatively.
- A lack of investor confidence that the rising stock markets correctly reflect strengthening economies.
- Many investors have lost faith in the investment industry and the advice it so freely offers. (Three unforeseen bear markets in 15 years can do that! According to MetLife, 75% of retirement savers have lost confidence in stock market investing.)
- Or a combination of all three factors above may be preventing investors from investing in stocks.
The chart below illustrates how this expected shift is not happening, how this time is different for investors. Despite the new highs in the stock markets, investors continue to invest more of their savings in more conservative investments such as cash, bonds, guaranteed investment certificates, etc. (i.e. not stocks!). The much-talked about and anticipated Great Rotation, where investors finally move their savings out of the more conservative investments and into stocks, is just not happening. Investors seem to fear losing money in the stock market more than they fear missing out on stock market returns.
Source: ICI Morgan Stanley Research
Mainstream media also sounding the rising inflation alarm
Usually the use of fear and greed to motivate investors to action is reserved for fringe newsletters and blogs. More established publications and information channels understand that the future is unknowable and that reality often makes crystal-ball gazers look foolish.
But lately even well balanced publications have jumped on the bandwagon of fear with their articles.
As is so often the case with crystal ball gazing, mainstream media has succumbed to the easy penguin logic when making their case for inflation and reasons why investors should make investment changes today. Articles and commentators often start their arguments for rising inflation with something along these lines:
When you read about all the money central banks are creating to keep the world economy afloat, you may wonder how it will affect your retirement portfolio. You don’t need to be an economist to understand that increasing the money supply eventually leads to inflation, which in turn erodes the value of your money. Sure, the inflation beast has been tame in recent years, but….
This simple black and white causal logic claims that inflation is a done deal, and it’s just a matter of time (that it’s simply a question of when – not if), has become the accepted argument by stock market bulls for why investors should dump (or at least stop buying) their bond investments and buy stocks. But the causes of inflation are not always simple, and almost never is inflation due to any single factor such as money printing. It’s more complicated than that!
Note: Penguin Logic, as the cartoon below depicts, is often used to link unrelated actions or events through the creation of simple, supposedly logical, action-reaction relationships where in fact no causal relationship exists.
Examining the industry logic around rising inflation
A lot of experts in the investment industry like to argue that printing money leads to inflation. Instead of merely accepting their logic, first let’s look at the ways their logic just doesn’t add up:
- For the past 4 years, the world’s central banks have flooded the financial system with trillions of dollars, and yet the rates of inflation continue to decline even making new lows. (Why?)
- For the past 30 plus years the Federal Reserve Bank in the United States has increased the supply of money twelve-fold (see the chart for US Money Supply - MZM) without any accompanying increase in the rate of inflation. (In fact, the rate of inflation has declined, so where was the printing-money-leads-to-inflation relationship during this period?)
- For the past 4 years, experts have been telling us that this liquidity will only do one thing – fire up inflation. (But just how much more liquidity must the central banks create before we get that higher rate of inflation – another $5, $10, $20 trillion? Funny how they never give us this number!)
The answers to these questions point out, of course, just how the industry cannot make proper inflation predictions and, therefore, how we as investors shouldn’t give too much heed to their inflation-based advice.
Central banks’ increase in liquidity different today
Next, we need to question the logic used in today’s inflation predictions typically based upon the surging liquidity created by central banks. Today’s predictions tend to ignore a few important aspects of inflation.
First of all, their penguin logic is not applicable to the most recent actions of central bankers. It’s too simplistic because the central banks are not creating liquidity in isolation of other policy initiatives. For example, central banks are also
- openly purchasing assets (i.e. bonds, mortgage backed assets, collateralized loans, stocks, currencies, etc. Over $20 trillion to date.))
- instituting polices to ensure domestic banks retain greater amounts of liquidity and higher quality assets on their balance sheets
- dictating (more so than ever) how banks manage their capital structure and liquid assets (i.e. share buy-backs, increasing dividends, loan repayments, etc.)
Second, there are different types of liquidity. While it’s true that central banks have been pumping liquidity into financial systems, this should not be confused with pumping liquidity into the economy (historically referred to as printing money). What’s the difference between these two types of liquidity?
The difference is simple and will mean different things for you, me, and the economy. Simply look for where the newly created liquidity ends up:
- Pumping liquidity into financial systems. When the liquidity ends up in the hands of the banks (bolstering their balance sheets and liquidity) and never gets into consumers’ hands, well then, this type of liquidity has a muted to minimal impact on the overall economy.
- Pumping liquidity into the economy. If the liquidity gets into the hands of individual consumers (like you and me), then this type of liquidity has a powerful positive impact on the overall economy. Money that ends up in our hands is very stimulative for the economy. We use this new money to make purchases, pay our bills, save and invest. The money tends to go directly into the economy, circulating and multiplying. Each dollar an individual consumer spends will circulate and actually has greater economic power than a single dollar (and inflationary impact). For example, if you receive a dollar and buy milk from your local grocer, the grocer uses that same dollar to buy from the dairy farmer who turns around and pays it to the veterinarian who then puts it toward the purchase of a new car and so on and on.
Keeping an eye on an economy’s overall health: money velocity
Economists have always monitored the circulation of money as an indication of an economy’s overall health. A high rate of money circulation (often called money velocity) indicates an active, healthy economy. A low rate of money velocity indicates an economy where things are not so good.
Take a look at the chart below that maps the velocity of the U.S. money supply over the past 50 plus years. Notice anything?
Notice how the velocity of money appears to have increased when the inflation rate was increasing (pre-1981), and it has been declining (continuing to make new lows) at the same time the inflation rate has been declining.
So, you might ask yourself, Why is the velocity of money circulating in the economy today appear to be declining at a time when central banks are rapidly increasing the supply of money? The simplistic answer, in the short-term, is that the increased money supply has been pumped into the hands of financial systems (banks) in an effort to solely
- bolster their balance sheets
- increase their profits, and
- build up their financial strength.
So, the money has not made its way into the hands of consumers and the economy today, and this type of liquidity, pumped into financial institutions, does not help the greater economy.
The bottom line? Simply increasing the money supply by itself will not cause consumer inflation rates to rise.
Note: We’re not attempting to negate the role that money supply plays in the rate of inflation. We’re simply trying to demonstrate that simply stating that increasing the money supply eventually leads to inflation is erroneous on its own.
So, which factors do indicate rising inflation? What should an investor do in our present climate or if/when inflation does actually rise? All good questions …
Rising inflation: many different factors
Inflation is a complicated entity. There are a number of factors that can contribute to consumer inflation, but typically the economic and social conditions need to create an environment for it to flourish. Here’s a brief outline of a few common factors:
- A growing economy is required to provide an increasing demand for goods and services. This in turn provides businesses with the confidence to grow. (Currently economies are extremely weak with Europe actually moving into a new recession.)
- A steady or declining unemployment rate is also typically needed giving individual consumers confidence that their jobs are secure, helping them to make long-term consumption and investment plans. Wage inflation is often a necessary condition for economic inflation to flourish. (Unemployment in Europe continues to increase and even the slight improvement witnessed in the U.S. may have more to do with people exhausting their unemployment benefits, giving up and dropping out of employment ranks.)
- A high manufacturing capacity utilization (MCU) rate is usually necessary. If your company has the capacity to make 100 widgets, but you only have orders to make 60, then your company’s manufacturing capacity utilization rate is said to be 60%. It’s tougher for prices to increase when manufacturing is at 60% than it would be if it were at 90%. So as an economy gains strength, manufacturers become busier and better able to raise prices – helping to drive inflation higher. (Although MCU has recovered off its low of 2009, it is not back to a level that would support higher inflation.)
- Slowing technological developments would support higher inflation. Advances in and the development of new technology has been a major contributor to inflation’s downfall over the past couple of decades. Technology has made manufacturing, communicating and managing businesses faster, cheaper and more profitable. (This trend has not slowed and it will continue to place downward pressure on inflation going forward. And if anything, it will accelerate. Learn as much as you can about Additive Manufacturing or 3D Printing.)
- A slow down in globalization would support higher inflation. Globalization in manufacturing, trade and the flow of money has added to the downward pressure on inflation. We continue to benefit from products made overseas, exported to our local stores, and the cheap money that flows overseas investing in new manufacturing plans and businesses. (Globalization continues to put downward pressure on inflation.)
- The pig-in-a-python affect does not help support a rising inflation scenario. The baby boomers, as they switch from accumulating and growing their assets to now living off those accumulated assets, are a major force helping to depress inflation. As boomers shift toward retirement they are shifting their focus away from consumption for today and toward saving for tomorrow’s retirement. This shift should cause boomers to place more emphasis on savings, paying down debts and shifting their assets away from those focused on capital gains to those generating steady income. (These reversals in focus toward lower consumption, higher savings and debt reduction all act to suppress inflation – not fuel it.)
Who loses most from inflation and rising interest rates?
The two groups that stand to lose the most from a rise in inflation and interest rates would be the very same central banks and governments who by their actions have helped to depress interest rates to current low levels.
Central banks have accumulated trillions of dollars worth of bonds (and other marketable securities) issued with the backing of governments like Greece, Ireland, Spain, France, Portugal, Japan, United States, etc. All of these bonds have benefitted, as interest rates declined, increasing their market values and making central banks look even more profitable and stronger.
If interest rates were to increase, the value of the central bank profits and assets would decline and the financial systems could potentially face a new crisis of confidence.
Note: Some investment people estimate that if interest rates were to simply increase by a mere 0.30%, this would put the U.S. Federal Reserve Bank into a capital loss position. Keep in mind that with a $3 trillion balance sheet, an estimated duration of about 8 years, and an average yield of only about 2.5% on Fed holdings, it only takes an interest rate increase of about 30 basis points to wipe out all of the annual interest that the government pays on this debt and to create a capital loss. – John P. Hussman PhD, Hussman Funds
So, it could very well be that all of the central banks’ liquidity creation and policy initiatives are now much more permanent than some prefer to believe.
Governments are in a bind. The vast majority of governments (Canada included) continue to borrow (by selling bonds) to finance their annual operating deficits and they must borrow to replace maturing bonds, annually. If interest rates were to rise, their borrowing costs would also rise thereby increasing their deficits and causing them to borrow even more, creating a virtuous cycle that would add fuel to a rising interest rate environment.
So, central banks and governments would have the most to lose from rising inflation and interest rates. This will help motivate them to do everything in their power to keep inflation and interest rates suppressed in the longer term.
What’s an investor to do?
Faced with all these conflicting messages and false, black-and-white penguin logic around the threat of rising inflation, investors no doubt may feel a little more than confused. But there are some concrete safe actions you can take when it comes to investing such as the following:
- Stay focused on your family’s financial plans and your spending and saving habits to ensure you are making progress.
- Review your Investment Policy Statement (IPS) to remind yourself of your investing goals and guidelines. (If you don’t have one, create one, and make sure it supports your family’s saving and investing goals.)
- Remember why you own your fixed income investments (bonds, guaranteed investment certificates (GICs), preferred shares, etc.) for the safety of capital, diversification, certainty and balance they provide for your investment portfolio and financial plans.
- If you’re a trader, or bond fund manager, buying and selling bonds and preferred shares, then I guess you need to keep one nervous eye watching for signs of inflation. (After all, you don’t want to get caught holding a 30-year bond if rates go up 20 basis points. That would hurt your performance numbers, not to mention your bonus!) But for most of us buying and holding to maturity works best.
- If you’re investing for your family’s financial future, then you should probably be buying bonds and GICs with manageable maturity dates (1 to 10 years) and simply hold them until they mature. Ignore all the chatter about inflation and interest rate risks. (A buy & hold, laddered-maturity strategy is typically best for most Canadian investors. This strategy lessens stress and worry about inflation and rising interest rates, and gives them greater certainty around their savings and achieving their financial plan.)
- If you invest in bond mutual funds or actively managed bond exchange traded funds, you should review the fund’s holding, average bond duration, the Portfolio’s Turn-Over Ratio (PTR) and distribution policy to ensure that they’re well positioned to handle a bout of rising interest rates if and when it occurs. (All three will help you to understand your inflation/interest-rate risk exposure.)
- Be careful of arguments used to support forecasting future events and outcomes. Take the time to think through the arguments and try and avoid penguin logic.
Remember, the future is unknowable. No one knows where interest rates and inflation are headed. So you need to ensure that your family has a well-defined and achievable plan, that your investments are arranged to help your savings to grow, and that your investments are well diversified across all asset categories. Be aware, in difficult times, it’s easy for an investment portfolio to experience asset drift – causing a gradual over-weighting in favour of one asset type over others.
Note: In fact, if you already use a buy & hold laddered-maturity strategy for your individual bond and GIC investments, you’re in a great position to benefit from rising interest rates when they occur. Why? Well, as interest rates rise, your bond and GIC investments are still going to mature at the same value and the maturity proceeds provide you with the funds to take advantage of the higher interest rates (not to mention all of the new flexible investment products the industry will create to attract investors in a rising interest rate environment).
Canadian investors need to understand that sometimes the logic employed by the investment industry has a singular purpose: it wants you to buy, sell, or both, so that it (the industry!) makes money. If this simple point was better understood by investors, then they would hopefully take more time to think about the simple penguin logic employed by the investment industry and save themselves a great deal of pain and regret.
Sometimes it’s just best to ignore the experts and their black and white expertise and stick to your plans.