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March, 2018:

Using Debt to Fight Inflation: If You Can’t Beat Them…

So last week we covered TIPS, a way to protect yourself against inflation in a no-risk, no-reward, but-at-least-not-sinking fashion, which is perfect for those who are getting close to retirement.

This week, we cover a totally different approach.  The way to not just keep up with inflation, but to turn it into something that works for you, not against you.

First, let’s ask ourselves again, why does inflation occur in the first place?

Governments spending more than they take in, creating debts which require the additional printing of money to pay back.  When they print more USD without adding value to the assets that USD holds, it reduces the value of USD that was already in existence.  They are intentionally using inflation to “pay” (shrink) their debts by removing value from the assets you and I own. 

So what does this mean for the gov’t?  They borrow $1000 in 2018 with a promise to pay $1,020 in 2019, but pay it back with currency that is only worth $980 by 2018 standards.  And they’re doing it in a way that the average joe does not understand, and thus, won’t get any negative feedback in the way that raising taxes would.    Why would they ever stop?

So not only do we know how inflation works, we also know that people in power have a very vested interest in keeping the little shell game up.  It’s not going to be changing anytime soon.  Unless gov’ts all of a sudden decide that they’d rather run balanced budgets.  I’m not holding my breath on that one, are you?

But wait… if it shrinks their debt… doesn’t that work for us, too?

You bet your ass it does.

That is the one single reason most baby boomers will manage to have a healthy retirement.  Not because of the value of their retirement savings, but because of the value of their debts like their house loans literally melted away in the early 80′s.   Say you bought a house in 1977, with an 8% interest rate.  But in 1980, inflation hit 16%!  That means that as the value of the money someone was making their mortgage payment with shrunk by 16% in one year.  In fact, within a six year stretch, the real-world value of their debt had shrunk by half before we even took the payments themselves into account!  

A $300 mortgage payment was a hell of a lot bigger in ’77 than it was in ’83.    And during that period, the value of the house itself increased along with inflation as well.  Not as high as the rate of inflation… real estate prices didn’t increase by 16% in 1980, but it was 8-10%.  Add that on to the debt shrinkage, and you have some serious damn value creation!  So much so that many smaller savings and loans either required bailouts in the early 80′s or went under entirely.  That money went somewhere alright… right into baby boomer mortgageholder’s pockets!

But there’s still one problem.  We have to pay more interest to borrow money than a government does.  While real interest rates (interest minus inflation) is negative for governments, it’s still positive for us, which means we’re losing value on the debt.   ex.   3% inflation a year isn’t going to do much against a 23% credit card interest rate. 

But, if we buy something that appreciates faster than inflation, we can add that onto the total, giving us a net profit!    Think of it like this.  Let’s (in our dreams), buy a Picasso.  Say we get a loan for $1,000,000 and put down $250,000 to do it.   (Cheap Picasso… was it a sketch on a bar napkin or something?)   And unlike the gov’t, which is getting it’s loans for 2% (or less!) We have to pay 3% or more based on the length of the loan.  Let’s say we’re paying 4%.

But, the value of the painting is going up an average of 4% in nominal dollar terms every year as well.  So we’re breaking even.

But if, for some, strange reason, inflation spikes because, say some gov’t debt goes through the roof and goes above 4%, we actually start making money because the value of the dollars the debt is in is shrinking!  And our 4% apprecation?  Well, the reason that painting’s dollar value is going up is not just because fine art becomes rarer over time… it’s also going up because the value of the dollar is shrinking.  And if that value starts to shrink faster, the “appreciation” goes right along with it!   

Let’s say that the time of inflation reckoning is year one (it won’t be, but for the sake of easy math) of 10% inflation.  You paid 4% interest, but the value of your debt shrunk 10%, and the value of the painting went up 8%!  We mostly kept up with inflation in our re-sale value, but we actually lost 2% of it’s value.  But our debt lost 10% of it’s value!  In inflation-adjusted terms, we made (-4% of $1m, -2% of $1.25m, +10% of $1m) $35,000 of post inflation value ($60,000 pre-inflation) on an investment of $250,000!  That’s 24% pre or 14% post inflation cash on cash!

Of course, don’t run out and buy a painting.  There’s all sorts of transaction and maintenence costs we’ve neglected, and how do you sell a painting, anyways?   And the value of art will go up and down independant of inflation due to other market pressures, the same as any other asset does.  (ask American homeowners about their houses)

But the principle remains.   Find something that you are very sure will appreciate at least as fast as your interest rate.     Get a rate of interest if not below inflation (damn near impossible),  as close to it as possible.   As long as the appreciation plus debt shrinkage is high enough above the interest rate to offset the risks and expenses of being in that asset, you are making value!

 

Treasury Inflation Protected Securities

Last week we promised you a single, and here it is.  This investment is a back-up for the fixed-income section of your portfolio, the portion that is traditionally exists to reduce volitility, which you need more and more of the closer you get to retirement.   When you’re 28, the 2008 market crash was a blip on the radar, but when you’re 64, it’s devestating.   

But that reduction in volitility comes at a price.   Traditionally, your fixed-income securities carry a significant portion of inflation risk in that if you receive a 2% return over the course of a year, but that year brought with it 3% inflation, your investment actually went down in value.

But not with Treasury Inflation Protected Securities, or TIPS.

TIPS are a type of fixed-income investment that carry two types of income.  The first, the normal interest rate you expect to find with any traditional bond.  The second, and key type, is that the principal value of the bond increases with inflation based on the consumer price index.

For example, let’s say you bought a $10,000 bond with a 2% interest rate.   Now, for the sake of easy math, let’s say that inflation had a early-80s kind of spike and came in at 10%.   The value of your TIPS increases from $10,000 to $11,000 to compensate for the loss of dollar value (something you wouldn’t get with a traditional security).  Then, you get your interest rate paid out on that amount.  In this case, that would be $22, instead of the $20 you would have gotten off of the $10,000 value.

They can be purchased directly from the Treasury, a broker, or through a mutual fund or ETF.

It doesn’t offer much from the perspective portfolio growth, but it is the only investment gauranteed by the US gov’t to provide you with a post-inflation positive return.  And for those of us who need to be dialling down the risk in their portfolios, that’s a great place to start.

Inflation… How Does it Affect My Assets?

So last week, we learned what inflation is, why it exists, and how it really effects you.  

That’s all well and good, I hear you say, but how do we stop inflation from eating away at our savings year after year?

The key here is to look at how different types of items and assets respond to inflation.

First up is cash.   Obviously, as the amount of cash and credit in circulation increases faster than the amount of goods and services it represents, the value of each individual dollar will shrink.   Since pretty much every government in the world runs a deficit, they need to print more credit and cash to cover the overrun, and this isn’t likely to be stopping anytime soon.

So what about things that you buy with cash?  Basically you need to look at each item individually.  Not only do you have to take into account how inflation affects each item, but whether they appreciate or depreciate over time, as well.   Also, does it produce income?  Does that income keep up with inflation over time?

Take a television.  Sure, it’s value is not going to shrink due to inflation, but it is going to shrink based on the fact that every year newer TVs are released with more bells and whistles than the last.  And every TV dies eventually.  Like a car, it loses half it’s value as soon as you leave the store.   So technology is out.

OK, how about stocks?  Well, in theory, a company’s profits are going to grow right along with inflation, but there’s the other major factor that determines a stock’s price.   Picking a good company is only half of the battle.  The other factor that determines how well a stock does is how much money is flowing into or out of the market at any given time.   This is a concept known as price-to-earnings ratio, or P/E.  How many dollars are the smart investors like Warren Buffet or Ray Dalio willing to pay for one dollar of company earnings.  

If that number starts going down because of, say, a economic downturn where people start to withdraw money from the market or the amount of credit (that is used to hold stock) begins to contract, any given stock is going to have a hard time making any headway.  So when we’re in conditions where the money going into the market is increasing, stocks are some of the best investments out there.  When money is heading out, they’re some of the worst.

What about hard assets like gold?  Traditionally, gold has been thought of as a hedge against inflation, but it does not really perform as such.   As you can see from this graph (pay attention to the red line, the inflation adjusted one), the (inflation adjusted) price of gold declined by more than 80% from the height of inflation in 1980 to 2000, yet at no point in that stretch did inflation turn negative.   So what was the big spike in 1980, and the run up to that 1980 high again in the present-day?  Fear.   Back then, it was the fear that inflation would destroy your savings (which was totally legitimate) caused everyone and their dog to pile into gold.  When the inflation started to head back down to normal levels, the fear subsided and people took their money out again.   Today, the fear has been going for a long time.  Will the US be able to pay its debts?  Will the EU collapse?  Will inflation go crazy again?  Will the US housing market continue to sink like a stone?

So if you think that the fear will only increase from here, then you’ve found a home for your money.  But really, wouldn’t you need a nuke for that?   The EU now has a more permananent setup to control the debts of their members, Greece has been declared technically in default, and despite everyone’s worst fears years ago, the market didn’t so much as blink.  

If you don’t know and can’t tell if the fear is increasing, then gold is perhaps something best avoided right now.  But if the economic meltdown rumors start to fire up again, (after the US election is resolved, and still nothing is moving forward, for instance), then it would be time to add a little, to be sold immediately upon any meaningful resolution.

 

Next week I’ll reveal one of the safest places to beat inflation.  It’s definitely not going to make anyone rich, but at least your assets will be able to retain your value.  (Don’t worry, we’ll be working it up from there.)

Inflation… Someone’s Got Their Hands on my Money!

As we’ve talked about before, one of the biggest, if not the biggest downward drag on your savings and/or portfolio is inflation.  Sure, you’ll be sitting on a big pile of dollar bills, but they’ll be worth about half as much as they are now 15 years from now.

Before we can talk about inflation-beating, it’s important to have at least a basic understanding of what inflation is, and why it exists.

Imagine you and three and your friends at work have chipped in and bought a pie.  You each plan on having an equal sized slice… one third of the pie.  Then your boss comes along and decides that he’s going to take a share, too.  Now, even though only three of you paid for the pie, you still have to cut it in four pieces.

Well, that’s what inflation is.   A dollar represents one share in everything that comes under the influence of that currency.   Everything that is owned by US dollars (land, possessions, services in places that use the currency) is the pie.    When more dollars come into existence, but the pie stays the same size, the amount of pie each previously existing dollar is able to buy is reduced accordingly.

And guess who the boss is.

For every dollar that the government spends that it does not have revenue to pay for (which is close to one trillion in the US this year), it has to issue a dollar of debt.  Debt that is bought up by anyone that wants the interest rate that is paid out.  Banks, individuals, corporations… and more increasingly, the Federal Reserve, the institution that controls the money supply. 

Basically, the Fed has the power to create money, or shares of US influence, out of thin air, without adding anything to the pie to make up for it.   And at the moment, the Federal Reserve is buying up about half of the debt that USgov prints up.  (For the sake of comparison, Chinese interests hold about 7%.)

But doesn’t that basically leave the government at the mercy of their debt?  Not really.  Here’s the clever bit.

Let’s say that you buy $1000 of US debt with a 1% interest rate for a period of 1 year.   If the rate of inflation (the rate at which the Fed has increased the amount of money over and above the growth of the US pie) is above 1%, THE GOVERNMENT MADE MONEY.

Well, not exactly money, but they made value.   They paid you $10 a year later.  But a year later at 3% inflation, that $1,010 of 2019 dollars is now only worth $979.70 of 2018 dollars.   The value of the debt has been shrunk.   Anyone

So does that mean the Federal Reserve is being ripped off?  No… they just made the money to buy the debt out of thin air in the first place.  But it DOES mean that everyone that bought US debt with real money IS losing value every year that inflation outpaces their interest rates.    So who sets the interest rates?   Again, the Federal Reserve. 

Which basically amounts to a tax on every dollar you save every year.   

And people simply holding dollars in savings accounts don’t even get the courtesy of an interest rate, so the value of their money declines even faster.  If the rate of inflation is 3%, then the value of a dollar in a chequing account goes from $1 to .97.  The next year, it goes down to .941.   And on, and on.  Pull up a calculator and type 1 x .97.  then hit the equal sign.  Hit the equal again, 19 more times.  That’s what your money is worth after 20 years.

And THAT is probably the single biggest reason why saving doesn’t work worth a damn.  Because the Federal Reserve is going to sneaky-tax the holy hell out of it.  Every.  Single.  Year.  Aaaaaaaah!

So what can we do?   For now, two things…  a)  Don’t go spending everything you’ve saved because it’s all hopeless.  It isn’t.     b)  Stay tuned.  It’s about to get good.