Roberts Nash Advisory Group

Inflation Is Coming

One of the most well known lines from the Game of Thrones story is “Winter is Coming”. To those unfamiliar with the story this must come off as an odd thing to say. Winter is always coming (and it will be followed by spring). But in the world created by George R.R. Martin seasons are less predictable, and can last for varying amounts of time. The saying that “Winter is Coming” is a reminder that one must always be prepared. Those who are not ready for more challenging times will suffer badly.

The developed world has enjoyed what could be described as a “controlled” inflationary environment since the early 1990’s. In Canada, outside of a couple of months in 2002, the inflation rate hasn’t been above 4% since the end of 1991.[i] Generally speaking rates have been in decline since they peaked at 12.9% in July 1981.

Inflation (economics) – A general increase in prices and fall in the purchasing value of money[ii]

There is an entire generation in the world today who may not be prepared for the fact that inflation (and as a result interest rates) will eventually go higher.

Coming out of the financial crisis one of the greatest fears of central banks around the world was that the global economy could enter an extended state of deflation. While inflation rates in North America have gone negative for short amounts of time, there hasn’t been an extended period of deflation since the early 1930’s.

Deflation (economics) – reduction of the general level of prices in an economy[iii]

Not everyone understands why there is such fear of deflation. On the surface it simply means that the things one wants to buy get cheaper - which many would think is a good thing. However, in a capitalistic society the perception that items will become less expensive over time can result in a delay of purchases. If this happens on a grand scale, and everyone is waiting to buy the things they want, then the entire system could collapse. Money loses its velocity.

Velocity of Money – The rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time.[iv]

Coming out of the financial crisis, central banks were faced with a significant problem. They needed to stabilize banks around the world without destroying the velocity of money. Raising bank reserve levels without limiting their ability to lend would be a difficult balance, especially in countries such as the United States where the reserve levels of financial institutions were starting from a relatively low level. This change in reserve levels is knows as the Money Multiplier and it can have a direct influence on the Velocity of Money.

Money Multiplier – A measure of changes in the money supply resulting from changes in bank reserves[v]

Over the past seven years central banks have facilitated an increase in bank reserves to a level they believe will prevent another financial crisis from taking place. At the same time, they have kept the velocity of money active by maintaining interest rates at historical lows. They overcame the impacts of a reduced money multiplier by significantly increasing money supply (i.e. Quantitative Easing).

We believe that risks have now shifted. Central banks will likely take time to evaluate the stability of the banking system before significantly reducing money supply as they don’t want to risk a return to financial instability. It appears to be more likely that they will allow inflation to rise, as an indication of overall economic health, before taking measures to keep it under control (i.e. raising interest rates). Doing this runs the risk of having inflation move above their 2-3% target zone and could result in higher interest rates in the future.

Inflation is coming – “when” remains the question. For now the inflation rate remains within the target zones of the Bank of Canada and the U.S. Federal Reserve, allowing them to maintain extremely low interest rates. However low energy prices have been a significant contributor to this low inflationary level for the last 18 months. Recent data suggest that energy prices could be moving higher throughout 2016 which, in turn, could lead to an increased inflation rate.

We believe that all investors need to be prepared for interest rates and inflation to start moving higher.

From a portfolio perspective this means keeping bond durations shorter and maintaining weightings in high yield bonds and/or preferred shares within the fixed income portion. For equities one needs to be aware of stocks that are bought only for cash flow as they could decline in value if rates begin to creep up (unless they are able to raise their dividends accordingly).

Beyond investment management, we believe that the younger generation (which in many cases is just taking on debt and buying homes) needs to be financially prepared for higher rates. Many have only ever experienced low interest rates and have no comprehension of the impact higher rates could have. Money is “cheap” today, but this will not always be the case. Those who do not prepare by budgeting as if rates were at higher levels may face difficult times in the future.

Once the Money Multiplier begins to trend higher, an increased inflation rate is likely.  we will be wathcing for a break above 2013 levels.

The St Louis Fed publishes data that helps us iew this noted in the chart below.

Click here for more data.

 



[ii] Oxford Dictionary

[iii] Oxford Dictionary

[iv] Investopia

[v] Encarta Dictionary

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** I have prepared this commentary to give you my thoughts on various investment alternatives and considerations which may be relevant to your portfolio. This commentary reflects my opinions alone, and may not reflect the views of National Bank Financial Group. In expressing these opinions, I bring my best judgment and professional experience from the perspective of someone who surveys a broad range of investments. Therefore, this report should be viewed as a reflection of my informed opinions rather than analyses produced by the Research Department of National Bank Financial **

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