Most investors believe that while inflation remains a risk, it has been relatively benign for some time. Official inflation figures show prices have been rising at a steady clip of around 2% per year.
But the reality is much uglier. Truer measures of inflation show that prices have actually been skyrocketing in the past five years.
The problem is now set to get even worse as Central Banks print trillions of dollars in the wake of the Covid-19 pandemic, risking a further acceleration of inflation.
Inflation is one of the key issues investors need to deal with. Inflation makes money saved today – particularly for retirement – less valuable tomorrow, eroding our purchasing power.
With inflation becoming a major risk, we believe that investors need to be positioning their portfolios towards traditional inflation hedges such as gold and property. They also need to be increasingly investing in companies that will succeed during high inflation, and investing in newer asset classes such as Bitcoin to lower risk and enhance returns.
The devastating impact of inflation on investment returns
Most people misunderstand inflation. We think it is the price of things going up. This, however, is a consequence of inflation, not the cause. At its core, inflation is an increase in the amount of money in the system, meaning there are more dollars chasing the same goods or services. Inflation lowers your purchasing power (the amount of goods or services that one unit of money can buy) and impacts how far your wages and savings go.
Inflation can also have a life-changing impact on when you retire and what that looks like.
Returns are overstated
Your investments in stocks may for example have earned 5%, but if the true rate of inflation was 8%, your actual (real) return is a 3% loss, not profit. If this were to occur for the next 10 years, your $100,000 of superannuation invested today would not be ‘worth’ $163,000, it would only be worth $73,700.
The great inflation con: why Governments adjusted the CPI measure
The problem for investors is that inflation is much worse than we’re told. If you are feeling like your wages and savings don’t go very far these days, even though the reported inflation rate is ~2%, your gut is right.
Purchasing power is measured by governments through its Consumer Price Index (CPI). Governments track a constant ‘basket’ of 500 consumer items and their price changes. The goal is to measure the change in the cost of living for individuals over a long time period.
In the 1970’s coming out of the high inflation period when Central Banks pushed up official interest rates to combat rampant inflation, national governments began to worry about the cost those high interest rates would have on their ability to borrow funds at low rates (through the issuance of government bonds), as well as fund pension commitments.
So Government statisticians made gradual changes to CPI methodology, including substituting cheaper, replacement items into the ‘basket’.
The net effect of the changes is that CPI has consistently underestimated the true cost of living for families.
A lower reported CPI has allowed governments to borrow increasingly higher amounts of money at lower interest rates. However for individuals, this results in near 0% interest earnt on bank accounts globally, while annual wage and pension benefit payment growth, which is usually indexed to CPI estimates, fails to keep up with rising prices. And what’s worse, the Government admits that it’s an inaccurate measure.
“No statistical agencies compile true cost of living or purchasing power measures as it is too difficult to do”. The Australian Bureau of Statistics
What is the true inflation rate?
Chapwood Investments is one organisation that has made an effort to replace government CPI guesstimates with truer cost-of-living estimates based on the pre-1980’s methodology.
The Chapwood Index shows that actual CPI has risen by >11% per year since 2015 across most large US cities. The official US Federal Reserve’s CPI estimate, however, has averaged just 1.5% over the same 5-year period. That has negatively impacted pensions and wage growth.
CPI vs ‘real’ inflationary index
The shortfall between the two measures has also decimated savings for US families. A family with $100,000 of annual costs would need to find an additional $23,000 over the full 5-year period to cover the impact of the annual 1.5% government CPI estimate. Using the truer Chapwood index estimate of 11.5% annual CPI, the household would require an additional $197.300 over the same 5-year period.
This rising shortfall, more closely approximates what is occurring across US cities today; people are struggling to meet rising costs, while high levels of under-employment across the US since the 2008 GFC have prevented most families from escaping this inflation trap.
Australia is not immune
The picture is the same in Australia where three main issues at play that are negatively impacting households:
- Stagnant wage growth throughout Australia over the 2010’s
- Rising cost of living in everyday expenses for families
- Declining purchasing power of investment portfolios and savings
According to Australia’s Treasury, wage growth in the first decade of 2000 was 4%. But in the last decade it’s only 2.2%.
Yet over the last 10 years, major household expenses have grown disproportionate to the increase in wages to cover them, seen here:
Annual average price increase for different household expenses (2009-2019)
Surging debts: Inflation will get even worse
The cause of rising inflation is closely related to how much money there is within the global financial system, which is increasing because of surging debt.
Since the 2008 global financial crisis, US debts have been accelerating each year as the US deficit gets worse than the previous year. As we begin 2021, US debts have reached an astronomical US$28 trillion.
Since 2017 the three big expense items for the US government — defence spending, interest on existing debt and social security payments – are now dwarfing total US tax revenue. So how has the US covered these three expenses?
By printing money! (Which, as discussed above, increases money in the system and leads to higher inflation and ultimately rising prices.)
Unfortunately, looking out beyond 2020, the data shows that the US deficit is likely to get much worse.
And with the arrival of Covid-19 in 2020, global central banks once again had no choice but to hit the accelerator on money supply, with the total global bill likely to surpass US$50 trillion.
This massive increase in global debt is increasingly causing rising asset prices everywhere, which most of the world’s smartest global investment managers believe will result in accelerating inflation, beginning in 2021.
How to navigate the impacts of inflation
Given the higher-than-reported rate of inflation, and given that rampant money printing in the US and around the world is likely to see inflation accelerate even further, what should investors do?
We believe there are five key things:
1) Firstly, investors should accept the reality of inflation outlined above, and not the Government narrative. They should listen to their gut and question how ‘healthy’ our current global financial system is. Many people now have to resort to depleting savings to maintain their standard of living.
2) Accepting reality means investors need to question what the consequences will be with governments living beyond their means through “printing money” to meet rising costs, especially as a consequence of Covid-19.
3) Investors should be wary of low-return bonds in a rising inflationary environment. Studying the effects of inflation through the last major episode of the 1970’s could provide some valuable lessons as we enter what looks like a similar financial picture in the 2020’s.
4) While fixed income has traditionally underperformed in high inflationary environments, hard assets such as gold, silver, and property traditionally do well. Bitcoin also has many of the same finite qualities of gold and is increasingly being included in portfolios of global institutional investors as a rising inflation hedge.
5) Equity investors should maximize returns in the highest-quality companies. Large global innovators may provide stronger returns than traditional sectors. Amazon is a good example – they represent one of the largest e-commerce platforms in the western world and therefore are likely to continue to attract investors looking for returns in a company that will continue to grow over the long term vs cash that does not grow and loses its value over time, especially during inflationary periods.
School up on inflation … and Bitcoin
Inflation can have a devastating impact on investment portfolios and quality of life during retirement.
Investors need to take the time to learn about the best approaches for inflation hedges maximizing investment returns so they avoid the trap of losing purchasing power on savings.
We also particularly encourage investors to learn and understand how a small allocation to Bitcoin may provide enhanced returns and lower risk for investors in a rising inflationary environment.
While few global investors currently understand Bitcoin well, rising investor sentiment towards the asset indicates investors are beginning to better understand the negative effect on savings of massive monetary intervention by governments.
If you are keen to understand more about the impacts of inflation, see our recent insight on this topic Why the 2020s are looking like the 1970s ; Asset Allocation