One of the things that I've written about consistently over the past few years is inflation. Inflation is something which is easy to understand initially but can be hard to appreciate in practice. Inflation simply put is a rise in prices. In economics, inflation has a specific definition which means a measure of the rate at which a basket of selected goods and services in an economy increases over a period of time. Inflation occurs fairly regularly in modern developed economies, but when it happens too quickly it can lead to severe economic problems and even political unrest.
Whether or not inflation will tick up in the future is hard to predict. There are a number of factors which can cause inflation. Inflation can be caused by supply side costs. If the raw materials that go into manufacturing and transporting a product go up, that will likely lead to a rise in the price of that product. For example, if the price of oil goes up, that often has an impact on the prices for many goods as it becomes more costly to transport those goods to stores and eventually to customers.
Another factor which can cause inflation is demand side inflation. When the demand for a particular product rises, the manufacturer of that product will be able to charge higher prices for that product without losing any customers. This is especially true when the supply is constrained or limited. A good example would be the demand for housing in Canada. As more and more people have moved to Canada and the population has risen, the demand for homes has gone up faster than supply. As a result, home prices in Canada have risen by larger amounts in recent years. Supply side and demand side factors for inflation usually only impact individual products or sectors of the economy but usually don't have a large impact on overall inflation for the whole economy.
However, another factor which can impact the economy as a whole, is the fiscal and monetary policy set by governments and central banks. Fiscal and monetary policy impacts inflation as a whole because it can impact the supply and availability of money throughout the economy. Just like any product, the value of money is affected by its supply and demand. Since the demand for money as a necessity remains fairly stable, the value of money mostly fluctuates by changes in the supply of it.
The supply of money is controlled by monetary policy and that is usually set by the central bank in a country. They can control how much money is available in the economy and how much it can cost to borrow money. Fiscal policy is usually set by government, and that can impact how available the money is to citizens to spend. When fiscal policy and monetary policy are both expansionary, meaning there is lots of money available in the economy and at cheap interest rates, that tends to make inflation rise in the economy. Essentially that is because there is more supply of money in the economy, and therefore it is worth less. Since the money is worth less, it costs more money to buy goods and services, and hence higher prices.
One of the biggest impacts that has come out of COVID 19 is that monetary and fiscal policy are EXTREMELY expansive right now. In fact, it would be hard to find a point in history where there was more money being pumped into the economy from governments and from central banks. This is leading to a higher supply of money in the economy and should in time lead to higher inflation, in theory. As I said above there are many factors which impact inflation at any given time, so predicting when inflation will start to rise is almost impossible to do. However we can certainly say that if the supply of money continues to go up, that will eventually lead to higher inflation.
For one, the cost of goods and services would go up, and that means its going to cost you more for the things you buy. This will impact everyone, but it will especially impact those people with stagnant wages or those who are on a fixed income. Many of the most vulnerable people in society will not be able to keep up with the rising costs of everyday goods which will lead to higher poverty and other social problems.
Another problem which would come out of higher inflation is that it would erode the value of many people's savings. If your money is in a bank account and the purchasing power of that money is going down because of inflation, then your savings will not be worth as much for you in the future, and that reduces the effectiveness of saving the money in the first place. Even if your money is invested in something which pays you interest, such as a GIC or a savings account, in order for you to benefit from that investment, the interest rate that you are paid has to exceed the rate of inflation. Otherwise you are effectively losing money in real terms. Investors with significant parts of their portfolio in fixed income will suffer in a high inflation environment, as the value of their fixed income investment will drop dramatically if inflation is higher.
A third problem with higher inflation is that it will force interest rates to rise, which will have a dramatic impact on the prices of all kinds of assets in the economy, from stocks to real estate.
These types of assets usually have an inverse relationship to interest rates in that, the lower the interest rate, the higher these assets tend to get valued. What happens in a high inflationary environment is that interest rates have to rise. This makes sense based on what I said above about fixed income. If inflation is consistently running at 3 or 4% a year, then no one is going to be willing to lend money at a 2% interest rate. It wouldn't make any sense because they would be locking in a negative real return on their investment. So instead they choose to lend at rates of 3-4% or even higher. If mortgage rates in Canada rose to 5-6% on average in a short time frame, that would have a dramatically negative impact on the price of housing in Canada.
In addition, higher interest rates are not good for stocks either as a higher cost of borrowing is bad for business in addition to being bad for the valuation of stocks. So what can we invest in if we are worried about inflation?
Traditionally people who are worried about inflation invested in hard assets like gold. Gold has historically been a good hedge against inflation because its supply is limited and so its price has always gone up in times of high inflation. In more recent times people have also invested in things like artwork or even cryptocurrencies as a hedge against inflation. These types of investments have characteristics which are similar to gold and should be a reasonable hedge against inflation.
However I'm not a big fan of investing in these types of assets as they are all non-productive assets. Being a non-productive asset means they don't really generate anything useful. Their value is entirely derived from your ability to sell it to another person at a higher price than what you paid. This is sometimes called the 'greater fool' method of valuation.
Contrast this with a productive asset like farmland for example. With farmland, you don't need to find a 'greater fool' because if no one wants to buy your farmland for a reasonable price, you can simply live off the crops it produces year after year. Farmland is also a great hedge against inflation because its value rises with inflation, and you don't need to re-invest much capital in farmland in order to keep it productive. A share in a business is also usually a productive asset. The business produces something useful, and the business then sells that useful product or service for a profit. This happens regardless of what the market price of the stock is.
But many businesses don't fare well in a high inflationary environment. This could be because they have a lot of debt and the costs of servicing that debt will go up in a high inflationary environment. It could also be because the business has high capital requirements which forces the owners to constantly re-invest capital in their business. In a high inflationary environment, the costs of this capital rise rapidly, and therefore it takes a lot more money to keep the business operating, which is obviously bad for returns.
Yet another reason a business might not fare well in a high inflationary environment is if the business does not have a moat which gives it pricing power over their business. Without a moat, the business will be unable to raise prices, even though the price of everything else in the economy is rising. This will squeeze profits and hurt the business.
But there are some businesses which are productive and are quite resistant to inflation. These are businesses with wide moats around their business which gives them pricing power. They also have low capital requirements and low debt, so inflation has little impact on the costs of running their business.
A classic example of a business like this is See's Candy. For those of you who are not familiar with See's Candy, they are a wholly owned subsidiary of Berkshire Hathaway which produces and sells candy in the Western US predominantly. They make some of the best peanut brittle money can buy. Because they have such great tasting candy, they have pricing power. When I want to get some peanut brittle, I'm not going to buy another brand of peanut brittle just because it might be $5 a box cheaper. I'm going to shell out the extra $5 to get the great tasting peanut brittle I want. So they can raise prices on me to an extent and I will stay pay to get that product.
In addition to this, there isn't a lot of capital required to make candy. The product hasn't changed very much since the 1970s when Berkshire bought See's Candy, so there isn't much in the way of research and development costs. And the candy is so good that they haven't had to shell out a lot of money in marketing costs to bring in sales over the years. Instead See's has just consistently spun off cash in greater and greater amounts over the years.
This is an ideal business to hold in a high inflationary environment. These are the types of investments I prefer, because they will work in a high inflationary environment, but they will also work in normal environments as well. There are great businesses that fit this mould today, including technology firms like Alphabet or Facebook. These firms make a lot of money without having to re-invest much capital into their business. They also have strong moats around their businesses which gives them pricing power.
Invest Properly and Protect Yourself From Higher Inflation
While I think higher inflation is a distinct possibility in the near future, investors don't need to be scared of it if they invest properly and protect themselves. By owning wide moat, low debt, and capital light businesses, investors can protect themselves from inflation, without having to give up anything while they wait for the inflation to happen. That's a pretty good deal if you ask me.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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