How to Invest With Inflation on the Way
This is a guest article by Greg McFarlane, the author of Control Your Cash: Making Money Make Sense, a financial primer for people in their twenties and thirties who know nothing about money.
People have feared inflation ever since… well, since the dollar’s last rampant bout of inflation in 1977. However, there’s every reason to believe that this time inflationary pressures are too overwhelming to discount. Or two colossal reasons, at least:
1. Legislative and executive leaders of the federal government, for whom fiscal restraint is a dirty term. No matter how laudable their objectives, they propose to spend and borrow an ungodly amount to achieve them. Any non-politician reading this blog knows the term “regardless of cost” can never be taken literally, but our elected betters think otherwise and aren’t concerned about the inevitable results.
2. A federal funds rate that resembles Carlos Pena’s batting average, or Countdown with Keith Olbermann’s Nielsen ratings. Here’s a really quick primer, because a lot of people act like they know this stuff but don’t:
The Fed (Federal Reserve) is the nation’s central bank. It actually creates our money out of thin air, which it sells to the federal government to conduct its business with. Commercial and investment banks like Chase and Wachovia also borrow from the Fed. The interest rate those banks pay is determined by the Fed and called the federal funds rate, which thus serves as a basis for just about every interest rate in the economy.
Most countries’ central banks set a single rate. The Fed instead sets a range — the more you borrow, the less you pay. This of course favors larger banks, although “favors larger banks” has been a relative term ever since the federal government confiscated $678 per United States citizen and gave lent it to AIG. Since December the range has been 0% to 0.25%, an all-time nadir. Inflation has kept pace, barely registering and keeping the dollar’s value intact while jobs disappear. The range eventually has to rise, since it can’t go in any other direction. Once it rises, in concert with the demand for additional dollars that government spending is creating, inflation should ensue.
What does this mean in practical terms? It means getting your assets the hell out of cash, or at least out of U.S. dollars.
The immediate temptation is to shop the world for the currencies the dollar will lose the most money against. There are candidates such as the New Zealand dollar and the CFA franc, but again, your investment will only then be as safe as that government’s fiscal conservatism.
One strategy that goes a step farther is to look at blue chip stocks that don’t trade in U.S. dollars. If the stock’s fundamentals are strong enough, it shouldn’t matter if it’s measured in Swedish kronor, Swiss francs, or almost any currency short of Zimbabwean dollars. Even if a localized bout of inflation causes the stock’s nominal price to artificially rise, its real price should remain consistently strong.
Here are some examples of giant corporations that don’t necessarily trade on the Big Board nor NASDAQ:
- Royal Dutch Shell (which trades under the symbol RDSA on the London Exchange)
- British Petroleum (BP, London)
- Toyota (TYO, Tokyo)
Yes, Toyota. Exhale. And while extolling the benefits of a particular security might make the author come across as a boiler room stock promoter, I’m not telling you to buy anything. I’m telling you to look critically at the reasons for a stock’s atypical behavior.
If you think a recent week of questionable publicity in one market can turn the world’s largest and most respected automotive company into a bad investment, you shouldn’t be investing in anything more demanding than an index fund. A few months from now, no one will remember the recent uncomfortable performance that the parent company of two of Toyota’s major competitors forced the company to undertake.
Furthermore, this is a perfect time to go contrarian. Toyota shares have dropped 20% in the last month. Think about why that might happen to a stock.
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- Is it a volatile small-cap? No, it trades at $71.
- Are its financials questionable? No, they’re healthy. Toyota made money last quarter after several quarters of losses. The company routinely buys back treasury stock, showing that on the investor relations side, it cares about preserving value.
- Did it suffer a one-time public relations hit, illustrated by unconvincing former customers telling stories of narrowly averted carnage and crying into the camera on cue? You can field that one.
Gold is the traditional inflation hedge, but when you see an investment being sold during commercial breaks on general-interest TV shows, that opportunity has clearly evaporated. Besides, gold’s value has quadrupled in the last 8 years. That’s swell, but if you’re looking to preserve wealth, remember that time continues to move forward, not backward.
What about Treasury Inflation-Protected Securities, whose defensive strength is written right into their very name? These are a type of U.S. bond whose interest rate, as you can probably figure out, factors inflation in. TIPS are great in theory, as long as you can trust the government’s consumer price index numbers and you can trust the government’s ability to honor its debts. “Full faith and credit of the United States government” doesn’t mean quite the same now as it did when the phrase was coined.
Article comments
This is Greg, the author of this still relevant but slightly dated piece. (And by “dated”, I mean Toyota’s no longer trading at 71. It’s trading at, ahem, 81.)
Let me respond to the criticism first. Apex, thanks for your insight and for making your points politely. As we’ve all witnessed, decorum is a rare online quality.
I didn’t explain as much as I could, largely because I wrote the post for readers of varying familiarity with the topic, and was trying to stay under 900 words. Yes, the rate is de facto 0, although political expediency forbids the Fed from saying so. But community banks that want overnight loans don’t get to borrow money at that rate. Instead, they’re forced to borrow it from banks large enough to be offered a seat at the Fed’s “discount window”. Those intermediate banks obviously need a cut, ergo my (grossly simplified) statement that the larger the bank, the lower the rate it pays.
The Biz of Life nailed it. The rules change when a government abandons classical economic principles. Few in the legislative and executive branches seem to understand or care what their meddling does to the efficient movement of resources. In the meantime, the best we can do is anticipate the certainty of some degree of intervention. Commodities and securities with some tangible underlying basis are easier to defend than investments in debt instruments whose performance is directly tied to the capriciousness of the issuing government.
If the stated value, of “Federal” Reserve notes, declines enough with respect to copper and nickel, the 1946-2009 nickels, composed of cupronickel alloy, could completely disappear from mass circulation.
According to the “United States Circulating Coinage Intrinsic Value Table” available at Coinflation.com , the April 1st metal value of these nickels is “$0.0603691” or 120.73% of face value.
Except that melting down or otherwise destroying U.S. Currency is a crime (including shipping them out of the country for this purpose) and if it happened on a large scale they would likely prosecute people who were doing it on a large scale.
However if pennies and nickels were to disappear from circulation I would consider that a positive thing. These coins are not worth even bothering with. I won’t even pick them up off the ground. I would sooner have a cool rock than those worthless trinkets.
Why would anyone want to melt nickels or pennies? People can be reasonably confident of the metal content of unmelted pennies and unmelted nickels. There is not the same level of confidence of the metal content of a blob of metal from a stranger.
Many unmelted coins made mainly, or purely, of copper, silver, or nickel have a higher market value than the intrinsic value of the metal contained in the coin.
Any laws, against melting or exporting nickels or pennies, are not going to stop some people from storing and holding relatively large amounts of nickels or pennies.
What would be the restraint on inflation without zinc and copper pennies and cupronickel nickels?
There are only two reasons I can think of for a coin to be worth more than its face value. One is rarity making it a collectors item etc. This is true with most silver coinage. The other is because its intrisic value of materials is higher than the face value of the coin. And of course both elements could be working together to have an amplified effect.
But the only reason to store large quantities of coins that are in abundant supply and have an intrinsic value higher than face value is to have someone someday melt them down for their metal. If they are not rare enough to have collectors and investors drive up their worth as a result of scarcity, then the only market forces that are going to drive up the prices is the ability to extract the intrinsic value which would have to be done via converting the metal into a more useful form.
Perhaps over time scarcity will take over but that doesn’t seem to be a near term possibility so I would still argue that the pennies and nickels are not worth more than face value right now unless someone is willing to melt them down or plans to sell them to someone who is.
Holding a 3% government bond if inflation is above 3% is not exactly a wealth-building investment. Holding a 3% gov bond if inflation is 1-2% still isn’t exactly attractive either.
If you want to invest in commodities stay away from ETNs like Rogers, unless you believe the issuer has rock solid finances and you have no worries about counter-party risk, and look at ETFs DBC or GSG.
The author says:
“Most countries’ central banks set a single rate. The Fed instead sets a range — the more you borrow, the less you pay ….. Since December the range has been 0% to 0.25%”
First of all, this is the first time the fed has ever set a range for the fed funds rate. You can verify that by looking at the fed funds rate history here:
http://www.federalreserve.gov/fomc/fundsrate.htm
The fed funds rate has always been a single target rate set by the fed. The reason it is a range this time is they don’t want to actually say the rate is at 0 so they say it is between 0 and 0.25%. So given this I would like to see you support your claim that the fed gives better rates to bigger banks borrowing bigger money. The range has nothing to do with how much you borrow and as I said the range is not standard operating procedure.
Further more, you seem to be confused on how the whole Fed Lending process works. The fed funds rate doesn’t actually have anything to do with what banks pay to borrow money from the fed. The Fed Funds rate is the overnight lending rate that banks charge each other for inter bank loans.
Banks charge each other this rate to borrow money they hold on reserve at the fed. Banks decide how much to charge each other and it varies but the Fed works in the market to keep the supply demand at a level that meets their target rate although individual banks might pay slightly more or less at any given time but that is determined by how much each bank decides to charge the other banks. The fed only operates to impact those rates by controlling liquidity and this is not the fed’s money that is being borrowed, it is bank’s money that is held on depository reserve at the fed. You can verify this here:
http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm#3
The rate that the Feds charge the banks if they want to borrow money directly from the Fed is actually called the Discount rate. You can verify that here:
http://www.federalreserve.gov/monetarypolicy/discountrate.htm
Very few banks ever go to the Fed for money, if they do it’s usually because they are desparate. Most all of them work through the inter bank lending system based on the fed funds rate. However if they do go to the fed for money, the Discount rate that sets their rate never did go to a range. It was lowered to a value just barely above the fed funds rate to encourage borrowing from the fed but was recently raised back to its typical value at 0.5% above the fed funds rate (or the top of the fed funds range in this current instance).
I don’t mean any disrespect but based on what you wrote here it seems you do not have a clear grasp of how the Fed Reserve’s Monetary and Lending system works.
As to inflation, it is true that lower interest rates do tend to eventually have an inflationary effect but I have heard this cry for inflation since the Fall of 2008. We are 18 months down the road and the Fed Funds has been effectively zero for almost the entire time and yet widespread broad based inflation is non existent as of yet. Eventually when we fully recover adjustments will need to be made and our large deficits and easy money probably means inflation is going to eventually get a little higher than we have been used to. However that isn’t going to be happening in the short term, and even in the long term, I suspect the rise of inflation will not be nearly as large or as quick as the inflation fear mongers having been preaching for the last 18 months.
Inflation is a problem we are more likely to start to deal with on a more pronounced and difficult to deal with level in a decade or two when our fiscal structural imbalances begin to overwhelm the federal budget. There are no easy adjustments to that. But prior to those kicking in, in earnest, I wouldn’t be too worried about 1970’s style inflation in the next few years.
I agree in the near term (2-5 years). But long term definitely yes. Question is as an investor, why not prepare now if you have a 10 year investment horizon?
So, is it easy to purchase BP or Toyota through a typical online discount broker? Of course, all of my dealings are in US dollars, so once I purchase one of these stocks, those dollars are converted *out* of the US dollar? …. and here is another questions: What about that Rogers Commodity Index?
“Full faith and Credit” means the same today as it did before. They just capitalized the word CREDIT. Bonds that pay dividends aren’t so bad unless you’re trading in them so buy and hold works with them as well as stocks. Allocating a mix of bonds and stocks remains the key to any long term investment scenario. Oh, those Legislative and Executive guys & gals ……. Please, Please don’t tell them what comes after a trillion!!
Some of the obvious choices here are commodity funds/ETFs, metals, oils, raw material stocks, real estate, and stocks in general. The worst things to hold in inflationary times are bonds. Governments around the world are going to have to inflate their way out of the debt bubble they have created.