Adjustable Flow
Mar/070
Adjustable Flow
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US $17.99
Inflation Strategy for Your Investments
Inflation has been largely under control since the early 80's. The current economic conditions are anything but typical, however. The government is spending previously unheard of sums to try and get the jobs engine working again. The implications of this heavy federal spending are significant.
In the past, heavy government spending has resulted in inflation. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply (according to Wikipedia). The recent spending to deal with the "Great Recession" of the 21st Century has broken all previous records. Depending on how you want to count the various stimulus efforts this amount may be between $1-2 trillion. I don't have enough space to put all the zeros in this number, it is truly exceptional. This extra money in the system can generate inflation if previous experience is consistent. The amount and duration of the inflation will be difficult to predict.
There is talk about pulling excess liquidity out of the system to counteract the expected inflation, but I'm not aware that this has ever been successfully done. When we had high inflation in the 1970's Paul Volker, the FED chief at the time raised interest rates. It worked in getting inflation under control, but the impact on the economy was significant and resulted in a recession in the early 80's.
Stocks:
As inflation crept over the nation, businesses found that it was easier to increase prices, but also found their costs ever increasing. Their ability to keep revenues ahead of cost increases floundered, and most corporate returns suffered. The stock market reflected this situation. Gains were essentially flat for the 1970's. The Dow Jones Industrial Average in 1970 was 809. After 19 years in 1989 it was 2177 for an annualized growth rate of 5.3%.
Bonds:
As interest rates rise, the value of your bonds falls. This is due to the opportunity for the investor to buy a higher interest bearing bond being issued rather than retain the lower interest bearing bond they are holding. If you bought and held bonds in 1977 you were punished with poor returns. If you bought and held bonds in 1981 you did great. The bond interest rate reflects the competitive environment for bond interest. US bonds are judged the safest in the world and can pay lower rates than other debt, but will still have to respond to the market. The treasury intentionally raised interest rates in the 80's to counteract the inflation in the 70's. Bonds during a period of inflation are risky since at the beginning of the inflation cycle your bonds will decline in value as new bonds have higher interest rates. If you can guess what the top of the cycle is, you can do very nicely. Of course with any cycle, you find out what the top and bottom were after they occurred, making timing very difficult.
Gold:
Gold is a traditional inflation hedge, but if you look at gold prices, it is more of an emotional shelter from inflation. As the economy stabilized in the late 80's from the inflation of the 70's, we saw the price of gold drop significantly. During the current high anxiety period, we see gold surging to early 1980's levels and beyond. Even so Gold returned 13.9% during this period. If you haven't already invested in gold, you may have missed the gold opportunity for this cycle.
Real Estate:
High interest rates hurt the sale prices of homes because doing a deal with high interest rates makes it harder for rental properties to show a positive cash flow, and hard for buyers to afford residential real estate on their budgets. If you have a base of residential real estate, the rental market was not significantly impacted, but the affordability of home sales suffered. Even though sales volume may have suffered, home prices remained on the rise during the inflationary period. Homes provided a 9.4% appreciation during this period which does not include any cash flow from rental. To manage risk in a real estate investment, having a holding that is cash flow neutral or positive will allow you to hold the property until you've reached your appreciation goal. In addition, you commonly get a tax benefit from deprecation on your property which can benefit you if you have a passive income to offset this passive loss. To further manage risk, use fixed rate mortgages so that you know what your holding costs will be for the property. Many real estate investors were caught when mortgages adjusted up and the property was no longer cash flow positive or neutral.
Fighting Inflation in the 21st Century
If we are going to face another inflationary period in the next 10 years or so, how do we best allocate our capital to reduce inflation's toll on our net worth? I would submit to you the time is now to buy and hold real estate and lock in properties that have positive cash flow. This strategy would imply that you buy the properties with fixed mortgages. As inflation hits rents will increase, but the value of your properties may not appreciate that well, while still being a cash generator for you. The primary concern has to be for properties are cash flow positive, and as a secondary consideration if you think the population and jobs trends are favorable for that market, you might get some appreciation. Don't plan on appreciation, think of it as a bonus. The property must generate cash flow today. That will protect you tomorrow. By using a fixed mortgage, you become less sensitive to the duration of the inflationary cycle. Don't put yourself in a position with a balloon or adjustable mortgage where the business will cash flow to day, but be negative cash flow in a few years. We don't know how long the inflationary cycle will last.
EW Ottem is an investor and student of human behavior located in the Silicon Valley. You can see more from him at inflationinvestor.weebly.com or inflationinvestor.wordpress.com Feel free to send him your thoughts at inflationinvestor@gmail.com
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