Saving In the Era of Inflation

Despite numerous rate hikes by the Fed and various national banks around the world, inflation is still projected to run at nearly double the rate that the US Congressional Budget Office (CBO) predicted a year ago, with current predictions suggesting that it will amount to about 4% for the year. So how can you save during inflation?

While it’s significantly down from the double digit inflation of a year ago, it indicates that an era of long term inflation, and the attendant high interest rates they necessitate, may be here to stay. What does inflation in the long term mean for your savings and financial planning in 2023? 

In this post, we’ll go over the key effects of inflation on your long term savings and financial planning, and try to give you some insights into how an era of inflation will impact your plans, or your ability to make plans. Generally we’ll cover a handful of important realities of any era of inflation and high interest rates; many of which are counterintuitive especially to those of us who have lived and worked primarily in the recent era of permanently low rates and low inflation.

But first: 

What’s Driving Inflation?

In order to understand this new era of inflation, it’s important to understand what’s causing it

Supply Chain Disruptions

Initially, inflation was driven by a combination of increased government spending and disruptions in the global supply chain caused by the Covid-19 global pandemic. As supply chains were disrupted, prices rose to reflect the difficulty of securing basic goods like timber, energy, petroleum products, and electronics on the global market. 

As supply issues have been worked out, that short term stress on prices has begun to ease, but the effects of the disruption will still be felt for years to come. The higher prices paid by corporations and governments during the disruption put a strain on finances, and caused a spike in prices that will take a long time to smooth out, leaving ordinary consumers paying the bill into the foreseeable future. 

Concerns About Inflation Fuel Inflation 

Another cause for inflation is, as we discussed in a blog post on the topic last year, the expectation that inflation will continue. Worries about inflation, paradoxically, are a leading cause for it. As businesses anticipate having to raise wages for their employees, they will preemptively raise prices, causing other companies to also fear having to raise their prices, and raise wages to match. 

High Interest Rates

Another paradoxical cause for inflation is the very thing that is meant to reduce it: namely high interest rates. During times of high inflation, central banks raise the cost of borrowing money for banks. They in hope that businesses and individuals will save money, by cutting spending. In theory, this should ease inflation, as there is less competition for a limited amount of goods. 

However, in an economy where inflation has been continuously high for a long period, companies and individuals are incentivized to increase their borrowing. Even when rates are relatively high, so that they can spend more money today, knowing that costs will be even higher in the future. 

From the perspective of a business, this can make sense. If I know that I can continue to raise my prices in the future, then I should try to borrow as much as I can now, in order to get as much of the supply of goods as I can today. This can mean that even when the cost of borrowing increases, prices continue to rise even faster, creating a situation where there is less liquidity (less actual money) available to borrow, but a great demand for liquidity, particularly among businesses.

Low Liquidity

In a situation where there is high inflation and low liquidity, banks must pay a premium to access money. They sell their assets (treasury bonds) for less than their market value, in order to get access to cash. That can make the banking system less stable. This is one of the reasons the merchant bank Silicon Valley Bank recently experienced a liquidity crisis. The lack of liquid money led the bank to have to sell off long-term assets at lower-than-expected prices. This impacted their ability to provide working capital to the companies that banked with them.

Even though the central banks have raised the cost of borrowing to discourage competition for limited resources, they have also created a situation where access to capital is, in itself, valuable. The situation with Silicon Valley Bank may serve as an indication to central banks that raising interest rates is no longer working to decrease competition among businesses. However, central banks have few other tools available to fight inflation. 

Impact of Inflation on The Stock Market

How does all this affect the stock market? 

“Asset Light” Companies

For decades, the stock market has been good for so-called “asset light” companies. Meaning companies that have large amounts of cash flow, but don’t directly own large parts of their own operations. For example, hotel chains that have sold off their properties and lease them back from a private equity firm are “asset light.” Asset light businesses do well during times of slow economic growth and low interest rates. That’s because the return on invested capital is higher for a business that relies primarily on sales. Rather than owning long term assets. Such companies can pivot more quickly to take advantage of changes in the market, ditching costs that don’t contribute to profitability, and investing more in parts of the business that generate money. 

Many retail brands have used this model in recent years, booking large profits; but it has a downside. As asset prices such as real-estate increase, and the cost of borrowing goes up, the cost of running an asset light business suddenly becomes quite high. At the same time, asset light companies cannot necessarily just raise their prices. They usually depend on strong consumer spending and easy borrowing to continue to grow. If consumers can’t borrow money, and asset light companies can’t afford to lease properties and pay for their supply chains, then these companies suffer financially.

To some degree, all businesses are “asset light” in certain areas. For example, it usually doesn’t make sense for a business to own all of its own technical infrastructure. Such as cloud services, or energy generation. Only the largest companies invest in this kind of infrastructure, so when inflation is high, companies that face higher costs for these kinds of services will lose some profitability. However, companies that have invested in long-term planning, either by building their own technical infrastructure or securing long term provision contracts, will benefit from this preparation when inflation is high. 

“Asset Heavy” Companies 

A period of high prices and inflation is generally favorable for companies that are more vertically integrated. Meaning that they own a larger part of their own supply chains, properties, retail locations, and other fixed assets. These types of companies, be they electronics manufacturers, retailers, or service businesses, are in a better position to absorb changes in the consumer market, having the flexibility to lower prices in the face of lower demand, or to delay capital expenditures when borrowing costs are high.

This difference is fairly intuitive if you think of the analogy of a consumer who rents, vs. one who owns. An asset light consumer rents their home, their car, and maybe even their clothing. When money is cheap and prices are low, this can all work out. But as the cost of borrowing increases and the cost of living is going up, the situation improves for the consumer who owns things like a home and a car, since they will have the option to delay purchasing a car in the future, and they will not be paying higher rental prices because they already own property.

When evaluating stocks to invest in, one of the key elements to examine is how much a company is reliant on external market factors. Does it own its own equipment, or merely lease it? Does it have its own infrastructure, or does it rent the use of someone else’s? While these are far from the only questions you should be asking, they are important considerations during a time of higher inflation. Previous financial performance doesn’t necessarily tell you how well a company is going to perform in the future. When the basic expenses they are facing are going to change. 

Impact of Inflation on the Money Market

The impacts of inflation and high rates on the money market (mostly bonds and savings) is easier to understand. 

Rising interest rates make bonds and savings accounts more attractive, but they also come with an understandable risk. Unlike with inflation, a bond has a set value at the time of issuing, meaning it pays back a set interest rate to the owner. If inflation rises faster in the future, the present value of a lower-interest bond will decrease. Just as with a savings account. If inflation is rising faster than the interest rate on the account, then all else being equal, the account is going down in value. While it is acceptable and even necessary for consumers and businesses to have some of their money in cash, it is a risk to keep too much of it in cash for too long, as higher inflation means that the effective interest rate on money saved can be below inflation. The more money you keep in savings, the less interest you can generally earn, since you’re paying a premium, in essence, to have access to that cash. 

This was the problem at the heart of the Silicon Valley Bank crisis: the bank had bought a large amount of bonds at lower interest rates, which it had attempted to sell in order to purchase higher interest bonds. When the bank reported the loss of the value they experienced on the bonds they were selling, this initiated a run on the bank, as depositors rushed to withdraw their money out of fear that the bank would not have enough funds to meet all its obligations. In truth, the situation was a lot more complicated than that. The real problem may have actually been that Silicon Valley Bank had been too conservative earlier on during the Covid-19 pandemic. And had been too quick to convert its free cash into bonds at lower interest rates. 

Inflation and Commodities

Another area of interest for many individuals looking to grow their wealth is commodities. Which is just a fancy way of saying “stuff.” 

Commodities can of course be found in financial instruments and financial markets, such as commodities trading and futures exchanges. But most people do not trade or invest in this kind of thing. The risks and complexity of commodities markets make them more the realm of expert investors who understand the commodity classes they are investing in. 

Commodities markets are specialized mostly in helping the producers of goods such as food, precious metals, and other products handle their complex financial needs. For example, there exist “crop insurance” companies which will, for a premium, insure a farmer against the loss of their crops due to bad weather or other unforeseen issues. On the other hand, farmers and manufacturers can also borrow money via the commodities market, by selling “futures” in the products they produce, meaning that they promise to pay the profits for those products, when sold, to the holder of the futures contract. By selling things before they have been produced, companies like food producers are able to get the cash necessary to increase their production, buy new equipment, or expand their businesses. By buying a futures contract, the investor assumes the risk that the producer will not actually be able to make the goods they are promising to deliver. 

Precious Metals 

Obviously this is not an area of investing that is suitable for the average investor, and you should always keep that in mind. There are huge potential risks, and having a deep understanding of the market for commodities is key. But one area of commodities trading has always been popular with consumers, and that is: precious metals. 

People invest in precious metals often as a “hedge against inflation,” and the reasoning behind this is fairly easy to follow. If I buy a single piece of gold bullion for $1000 today, the price of that gold is not going to remain exactly the same as inflation rises. As money decreases in value, the price of that gold may increase.

I say: may increase, because despite the fact that so many consumers invest in precious metals, there is absolutely no guarantee that they always increase in value. The discovery of new sources of these metals can mean that the market for them can collapse. The same can happen for all kinds of tradable commodities, from gold, to diamonds, to collector memorabilia. The market for these goods is fluid, which is why investing in them is always a risk.

Risk and Reward

One of the reasons so many consumers invest in precious metals is a practical one: unlike futures in food production, or real estate, or stocks and bonds, precious metals can be held in your hand. They are finite, and their value is whatever someone is willing to pay for them right now, in cash. Many people feel safer investing in things like gold and silver simply because these commodities cannot disappear in a financial crisis. They don’t rely on a government to enforce them, and they are not tied up in a company or a contract. To many people, the surety of being able to hold these valuables in their hands outweigh the potential risks. 

Many financial advisors therefore encourage consumers to buy small amounts of precious metals and other physical commodities, if only to afford them some peace of mind in an ever changing world. If the prices of these commodities jumps suddenly, an investor can take advantage and turn these assets to cash quickly. They can also be sold later in life, sometimes for a big profit, and yes, they are somewhat resistant to the effects of inflation. 

Many advisors however suggest that no more than 10-20% of your assets should be kept in these types of commodities. Not only is their value never absolutely certain, but these kinds of assets can also be easily stolen, misplaced, or even taken away by a government in time of crisis, such as occurred during the Great Depression, when governments confiscated gold from households to stop people from hoarding it as a check against inflation. 

All those risks ought to be considered when you think about investing in risky commodities. Remember: everything is a balance of risk vs. reward. Risking everything on one asset may reap a large reward… or it may precipitate a major loss. 

Inflation and Real Estate: What You Need to know 

Many investors turn during times of high inflation to one of the most popular assets in the modern world: housing and real estate. 

If you’ve been following along up to this point, you’ll realize that inflation is most damaging for liquid assets: cash, bonds, and other tradable assets, whose value is whatever someone is willing to pay for them at any particular moment. These assets are vulnerable to inflation because they have a “face value,” which will decrease as inflation rises. 

The same cannot be said of real estate, which unlike cash and bonds, is not an easily tradable asset, and unlike cars or other consumer goods, does not usually depreciate in value over time. There is always a limited amount of real estate and housing available, and historically, the creation of new housing has nearly always been slower than the demand for that housing. 

Lack of Supply Means Rising Prices 

This lack of supply keeps prices from falling. Even though the physical structure of a house may depreciate (become less valuable), due to age and wear, the increase in value of the land and the home usually counterbalance this effect, causing prices to rise over time. If the supply of housing continues to be too low for demand, the value of housing may even increase faster than inflation, as it has done in most parts of Europe and the United States over the last decade or so. 

This is by design. As it is one of the absolute bedrock elements of middle class wealth in the western world, developed countries take care to ensure that housing does not lose value over time. In periods where housing prices have steeply fallen, such as in 2008 or during the Great Depression of 1929 to 1937, major economic crises have quickly followed. This is because if household wealth is dropping as housing prices drop, the ability of consumers to borrow, invest their earnings, improve their homes, or enter retirement decreases. This leads developed countries to strongly emphasize rising housing prices as a key economic goal.

Rising Prices Means Growing Wealth 

Of course, there are negative effects associated with this focus on real estate prices. Lately, particularly in the United States, large private equity firms have been buying large amounts of suburban real estate, hoping to take advantage of the constantly rising demand to extract huge profits from families seeking homes. However, for those who are able to afford to invest in a home, particularly one they plan to live in and improve over time, the historical rise of housing prices ensures that they will be able to continue to afford to live in their homes in the future. 

As housing prices continue to rise, consumer credit also increases, since the home owners can borrow against the increased equity that they have in a home. If you bought a house for $250,000 a decade ago, that house might be worth $400,000 today. And since you only borrowed a portion of the original sale price, the rest of the price increase is added to your own equity, allowing you potentially to borrow more, or to sell for a large profit. This is the means by which many people in developed countries achieve financial security later in life. 

Capitalism Reward Ownership 

One of the most important takeaways here should be that capitalist systems such as those of most advanced economies strongly emphasize ownership as a means of increasing one’s wealth over time. Owning precious metals that are always scarce, owning stocks in companies that are always growing, or owning a home that is always in demand, is a key way to drive consumer wealth and ensure financial stability in the future. 

Therefore, owning a home is one of the best investments a person can make; particularly if they plan to live in that home and continue to maintain and improve it over a long period of time. While of course, modern economies change, and the demographics of advanced economies will not continue to grow forever, the fact is that real estate is naturally scarce, and historically has always been in demand. 

Starting Early and Starting Low

Absolutely key to successfully building one’s own wealth in real estate are two things: to get started early, and not to overpay or overreach. By buying a home you can afford, you reduce the chances of defaulting on your mortgage and losing the home. You also increase your freedom to improve and maintain your property. As your home increases in value, your ability to sell and upgrade to a larger home also increases. 

This cannot be said for people who pay too much for a home, taking out too much debt, and finding themselves unable to improve or maintain their new property because of the high cost of the mortgage. As many investment gurus will tell you: “a house with a huge mortgage is just a rental with debt.” Being able to own more equity in your own home as soon as possible ensures you will benefit from the rise in demand in the future. 

Diversification and The Uncertain Future 

One of the most time-tested adages when it comes to individual investors is this: diversity is your friend. 

We’ve seen that there are ups and downs in investing in all kinds of things, from stocks and bonds, to metals, to houses. The only sure thing about the future is that it will be unpredictable. This means that while large risks can pay off with huge profits, they can also result in devastating losses. A strong investment portfolio is one where the risks are spread across a range of assets, allowing a person to potentially enjoy the benefits of several successful gambles, while shielding them from the worst consequences of the risks that don’t pay off.

Diversification is also important because the fate of any one type of asset is often tied to the fate of others. For example, if gold prices increase massively in the future, that may cause other assets to decrease in value, as more money must be spent buying gold instead. Or an increase in gold value might also see a corresponding increase in metals that serve as an alternative to gold. The effects of a single trend in prices are complex to the point that the very smartest and best informed investors in the world find it impossible to predict what will happen if one set of assets gains or loses value.

Everything, Everywhere, All Of the Time

We see this not just in financial assets, but in things like housing too. As housing prices increase, perhaps younger people invest less in stocks and bonds, causing their prices to stagnate. Or as baby boomers sell off their homes and get more money in their financial portfolios, they may increasingly buy stocks and bonds, causing the prices to rise. All of these effects are always happening, all together, constantly, with every cause and effect being linked to an endless chain of other causes and effects.

This is what makes investing so unpredictable: the future isn’t set, so nobody knows what the price of anything may be in the future. Again, the only sure thing in life is that nothing is really a sure thing. So when planning for your future, accept that whatever will happen, it will not happen as you predicted. Investing and saving with this in mind can keep you from the worst possible outcome: that of all your bets being wrong.

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