Are your investments between a rock and a hard place?

The phrase “between a rock and a hard place” literally means what it says, and that is where the Fed, and many other central banks, find themselves today.

Interest rates are the traditional tool to keep inflation in check to ensure price stability or, put differently, to not allow our purchasing power to run away from us too quickly. I say “too quickly” because based on a long-term (±100 years) South African inflation rate of around 6.0%, purchasing power halves after 12 years (that is already a scary thought). This begs the question: Do central banks allow inflation to run and continue to deplete your purchasing power, but at a higher pace, or do they increase rates?

The world currently has a debt-to-GDP ratio fast approaching 400%. With this amount of debt all is fine and dandy when interest rates are at their lowest in 4,000 years, but the moment inflation rises you start to run out of options and hence are caught “between a rock and a hard place”. Higher rates will rapidly crowd out spending on government budgets that are already running large deficits, they will place pressure on fragile personal and corporate budgets that are under pressure, and they could cause asset prices (wealth) to fall too quickly.

At this juncture it is important to note that central banks can monetise debt by printing money and lending money (by buying bonds) to central governments. This means that, in theory, central banks can continue to create money out of thin air, as long as the world still trusts its governments to be creditworthy and repay such debt, and investors still see value in owning those bonds. The real yields of 10-year treasuries in the US and the Eurozone are already negative. The moment investors decide that other asset classes are more attractive and start to sell those bonds, the central banks will become the default choice (the buyer of last resort), creating all kinds of problems in the devaluation of the currency, reducing purchasing power and hence causing runaway inflation.

The other factor that we need to consider is political will. Is it more popular (votes) to stimulate growth through lower interest rates and other accommodative fiscal policies or to increase interest rates and taxes to provide price stability and reduce the need for debt? The answer is quite obviously to stimulate, especially if you cannot afford to increase rates (as mentioned above). If governments get their way, the most probable route out of this scenario is financial repression where inflation is above interest rates allowing governments to effectively inflate away their debt over time (i.e. reducing the value of the debt).

Any increase in rates will most likely be very slow and take place over a fairly long period of time. In a world where inflation will potentially continue to be higher for longer and where the monetary policy doesn’t seem to have the tools to keep it under control, the risk for you and I is that inflation outpaces our returns and that we are therefore compounding backwards in our quest to create wealth (i.e. failing to meet our goals).

It would make sense to diversify your investment portfolio for many scenarios, one being above normal inflation for longer. If there was ever a time to ensure that you break down your overall investment into specific objectives, it is now. Why, you might ask. Each objective typically has a different time horizon associated with it. For example, an emergency fund, as the name suggests, expects something to go wrong anytime and is therefore short-term in nature, whereas a retirement plan, depending on your age, will be long-term in nature. Where time-horizons allow, it is wise to include asset classes that benefit or protect you from increases in inflation. For example: equities or stocks. In this scenario, you can be a shareholder of a business and ideally have a diversified portfolio of quality businesses that are able to pass any price increases to the consumer and as a result compound their earnings above inflation. Share prices over the long term have a very strong correlation to earnings growth, and if you pay the right price for a share this can be a good way to protect yourself from higher inflation. A person who typically is 100% invested in money market funds could consider adding a portion to stocks, if time horizons allow, to ensure that they are not exposed to getting below-inflation returns. Remember, returns equaling inflation means stagnation, and the risk is that you are not even standing still. Each asset class has unique characteristics and stocks can be more volatile, thereby requiring more time. In a hypothetical portfolio with 70% money market and 30% stocks your overall volatility profile is roughly three years, while still providing much liquidity for income needs. Hence, even if you are a more senior person who is already some way into retirement, adding some stocks or other asset classes could make sense. Talk to your financial advisor and ensure that you are prepared for any scenario.

René Olivier(CFA) is the Managing Director of Wealth Management at IJG, an established Namibian financial services market leader. IJG believes in tailoring their services to a client’s personal and business needs. For more information, visit www.ijg.net.