Understanding Inflation and How it Impacts You | August 16th, 2021

Understanding Inflation and How it Impacts You

We hear a lot about inflation these days. We marvel at housing prices, lumber costs and rising grocery bills. We hear about pent up demand and supply chain bottlenecks and shortages of semiconductors that are impacting auto production resulting in massive increases in used car prices.

Experts say this is transitory inflation (temporary in nature) and nothing to worry about. Indeed, politicians tell us that with rates so low, government “took on debt so Canadians didn’t have to.” The pandemic has created many unfortunate outcomes including significant unemployment as the Canadian service industry is trying to survive shutdown after shutdown. With all the economic hardship, scarcity and the resulting inflation, many people are asking, “Should I even care? Won’t everything be back to normal soon enough?” Well, let’s take a closer look at how inflation, interest rates and an economic imbalance can impact you and what it means for your financial planning.

UNDERSTANDING DEBT: GOVERNMENT AND HOUSEHOLD

Canadian Government Gross Debt to GDP

Canada recorded a Government debt to GDP of 117.80 percent of the country’s Gross Domestic Product in 2020. source: IMF

A significant increase can be seen in 2020 after several years of mild fluctuation.

Canadian Households Debt to GDP chart

Canadian Households Debt to GDP

Household debt in Canada decreased to 111.59 percent of GDP in the first quarter of 2021 from 112.62 percent of GDP in the fourth quarter of 2020. source: Statistics Canada

Again, a significant increase in 2020/2021 relative to the plateaus seen in previous years.

Canadian Households Debt to GDP chart 2

Debt has been increasing significantly for both Canadian households and the Canadian government, at a cost determined by the global bond market. We can clearly see that our debt has not only grown, but it has grown much faster than that of any other country according to Deutsche Bank.

Canadian Households Debt to GDP q4-2019 to q-3-2020 bar chart

How much debt we have and how much it costs to service the debt is precisely why inflation matters. Inflation determines the price at which global investors are willing to lend. Higher inflation means higher interest rates and eventually less disposable income. Indeed, higher interest rates will mean more of our tax dollars will be eaten up by interest costs and as a result, not be invested in healthcare and education where many of us would like it to be spent.

INTEREST RATES

Over the past 30 years or so, we have lived in an environment of falling interest rates and disinflation. Prices have been rising but at ever diminishing levels. There was fear not long ago that deflation or outright falling prices, was the biggest risk to financial stability. In fact, over 17trn USD of global government debt recently traded at negative yields. The reasons for this merit an entirely separate conversation, but the forces of disinflation may be waning and although 5%+ inflation may well be temporary, the largest central bank in the world, the US Federal Reserve, is on record saying inflation can stay above target for a period of time and they will look at average inflation through cycles.

Long term interest rates have been quite volatile year to date. The 10-year US Treasury note, one of the standard metrics investors use to gauge inflation expectations, started 2021 at 0.92% yield. Bond prices fell in Q1 and the yield rose to an intraday peak of 1.78% near the end of the quarter, only to fall back close to a low around 1.13% recently – a conundrum for many in the market as inflation data in the US has been the highest in decades. More importantly, the yield curve flattened significantly, a clear indication that the bond market is unconcerned with inflation. So why are we seeing clear inflationary trends and yet the bond market is unimpressed? Should investors back the long-term trend and fade inflation fears?

Although the bond market is currently suggesting a slowdown and reflation fading, monetary policy is extraordinarily accommodative. While questions remain around the size of the fiscal stimulus via the infrastructure bill in the US, there has already been immense fiscal stimulus thus far, and according to our Institutional Strategy team, new stimulus in the form of Child Tax credits will more than offset the end of Covid related programs.

overall economic impact of stimulus programs ending vs child tax credit chart

DIMINISHING INFLATION

As investors we have always asked ourselves, what do policy makers want? What does the FED want? As a student of economics, I have always believed in the statement, show me an incentive and I will show you an outcome. The FED wants the economy moving towards full employment. They have stated that inflation can run hot, and they will look at a longer-term average inflation. The FED wants higher inflation, a policy I am not entirely comfortable with, but it is never good practice for an investor to fight the FED. The Bond market is currently pricing a policy error by the Fed. Recent bond market price moves imply a slowing economy via the yield curve flattening. Low long term interest rates are not currently supported by fundamentals in the economy unless the FED tappers bond purchases too soon and snuffs out the economic recovery. This view is hard to support, so the recent rate action in the 10-year bond should reverse closer to Q1 levels. Consumer balance sheets are very strong, mortgage rates are low, pent-up demand, and still extraordinary monetary and fiscal stimulus points to the economy continuing to strengthen. The risk of inflation is probably diminishing but the prospect of post transitory inflation being slightly higher than the past is real. We only need look at the Commodity index to see this. The GSCI Commodity Index is higher today than at any point since 2014. WTI is trading back above $70 per barrel.

WHY IT MATTERS

Back to why inflation matters to everyone – inflation brings higher interest rates. Canada and Canadian consumers specifically have been binging on debt like no other time in our history. Extraordinary times call for extraordinary measures, but we must be cognizant of the risks ahead. And to me, the risk is in global central banks losing control of the normalization process, not a post pandemic slowdown. And for countries like Canada that rely significantly on foreign lending, being forced to pay higher interest rates to attract investors, diminishes our ability to spend on what needs more focus, like our healthcare infrastructure and education system in a new post pandemic world. To that end, the risk to markets from high and persistent inflation is greater than the risk of slowdown. We are not predicting one over the other, but rather emphasizing that it is more prudent from a capital preservation perspective to build a portfolio that can withstand the inverse of what the current market is pricing in. We see a near term recession as a low probability, and a change in view on this would alter portfolio construction considerably.

Investors and consumers alike need to be aware of these economic imbalances and prepare for any outcome. Anyone can invest, but the strength of your investments requires insight and an extensive understanding of the markets, which is how we, at Tall Oak Private Wealth, can help. We are happy to review your portfolio, discuss relevant issues or concerns, and set you up for success.

Curious about your portfolio? Reach out to us today.

Sincerely,
Your Tall Oak Private Wealth Team (Written by Ben Legge, Portfolio Manager)

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This material is provided for general information and is subject to change without notice. Although every effort has been made to compile this material from reliable sources; no warranty can be made as to its accuracy or completeness, and we assume no responsibility for any reliance upon it. Before acting on any of the above, please contact Tall Oak Private Wealth of Raymond James Ltd., for individual financial advice based on your personal circumstances. Raymond James Ltd. - Member - Canadian Investor Protection Fund. Insurance offered through Raymond James Financial Planning Ltd., not a member - Canadian Investor Protection Fund.

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