Saturday, December 16, 2017

Where to invest in the unfamiliar environment of rising interest rates

So the idea is to ‘normalize’ interests rates first – historically around 4% or 1 to 2% above the rate of inflation. But with all the current government spending it looks like inflation may pick up a lot more over the coming years.  Remember what high debt did to Canada in the 1990s?  First our credit rating went down and just like now in Alberta, that means that governments must pay higher interest rates and thus more interest dollars.  That means, of course, that other borrowers also will have to pay more interest on their debt. In other words, rising prices and inflation.  But as Mulroney learned when he tried to clean up Trudeau Senior’s debt mess, his government had to spend more and more on interest and if Mulroney wanted to reduce the budget deficit by even a tiny bit he would have to increase taxes.  It was during the Mulroney years that the marginal tax rate was the highest during all my 40 years in Canada. It was over 53% here in Alberta; compare that to 38.8% during the Harper years.  Every time I had a pay increase Mulroney took over half of that… very demoralizing for my work attitude!   But rising taxes required higher salaries and higher prices for our cost of living, i.e. even higher inflation! Thus… higher interest rates... and that is how we got trapped into ever higher interest rates and inflation.

Earlier in 1982, Paul Volker in the U.S. had broken the rising inflation/interest cycle when mortgage interest rates reached nearly 20%. Ever wondered why the U.S. stock market outperformed Canada’s by so much during the 1990s?  Well Canada’s debt misery peaked under Brian Mulroney. So now Notley, Wynne and Trudeau Jr and in the U.S. Obama and now Trump are repeating this higher inflation/higher interest rate/ higher taxes cycle again.  By voting for the Liberals in Canada, Millenniums are repeating the mistakes of their parents, the Baby boomers.  Do we ever learn?  The expression goes: “We don’t get the government we vote for but the one we deserve!
So, how do you invest in an environment like that? My answer is real assets.  I call stocks and bonds not real assets, they are paper assets.  As share owners of TD Bank, did you ever walk into a branch and took away part of your property?  Say, a door handle?  Yeah, just try and see how fast the police is after you. 😊 Stocks, bonds, mortgages, etc. are not REAL assets and they suffer during periods of inflation – some more than others. You think that as an owner of debt you gain because you get more interest?  No your principal decreases in purchasing due to inflation and due to taxes. To top it off, your debtors are more likely to default including debtor countries.
Real assets have a better chance. Real Estate typically keeps up with inflation because it is real. Not Real as in Royal if you get my pun (just look up the etymology of the term Real Estate). Gold is real, so are all commodities, farm land, timber land. The house you live in, you can really own. You can touch it, you can tear it down and build a new one to live in or rent it out. That is, until you don’t pay your mortgage. But the good news of inflation is that in purchasing power your mortgage principal goes down and it also goes down because of your principal repayment that is part of your monthly payment. And.. the purchase power of your monthly payment also becomes less and less each year until renewal time.  Now that interest rates are on the rise again, consider variable rate mortgages – but do the math first.

During times of inflation, real assets, including your job, are the best protection and the best way of making money on your savings. But never forget the effect of rising taxes – avoid RRSPs and love, yes LOVE, TSFAs. It may also be that people lose their confidence in fiat money and government debt and then pray that we come out of the mess in one piece!  After the, nearly unavoidable, crash in cryptocurrencies, a recovering blockchain and cryptocurrency market may also be a good source of long term protection and even profits.

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