By Professor Ricardo “Rick” Ulivi, Ph.D.
December 2017
Amid the euphoria we are witnessing in the stock, bond, real estate and bitcoin markets, are there any clouds on the horizon that presage a crash? I believe so, and I will explain what I feel is the main culprit that will put an end to the ecstasy in the financial markets. It’s un-expected inflation, of course.
Inflation to an economy is like fever to the human body. It’s an indicator that something is wrong and if its causes are not treated, they could cause severe damage.
In the USA, inflation for the last 10 years has been well below its historical average, which confirms that there is no fever in the economy. Because of this lack of inflation for so long, most people believe this will continue. That is, they expect low inflation. The danger, of course, is the un-expected event.
One of the positive effects of this low inflation has been its impact on keeping interest rates super low. This, in turn, contributed to the incredible appreciation we have seen in the prices of stocks, bonds, and real estate (bitcoins are a different phenomenon, that I won’t discuss at this moment).
Why did asset prices increase so much?
There is an inverse relationship between asset prices and interest rates. That is, if interest rates are low or go lower, the prices of stocks, bonds, and real estate will stay high or go higher. However, if interest rates start increasing, you will see asset prices come down. The higher the rise in interest rates, the faster asset prices will drop.
So where are interest rates headed? Most likely rates will begin rising, and the main reason is that inflation appears to be accelerating.
What’s causing an increase in inflation?
Inflation is a very complex phenomenon, and it’s affected by many forces. In the most basic form, think of it as too much money chasing too few goods. The Fed has been flooding the markets with money, and so has the European Fed. Eventually, this has to put pressure on prices, and we are seeing evidence of that at the wholesale level.
The index that measures inflation, or the fever, is called the Producer Price index. Last month it grew on a monthly annualized rate of 5.25%. Wow! Compare that to the annual consumer price index of 2.2% for the past year, and you can see how inflation is getting into our economic system. Just like a boa snake takes time to digest its victim, so does it take a while for wholesale inflation to reach consumers. When it does, you can expect interest rates to take a jump. And then, what? Asset prices will begin dropping.
What is the relationship between inflation and interest rates?
It all has to do with the purchasing power of money. When you lend or invest money, you should never expect only the return of your money. You should always demand, at minimum, the return of your purchasing power. For example, assume a cup of coffee is worth $2, and I lend you $1,000 or the equivalent of 500 cups of coffee. If a year later, you return my $1,000 but that only buys me 400 cups of coffee, I have lost the equivalent of 100 cups of coffee. Although now I have the same $1,000 I had a year ago, I am actually poorer. That’s because the price of a cup of coffee went to $2.50 from the original $2. Losing purchasing power made me poorer.
How could I have maintained the purchasing power of my money?
When I lent you the $1,000, I should have demanded that you return to me, not the $1,000 I lent you, but the equivalent of 500 cups of coffee. Therefore, a year later you would have returned $1,250, because that would buy me the same number of cups of coffee I originally lent you.
If you expect inflation to increase, you should demand a higher rate of return on your investments. But, as you and other investors demand a greater return, the price of assets will drop. So keep your eye on inflation to protect the purchasing power of your investments.
My wish for you for the coming New Year is that you protect yourself from losing purchasing power. Just as it is good practice to have protected sex when enjoying multiple partners to avoid disease, you should protect your money, and investments, from inflation and rising interest rates. What protection are you using?
To set an appointment to discuss this further or to review your finances, call me at 1-714-771-6000.
