In the previous post on whether the US would experience a depression I said that this was unlikely, but that a recession accompanied by the devaluation of the Dollar resulting in inflation would be more probable.
What are the effects of inflation on conventional investments?
Inflation causes rising prices. It makes money less valuable. If the price of services and goods double, the value of your investments is effectively halved. It’s as if the prices had stayed the same, but you had just lost half of all your assets. Inflation reduces and can eventually destroy purchasing power.
Those most at risk are the ones who have their wealth invested in bonds, savings accounts & CDs, pensions, insurance products and other Dollar-denominated assets.
Bonds usually perform poorly during inflationary periods (this time may be different since there are several foreign pension funds, governments and populations who are willing to subsidize the low interest rates of the US but the outcome might be the same. And I wouldn’t bet on them willing to subsidize us over the long run). The 30 year Treasury bond currently yields under 5.5%. I don’t think this return will outpace inflation. 30 years ago, $50,000 bought a small house in California whereas today it costs over $600,000. However, compounding the same $50,000 at 5.5% over 30 years nets us only $249,200 before taxes, so we can see that in the long run, bonds do not make a good investment.
Similarly, savings and CDs have sub-par performance. The main victims are the elderly who must live off their savings. Every year, their standard of living drops as inflation erodes the value of their savings.
The actual loss of purchasing power is far greater than the official Consumer Price Index would lead us to believe. Volatile products like housing and energy are excluded from the calculation. But most things now cost more than the bogus official 2% inflation rate.
Insurance products don’t fair well either. They also make it very difficult to calculate the amount of life insurance benefits needed. For a given amount of life insurance benefits today, if the Dollar is depreciating 8.5% a year, in about 5 years you’ll need an extra 50% of insurance to get the same benefit. And even if you’re successful at predicting the amount of inflation over a given period of time, increasing the insurance amount to compensate will increase the premiums, skewing your calculations.
Inflation usually results in a tightening of the money supply which makes it more difficult to borrow money. Marginal businesses will find they cannot borrow any money and usually go out of business. Real Estate loans are also more difficult to obtain and this puts a damper on price appreciation. City property values lag the overall rate of inflation due to the depressed business conditions. However, farmland usually appreciates well during these times due to an increase in the price of soft commodities like corn, wheat and cotton.
Commodity prices usually rise more than the rate of inflation. Metals (especially precious metals, which are a store of value) do exceptionally well. However, commodities are illiquid, difficult to trade and can be riskier than investing in stocks if you don’t do your homework. On the other hand, they can be very profitable too.
Common stocks are usually very volatile during these periods. In real terms, valuations suffer because businesses face soaring costs of inventory and equipment replacement, while the depreciation allowed is insufficient to cover costs. Consumer demand may also drop off at the same time that capacity is being increased, which results in over-capacity and losses. Inflation is essentially bad for stock prices. You have to be able to pick the right stocks at the right time.
So what are good investments?
According to Jerome Smith,
Traditional rules of money management lead to incremental destruction of one’s principal at rates exceeding dividend and interest income rates - and ultimately, the destruction of one’s capital. During a runaway inflation, the investor’s primary concern must be the preservation of his capital. With conventional avenues becoming guaranteed losers, he must seek new investments, evaluating them according to new criteria.
So what are the essentials for preserving wealth?
1. Invest in real assets like precious metals.
2. Invest in foreign currencies.
3. Don’t over-leverage. Some leverage is okay, but too much is risky. Its always good to have liquidity.
Precious Metals like Gold and Silver aren’t investments in the usual sense. They are a store of value. As the Dollar devalues, their price will continue to appreciate. Don’t forget to sell them at the top of the cycle otherwise you’ll ride them back down again. Platinum has also historically done well in inflationary times.
During these inflationary times, Diamonds and Collectibles (antiques, rare stamps, artwork) have historically done well. I don’t own any diamonds, but my mom and my wife sure do! I also don’t own any antiques or expensive artwork either. However, one easy way to invest in collectibles is through Stanley Gibbons. They’re a stellar British company that’s been around for generations and you can invest with roughly 5,000 GBP (thats $10,000 in USD).
You can also invest in foreign currencies since the Dollar has gone down against almost every major currency this year. With new ETFs, its easier than ever. You can buy an ETF for the Australian Dollar (FXA), the British Pound (FXB), the Euro (FXE) and a few others. They all pay interest too! You can also buy mutual funds like MERKX that invest in hard assets like gold and also foreign currencies.
Another way to diversify outside the Dollar is to buy blue-chip stocks with global sales. Companies like Unilever (UL), Johnson and Johnson (JNJ) and Procter and Gamble (PG) make a lot of money abroad. As the Dollar devalues, their foreign earnings will look better and better. These stocks also pay a dividend. In general, dividend paying stocks out-perform their non-dividend paying counter parts.
You can take this idea one step further and invest directly in foreign stocks or markets. But this is riskier because less information is available about them and they have less stringent accounting and reporting regulations. Also, some markets are currently over-valued (like China is right now). But some of them trade on the NSYE as ADRs (American Depository Reciepts) like PetroChina (PTR), AngloAmerican (AAUK) and IRSA Investments and Representations (IRS) and could be good investments.
The thing about these three companies is that they invest in real assets - oil, metals and land. All of these should do reasonably well. Other examples are BHP Billington (BHP), Freemont Morgan (FCX) and Southern Copper (PCU). AAUK also owns a major stake in De Beers, which is another way to invest in diamonds.
You could also invest in foreign market funds or ETFs like Templeton Emerging Market Fund (EMF) or the Thailand Fund (TTF). There are a slew of these products to chose from.
Another interesting sector is real estate in certain foreign markets like parts of Asia and South America is undervalued, especially compared to parts of US and Western Europe. I particularly like Japan and there’s a risk-free way to participate in its appreciation through Everbank.
Energy stocks and Timber stocks should also be considered. Canadian Income Funds or Canroys are a good way to invest in this sector. There are many to choose from and I strongly recommend investigating these in greater detail.
Some good timber stocks are TimberWest Forest(TWF.UN) and Plum Creek (PCL). These pay regular dividends too. (As you can probably tell, I’m a big fan of dividend paying stocks).
It isn’t difficult to protect your savings and find profitable investments. I hope you have a better idea of what to look for to profit in the current environment.
Disclaimer: This investments are mentioned for informational purposes. They are not recommendations to buy. If you buy them and lose money, don’t blame me!
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