OK listen up because I’m only going to say this once. Well, maybe that’s not true as it is going to become my mantra now for anyone who will listen. Not a day goes by I don’t think about the current economic environment we’re in. I know that sounds like a complete geek thing to say, but it’s true. We’re in no-man’s land and everyone’s trying to figure out where we go from here.
I want to set the stage for a moment. Inflation, in basic terms, is the cost for goods and services going up in price. There are a variety of reasons this can happen such as excess demand, limited supply, a combination of both or the monetary outlier, currency devaluation.
The supply and demand relationship is easy to explain. Let’s say that the University of Kentucky basketball team managed to string together multiple wins and even knock off a few biggies. With the fan base excited, the next home game ushered in a #1 ranked Gonzaga. Assuming Rupp arena had no Covid restrictions, each of the 23,500 seats (fixed supply) was up for grabs. Do you think the price of the ticket would be higher or lower than when they were losing? Higher is the right answer and my guess is, scalpers would be having a field day. This is an example of a type of inflation due to supply and demand. Inflation as a result of monetary issues is a bit harder to explain, but let’s give it a go and take a peek into the history books as our guide.
The year is 56AD and the primary Roman currency is the silver Denarius. The Empire is booming yet the cost of further expansion (war), infrastructure and increased social programs are creating an issue when it comes to a fixed amount of silver to forge more coins. Rather than scale back on spending, the government underwent one of the first recorded quantitative easing measures by simply ‘clipping’ off some of the silver on each coin in order to use this for future coin production. The government saw no harm in this currency devaluation, however, this quickly led to increased asset appreciation, which requires a further fictitious illustration.
Marcurious the 2nd was a great Roman soldier, having successfully fought and returned from 3 previous tours. Upon learning of his next deployment, which would be his last, he began to seek out a plot of land that he could buy with his post-tour wages in order to settle down and enjoy retirement. His research yields a beautiful parcel of land which he negotiates with the owner to be sold for 100 Denarius, or the sum of his final tour payment, upon his return.
Marcurious ventures off to battle for two long years and while gone, the government pursues the clipping of the Denarius, reducing the silver content of each Denarius by approximately 10%.
Marcurious returns home and collects his payment of 100 Denarius for his tour and promptly ventures off to the landowner to settle their agreement. He is shocked to learn that the landowner now requires 110 Denarius, or a 10% increase, due to the ‘clipping’ that has occurred since the soldier last deployed. This asset appreciation sparks Marcurious into action, at which point he returns to the general of the Army and promptly demands an increase in wages for his previous tour (Wage Inflation). While the general does not first comply with this request, word spreads among the soldiers of this currency issue at which point they all demand higher wages. It is at this point that the cycle of inflation begins and is very difficult to stop. In fact, from 56AD through 268AD the Romans had devalued their currency by 90%, resulting in a 1000% increase in inflation. The Roman empire ceased to exist by 460AD.
Hopefully, this example makes sense and you now understand the real relationship between currency devaluation and potential inflation.
Step one is to actually devalue the currency by adding additional funds into the system that were not previously available. The result becomes asset appreciation, or the price of goods and services increasing, which ultimately results in wage inflation. Wage inflation sparks a further rise in increased prices, which sparks further wage inflation. Rinse and repeat.
Now that you understand the particulars, let’s set the stage for where we are now. Never before have we seen such an increase in money supply as a result of stimulus and government intervention. Money in circulation is measured by a statistic called M1. I won’t go into all the particulars, but it is good to know that this simply measures the amount of physical currency and demand deposits in the US or put simply, checking accounts. As you can see from the graph below, this has seen a parabolic rise in the last year due primarily to such things as direct stimulus and forgivable PPP loans.
While the value of the dollar has remained relatively stable, due to global demand, we have set the stage for what I believe will usher in a significant increase in asset prices as a result of increased money supply as well as pent up demand and limited asset supply. In fact, we’re already seeing this play out in certain areas such as lumber, steel and aluminum.
While these notable price increases have transpired in certain areas, so far they have been relatively modest in other areas such as groceries or utilities. If, however, currency devaluation plays out, I feel it is only a matter of time before we see a significant rise in all products and services, thus resulting in a demand on wages and a new significant inflationary cycle will begin.
So what does one do? I have pondered this question for years now as this inflationary path has been a potential since the great financial crisis but kicked into high gear due to Covid. I am not alone, as inflation is a common theme among many advisors and a common concern among investors. While you may not have grasped the particulars leading to inflation, odds are you grasped the idea of its potential. This theme is not new.
Typically, the discussion immediately move towards investments with a discussion regarding various asset classes or strategies in order to keep up with rising prices. Or maybe a discussion of how cash is an eroding asset class and despite what someone may think is a good CD rate, they’re actually losing money when you factor in even a modest inflation rate. While yes, these are good subjects to discuss, it unfortunately still does not solve the problem for most Americans. After countless hours of pondering, there is only one answer in my mind and it’s really quite simple: personal debt reduction.
We find ourselves in an environment with unbelievably cheap money. Buy a home, finance a car, make payments on a boat, heck why not put it on the store credit card?! It’s enticing, and according to the latest consumer debt report, this cheap money is being utilized by most Americans. In fact, at the end of 2020, Americans held over 14 Trillion in consumer Debt, a new record. However, with rates so low and prosperity on the rise, what is the problem? Well, the problem comes when general expenses rise by 20, 30 or even 50%.
Let’s say that a large family in the US spends around $1,000 per month on groceries. While most are wondering where to invest their excess cash to keep up with inflation, what happens if those grocery bills go up by 50% or $500. What if, on average, general household non-debt expenses go from $3,500 per month to $4,750 per month? Lump in fixed debt payments and we have a problem.
So rather than being so concerned about where to invest, why not pay off that car payment and free up $500 per month. This would mean that your grocery bill could increase by 50% and you would have the capital to pay it as you no longer have the car expense. While yes, it is true you took capital that at the moment was earning a higher rate to pay off a debt earning less, you freed yourself up with the ability to handle any increase in monthly expenses that may come your way.
Two car payments? How about car payments and credit card payments? Heck, while so many are telling you to borrow as much as you can for that home that will always go up in value (tsk) how much extra would you have to spend towards rising costs without a mortgage payment?
I realize this isn’t some complex investment strategy that has you minting millions, nor is it the greatest next ‘stock pick’ for the future. The reality is that, in my opinion, this is by far the smartest thing a person can be doing at this very moment to protect themselves for what may be coming down the pike.
With consumer debt at all-time highs, yet income to debt service at all-time lows, it looks as if this isn’t a problem at all. Unfortunately, not a single statistic factors in the ramifications of a significant increase in monthly expenditures. The only way to control this is to mandate that your income far exceeds your outgo and that any additional expenses can be cut or trimmed back at a moment’s notice. Unfortunately, with fixed debt payments, you do not have this luxury.
Rather than be focused on what to invest in, or where to put your capital to keep up with inflation, consider bucking the general sentiment and pay off debt, maintain a modest budget and have a healthy emergency fund. Once these ducks are in a row, then you can consider the proper allocation to maximize your returns. Until then, focus on one thing and one thing only: knock out that debt!