5 Minute Read
23 February 2021
By David Naylor
“The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” – John Maynard Keynes
Many people are familiar with the story of Weimar Germany, a state which became infamous for its hyperinflated currency, the Papiermark. For those who aren’t familiar with this story, picture this, a loaf of bread, which cost 250 Papiermark in January 1923, had risen to 200,000 million Papiermark in November 1923. This tale demonstrates the power of inflation. This virulent form of inflation is termed ‘hyperinflation’. It is the rise in the cost of goods and services due to the weakening of a currency’s purchasing power. Whilst one need not worry about inflation to the extent in which it was seen in Weimar Germany in the 1920s, recent changes in monetary policy, caused by the pandemic, have caused the ECB to increase the amount of euro in circulation by over 1 trillion in 2020. [Balazs Koranyi, Francesco Canepa, Reuters, 2020] What does this mean for you? Well, with an increased money supply in the economy, there will be this additional 1 trillion (1,000,000,000,000) chasing a fixed number of goods and services. Therefore, goods and services that are fixed in supply, such as property, land and rental accommodation are likely to see an increase in price.
Inflation, put simply, is a decline in the purchasing power of a given currency over a period of time. The official measure of inflation is called the CPI or consumer price index. The CPI measures the % change in the price of a random basket of goods with respect to some time in the past. Goods accounted for in the CPI include food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.
However, the CPI has many limitations. Firstly, the range of goods and services included in the index is limited. Most notably, the CPI does not account for the increase is the price of assets, bonds, stocks or life insurance. Inflation has not accounted for the increase in the price of property in urban areas or the increase in the price of stocks that would yield a fixed yearly dividend. Therefore, the CPI may be more useful to those who consume goods and services similar to those in the basket of goods. What is evident since the Great Financial Crisis is that there has been a polarisation of inflation in different cities around the world. Taking the USA as an example, we found the inflation rates for a sample of cities. As shown in the image below, there is a wide variation in the inflation rates of these locations – with San Francisco having a compound rate of 3.71% vs Baltimore with 1.1%.
Those looking to buy a property would not benefit from analysis of the CPI. Therefore, whilst the CPI is a useful tool in measuring the increase in prices for a basket of regular goods, it does not account for a wide range of assets or income tax rates, which also have a significant effect on the cost of living. Despite being a useful indication of the level of inflation in the economy, the CPI is not an overall indication of the cost of living.
Inflation is usually categorized using three different terms: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation. Demand pull inflation, as the name suggests, is the rise in the price of goods or services, caused by an increase in the demand for these goods or services, with the supply staying fixed. Demand pull inflation is often described as ‘too much resources chasing too few goods’. This is logical, think about a ticket being auctioned for a music festival. The more bids for the ticket, the higher the price will rise, given that the number of tickets is fixed in supply. Cost Push inflation on the other hand can be thought of as the inverse of demand pull inflation. In this case, the price of a good or service rises due to the increase in the cost of the cost of production of this good or service. The price of oil is the typical example of ‘commodity driven cost push inflation’. As oil is essential in producing and transporting goods, services and people, an increase in the price of producing oil leads to an increase in the cost of all those goods and services reliant on it. If the price of oil suddenly rose by 50%, then the price of a fare to New York would invariably rise by a similar amount. Built in inflation is the final form of inflation mentioned. Built-in inflation is inflation caused by past events, that are still in the psyche of those affected by these events. For example, an increase in the price of goods or services via cost push or demand pull inflation may lead workers to demand higher wages, which in turn leads to higher priced goods and services due to an increased cost of labor. Built in inflation may be driven by inflationary expectations, that is, if consumers expect the prices to be higher in the future, then they will increase their demand now.
Although inflation is perceived as a negative phenomenon, it does serve a purpose in the modern economy. The renowned economist John Maynard Keynes believed that a certain amount of inflation was necessary to prevent what he called the ‘Paradox of Thrift’. The idea being that if consumer prices are allowed to fall consistently, through technological advances or otherwise, then consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox would be a reduction in aggregate demand and reduced economic growth. This idea is quite intuitive. Imagine that you are saving to buy a new car from a dealership. You have saved the required amount to purchase the car, but you know that the price of the car has been falling for the past year, so you decide to delay the purchase as you expect the car to be cheaper in the future. This demonstrates why a certain amount of inflation is necessary to stimulate economic activity. However, inflation may also be viewed from the perspective of the saver. The real cost of inflation is felt by those who are holding assets denominated in currency, such as cash or bonds. From the perspective of an individual holding a bond, inflation erodes the real value of their asset. Putting this in perspective, if a government bond returns a 5% coupon, that is, if you buy a 10 year bond for $10000, you will receive $500 each year for 10 years. However if the rate of inflation is 6%, then inflation would consume the bond’s return and leave you with a negative real return . In other words, despite the 5% coupon, you would still end up ‘losing’ 1% of your purchasing power each year. Inflation is often referred to as a hidden tax, as its true impact takes years to be felt. However, the impact of inflation affects all consumers. Those who believe that their money is safe in a bank account are sadly mistaken. For example, if you had lodged 10000 in your bank account in the year 2000, this lodgement would now buy you 6583 worth of goods and services in 2021. This demonstrates the power of inflation overtime. Inflation may be seen as the inverse of compound interest, instead of your money growing exponentially over time, its purchasing power is exponentially weakened overtime.
As inflation attacks assets denominated in currency, common methods to offset this phenomenon is to invest in inflation-hedged asset classes such as gold, commodities, real estate or Treasury Inflation-Protected Securities (TIPS). However, as the return yielded from TIPS is fixed to the CPI, their value is eroded by inflation that is not accounted for in the index. Avoidance of fixed income assets, such as government bonds (with a fixed coupon) is an effective way to be proactive against inflation. Warren Buffet describes inflation as ‘a gigantic corporate tapeworm’ that indiscriminately attacks the balance sheet of businesses. The less prosperous the enterprise, the more damage that this ‘tapeworm’ will cause. Therefore, the key to creating a thriving portfolio in the face of rising inflation is to invest in companies with pricing power and a robust competitive advantage over their competitors. Businesses with these attributes that are likely to be able to raise their prices in tandem with inflation in order to maintain their profit margins and boost their dividends in line with rising prices. If you’re looking to safeguard your portfolio from inflation, identifying these companies is a great place to start. Technology companies have a distinct advantage, in that they have high margins and low variable costs.
At Aikido, our users benefit from our quantitative analysis in discovering these high quality companies. See our Magic Strategy, which finds quality companies, trading at a discount. This strategy quantifies Warren Buffet’s investment approach, and it was documented in “The Little Book that Beats the Market,” by Joel Greenblatt. Aikido does the research for you, giving you the confidence to develop a portfolio based on results showing high and stable performance which can counteract inflation.
Diversification is an effective strategy to hedge against rising inflation. In addition to buying high quality stocks, investing a fraction of your portfolio in cryptocurrencies may also be worthwhile in maintaining your purchasing power. Whilst many cryptocurrency tokens can be highly volatile, some have inherent properties that make them deflationary rather than inflationary. Take the most prominent token ‘Bitcoin’ as an example. The supply of Bitcoin is fixed, meaning that any single person or company cannot decide to issue more bitcoin at will. Decentralisation or defy are terms which are often used to describe this property of certain crypto tokens. This means that the control of the currency is not managed by any central authority, such as the European Central Bank or the US Federal Reserve. This is totally at odds with fiat currencies such as the dollar or euro. The transaction and ownership data for most cryptocurrencies is stored on a blockchain, which is a distributed ledger of information. Storing transactions on distributed databases throughout the world using strong cryptography minimises the risk of hacking or fraud, protecting your investment. Without getting too technical, one can think of cryptocurrencies as a stake against the traditional monetary system. As faith in regular currencies dwindles, due to increased money supply, as mentioned above, cryptocurrencies may offer an alternative store of value for investors looking to protect their earnings.
The Aikido team has been busy researching cryptocurrencies and will be adding some cryptocurrency strategies to the platform very soon. While our immediate goal is to build an end-to-end user flow to automate our users equity portfolio creation and management, much of our technology stack lends itself to the crypto domain. Stay tuned for some more exciting updates on this front.