Investors Should Take Note Of Higher Inflation Rates. Here’s Why
One of the biggest buzzwords in the investing world is inflation. Investors are always talking about using their investment returns to beat inflation. What happens then, if the expected inflation rate becomes higher in the future? How is that going to affect our investments, and what are some factors investors should take note of?
In Episode 91 of The Financial Coconut, Reggie breaks down the idea behind higher inflation and 3 factors that can affect your investments. Don’t worry if you are unfamiliar with the concept of inflation as Reggie begins this episode with a clear explanation on this topic. He also shares a very helpful video recommendation too.
Based on the premise of a higher inflation rate in the future, he then shares how we should assess growth stocks, cash flow generating assets and debt instruments that are already issued in the market. Tune in to find out which one will become more valuable, which one will become less valuable (!) and which will be discounted much higher.
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Reggie: Hey Coconuts! So yes, recently there’s been a lot of talk about inflation, and I know many of you guys are concerned about how inflation is going to affect your investments. To shape the discussion a little bit, you need to recognize that it is really about the expectation of higher inflation that is shaking the market and not inflation in itself.
The Fed, Federal Reserve, which is the US central bank, which is the biggest central bank in the world, actually has an expectation of setting inflation rates at about 2%. They say they want to go below 2% but it has been a little bit messy thing going on with them, but generally the idea is they want to keep inflation low and consistent, and there’s a reason why. We’re going to talk a little bit about all of these and how does this whole discussion around inflation going to affect your investments today?
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Good morning everyone! I welcome you to another day with The Financial Coconut. In our podcast, we’re debunking financial myths, discovering best financial practices and discussing financial strategies that fits our unique life. You get it, ultimately empowering us to create a life we love while managing our finances. Today, we’re going to spend some time to talk about how higher expected inflation rates are going to affect our investments.
Okay, before I go further, I want to put it out there that today we are not going to talk about what is the causes of inflation, what are the effects of inflation on your life. It’s too complicated, there’s too many caveats and things to understand before you can have a very good grasp of what is inflation, how does the economy work. I’m just going to link you to a video. Check out Dalio’s video on how the economy works on YouTube. Just go and search “Ray Dalio how the economy works”. I think he has a pretty good video over there to share with you a certain way to look at the economy as to how money is being created, how the money moves around the economy and how does that then form the whole economy in itself.
Of course, when there’s too much money chasing after too little goods, inflation happens and that is what a lot of people will tell you out there. (It) essentially means if there are only 10 apples, it used to be $10 moving around a market, every apple will be maybe let’s say, $1, assuming everybody is a rational thinker in economics. Everything assumed rational thinker… but it’s not the reality. People are not fully rational. [laughter] You know, people do all sorts of weird things, like umbrage… but anyway.
So yes, assuming people are rational, 10 apples, $10. Every apple goes for a buck. That forms the whole economy. But suddenly everybody has $10 now, but there’s still 10 apples and you want to buy up all these apples. You will bid up, right? Everybody will bid up and the cost of all these apples will go up. So the price that is transacted goes higher, and that is an effect of inflation on the day-to-day consumer goods.
That being the very simple, basic understanding of inflation, that is how most people will embrace inflation. Even the auntie downstairs will tell you “wah, inflation, inflation. 通货膨胀 (inflation)”. Essentially, what they are saying is the meat is getting more and more expensive, the vegetables getting more and more expensive, things are getting more expensive.
But I want to introduce you to another way of looking at inflation, which is that your money is getting smaller. Price is going higher… is one way to look at this thing. The other way to look at inflation is that your money is getting smaller. Why is this a better way to look at inflation when you’re understanding investments?
Because when you’re buying investments, you’re really trying to make money and it’s not an end point of transaction. You’re not trying to buy Apple share because you want to own Apple share. You are are trying to buy Apple share because you believe that by buying Apple’s share (by the way, not a recommendation, just a random example), you will continue to profit into the future to make more money into the future, so that in the future, you’ve got more capital to do more things.
A better way to look at inflation when it comes to investing is really your money getting smaller over time. Based on this idea of your money getting smaller over time, what does it tell you? It tells you that money today is worth more than money into the future, which is why when people talk about investing, people always talk about beating inflation. If inflation rate is at 2-3%, which is not always the reality, it is just something that we’re so used to and comfortable with to take it as an assumption. But I’m going to take it as an assumption. So 2-3%, year on year inflation rate, people always talk about beating inflation. So if you can make 5% year on year, 6% year on year, you are making actually net net, including inflation, your portfolio is really growing at only about 4% real value.
What does real value means? A lot of terms, right? Real value really means that when you take this money to go and spend a market, what can you buy? Because goods are getting more expensive, right? Assuming inflation, goods are getting more expensive, 2% every year. Your investments make 6%, but the goods out there in the market in a year’s time is 2% higher. So you are actually only having 4% of real growth in your total capital that you can use into the future. Does that make sense? I hope we are still here [laughter]
Okay, I’m going to use a real example. Let’s say you want to buy an apple. The price of the apple is $1 today, and you have that $1 to buy this apple, but you choose not to. You want to invest your $1 so that in the future, maybe you can potentially buy more apples. So what’s the reality? Your apple today cost $1, right? The price of the apple is $1. It grows at an inflation of 2%. The next year, it will be $1.02. That will be the price of the apple and your investments are going at 6%. So at the end of one year, your investments become $1.06. So at end of year one, assuming you invest for 6%, the apple goes out at 2%, at the end of one year you decided that “okay, now I feel like eating apple. Suddenly I very ‘feel'”.
I take my investments, I go and buy the apple. I have a surplus of $0.04 sitting around because my investments now is $1.06 in total, the price of the apple is only $1.02. I actually have extra $0.04. That is the real investment return that I’ve made. So if you extend that over a long period of time, over like 30 years, you will see a much, much bigger difference of how investments can change your life and also how inflation can compound also over time.
Okay, enough of the apple oranges and fruit stall uncle downstairs. But the idea here is that money in the future becomes less valuable than money today. So what is the discussion ongoing in the media circuit? There’s a lot of talk about higher inflation, right? It’s not about inflation in itself. People are extremely okay with 2-3% inflation, and I tell you, people will be okay with 4-5% inflation if that was the norm. That is the thing about the markets and economics and all these kinds of stuff. People are extremely okay once things becomes consistent. Of course, it will create other set of problems. But as long as things are consistent, it rarely shakes the market.
It is when things are changing that prices will then change along and then the markets will start to move and you see growth stocks coming down. You see bond use going up etc, all these kind of stuff happening in the market recently… past few weeks. This is the idea of expectations of higher inflation rates. But that’s not to say high inflation rates are already here. It is really the expectation of higher inflation rates that is driving the markets in all these different directions. The markets tend to be ahead of reality, they’re always trying to capitalize and price in the future. I always hear this word: pricing in the future. It essentially means they’re trying to look at all these factors and try to see how we can beat the market, how can we do better than the market itself? There’s a whole sector called financial markets.
So that is the idea here and if you think about it, essentially these guys are trying to predict the future. If you believe that their prediction is wrong, that means you believe that inflation rate is going to stay about the same, or it may even come down, you can take opposite directions from them and maybe you will profit even more than these guys, because they are already pricing it into the markets. This is a discussion for a whole other day, but think about it, right? Everybody is just trying to bet into the future. It is an expectation, inflation rate have not happened… or at least higher inflation rates have not happened to be exact.
But based on expectation of higher inflation rates, or if let’s say inflation rates really go up, how’s that going to affect your investments? Number one is growth stocks will be discounted much, much higher. What does this mean? Because growth stocks are all your Lemonade, your Square, all these companies that Cathie Wood is buying, essentially they are all not profiting as much. They’re not generating cash, they’re reinvesting their cash into their business and they’re trying to grow, grow, grow, grow, grow. They are doing all these growth strategy, spending a lot of money and burning a lot of cash. They are not generating cash for you or for the business itself because every single dollar goes back into investing. Some of them are running negative earnings.
What are they trying to do? This is a new way of running business, which is to grow market share. Once they have a bigger market share, then they can do all the interesting things to make money from you. It’s kind of like how Facebook did it. In the past. everything is free. Today it’s free, but because they’ve grown so big, they managed to monetize our existence on their platform in all these different ways of advertisements and business processes at the back and all these different things.
If you want to learn a little bit more about Facebook, you should sign up for our members backend. We had a good discussion about Facebook. Yes… not so shameless plug [laughter] I mean, it’s our show. No need paiseh (to feel embarrassed), okay?
But the reality is… back to the discussion. The reality is because all these growth companies are growing, growing, growing 5 years, 10 years into the future, they’re not really making money in the next 5 years, 7 years, 10 years depending on which stage of growth they are at. So by the time they start making money, that money is going to be much less valuable than it is today.
To give you some context, assuming in 10 years time, these growth companies start making money… okay, not everybody take 10 years, but let’s say, we assume these growth companies take 10 years to make their money, to make that first dollar. The dollar today and the dollar in the future is different, right? Like we have established, money into the future becomes less valuable than money today. That is how I see inflation, that is the concept we’re going to base on.
What is the money going to be like in the future relative to the money today? If inflation is at 2% year on year for 10 years, the first dollar that they’re going to make in 10 years’ time is actually only worth $0.82 in today’s value. That means the $1 that they’re going to make for you in 10 years time, if you look at it today, it’s only worth $0.80. It can only buy $0.80 worth of things, or $0.82 to be exact.
So that is 2% inflation. But if it’s 5% inflation year on year… because that’s what analysts are concerned, right? They’re concerned about higher inflation rates. So let’s say inflation rate is going to be at 5%. We just assume, we don’t know yet. Assuming it’s a 5% for the next 10 years what’s going to happen is that the dollar that these growth companies are going to make for you in 10 years’ time, on a 5% discount year on year because inflation, it’s going to be worth $0.60 today. It’s very, very drastically different.
When you look at it, this is why growth stocks are being sold down, because a lot of them are not making money yet. You buy them on the promise that they will make money into the future because they’re building this amazing platform, they’re going to change the way business work and they’re going to start making a lot of money for you into the future. But if inflation rate goes higher, the money in the future is much, much lower.
Because of compounding, this thing is an exponential thing also. It is not a linear thing. It’s not like minus $0.02, minus $0.03, no. Compound, multiplier… so 5% is going to compound by the time it’s the 10th year. The money is not as valuable, that’s why growth stocks are being sold down. That’s the idea behind it.
But of course, yes the economy does not work in a vacuum. Businesses do not work in a vacuum, markets do not work in a vacuum. It is not a single factor thing. It can be because the economy is opening up, the real economy is opening up. People are going out to spend, so maybe tech companies will not be able to grapple as much of the market… whatever. All those things, they do add up.
Based on the recent discussion about a fear of higher inflation, if that is really the case, why prices are being sold down? This is the reason why: because the dollar in the future is worth lesser and growth stocks are not going to be making money until 5, 6, 10 years later. So higher inflation rate is going to be much, much higher discount on the dollar that they’re going to make.
But this is the interesting part: if you believe that inflation rate is not going to go up as much, or not going to go up, it’s going to stay constant, then hey, this may be a good time to bet against the market. If you think about it, that is the idea of betting against the market. The market believes higher inflation, they sell down growth stocks, but you believe that “oh, maybe it’s not… inflation is not going to go up as much. It’s an over concern, and I also believe that a lot of these growth stocks will continue to double down because COVID is going to be here to stay for longer. More people are gonna adopt more tack and more people are going to work from home more and do all these different things. The growth story behind these growth stocks may be able to beat the inflation. It’s going to be even higher” then hey, maybe this is a time for you. Maybe this is an opening for you to rack up on these growth stocks. That’s the idea of betting against the market.
That is the part about growth stocks. I know a lot of people are very concerned. We’re going to go into the next investment class, which brings me to point number two and that is cash flow generating assets becomes more valuable today. We’ll talk about this after a word from our sponsor.
Following that same train of thought, money in the future becomes less valuable than money today. What does it mean? The other side means that money today is more valuable than money into the future, which is why you will see value stocks, you will see cash flow generating stocks. I try not to use the word ‘value’ too much because there’s a little bit of assumption behind value stocks. We just use cash flow generating stocks.
Stocks that are… companies that are generating very good cash flow today, or businesses that are generating very good cash flow today will be priced up because they are making more money today and then you can take the money and continue to invest. If you think about it, the money comes to your hand first, then you keep compounding and investing, then yes, you can have a better chance of beating inflation compared to the money coming in 10 years later.
Which is why, despite the whole discussion of a higher inflation rate, a lot of these big companies that are generating cash flow like Apple, Amazon, Facebook, Disney, a lot of these companies, they’re huge, right? Even Sheng Shiong here, Sheng Shiong just went up 15% because everybody go buy toilet paper…. but anyway. A lot of companies that are cash flow generating and they make a lot of money now… not into the future. They will get priced up because every dollar that they make today is going to be more valuable.
It’s the case for REITs, it’s the case for dividend plays, it’s a case for all these different companies, as long as they’re making money. Even if you buy a tuition centre downstairs, that’s an investment, right? That is a business. If the tuition centre is already making money, every dollar that it makes today is going to give it an advantage to go into the future because the dollar in the future is going to be less worthy.
So you may see a higher value being priced into a lot of these cash flow generating businesses and they may be bidded up. I’m not sure exactly how is that going to play out, but yeah, you will see. If inflation rate goes up or if inflation rate… expectation continues to go up, then a lot of these cash flow generating assets will get bidded up because they become more valuable relative to these other companies.
But bear in mind, (the) market is not an individual factor kind of thing. There are many factors in this, so don’t go and randomly buy some big names because you think “oh, you’re a big name doing very well.” [laughter] You realize a lot of big names are not doing that well, they’re not really making money.
It’s not about value, it’s not about big names. It’s about whether or not these companies are generating cash. If they are generating a lot of cash, then there is a premium attached to them, given an expectation of higher inflation or given an environment of higher inflation in the future, which brings me to point number three: debt instruments that are already issued becomes less valuable. Caveat, important: is that “already issued”.
If you think about it, if we go into the future in an environment where inflation rates are much higher, that means inflation today is 2-3%. But if inflation is 5- 6%, why would I want to lend you money at 2-3%? I will definitely want to lend you money much higher, but then you will ask me “you know, now inflation rate is 2-3%, but interest rates are at 1% or 1-2%. Why?” This one is a whole big story another day. But generally the idea is because the central banks and the broader financial markets are trying to stimulate lending. They’re trying to stimulate the economy. So they set interest rates very low, people will lend and then divert this money into the real economy and keep it growing. If you want to understand this a bit better, definitely go and watch the Dalio video on how economy works.
The basic idea is that if inflation rate goes up, I will want to lend you at a much higher rate. There was a time when endowment plans were paying 10, 12% year on year. Why? Because inflation rates were very high at that point in time, so it makes no sense for me to lend you money much lower. But like I said, debt-based instruments are very complicated and they have their whole discussion on themselves.
We’re not going to talk about future debt instruments that will come up, but we’re going to talk about debt instruments that are already out there, already issued. Why do they become less valuable? Same idea, because money into the future becomes less valuable and a debt-based instrument is exactly that thing where I lend you money and then you pay me in the future. Assuming that inflation rates are going to go up, which means money in the future is getting smaller than what it is today, then the instrument which is the debt or the bonds, it’s gotta be less valuable, right? It’s not as valued already because by the time you pay me back, the money becomes lesser. You get the idea?
Which is why you hear this discussion about bond use rising. Yes, I know, the bond market have their own lingo: coupon, yield, maturity, all those kinds of stuff. If you need a better idea, check out the one, the Chills with TFC episode with Chuin Ting (Chills 6) that we did. I’m going to get her on again to talk a little bit more, to comment about this situation.
I’m going to attempt today to try to explain to you how this works. Assuming I’m an institution and I have $100 000, I want to lend to the government. The government is giving me a bond coupon of 2% year on year which means that once I lend the government this $100 000, every year, they will give me 2% interest on this bond, and then at the end they will pay me back the capital. Some arrangements may be different, but this is the general idea. So after 10 years of 2%, 2%, 2%, the total value of this bond will be worth $121 000, from my $100 000 to $121 000 in 10 years.
This is the upside, the max cap, top, if I hold from the start to the end. But what happens in the bond market is after the person buys… the primary dealer, the first person that buys these bonds, they then take the bond and package it and sell in the secondary market or they sell it the secondary market directly.
What happens is the obligation from the bond issuer, which in this case is the government, they don’t care about what happens in the secondary bond market. They will only give 2% to whoever that still holds the bond and that’s it. That’s all they care for them. So we put them aside.
Now we look at a secondary bond market. So this is when the higher inflation rate comes in. When higher inflation rate is expected, money in the future becomes less valuable or expected to be less valuable. The bond today becomes less valuable because the money that it’s going to generate is capped. The maximum upside is fixed, 2%. The primary guy only going to give you 2%… does not matter what happen. But because inflation is going to be higher, this thing that you own now, the bond, is going to be less valuable because it’s not going to be generating more money and you’re locked into this bond.
So then you will start to see bond prices come down and inversely, you see bond yield go up. That is the whole idea because when bond prices come down, the total yield that you can make from this bond if you enter now becomes higher. Very 乱 (confusing), I know. I will not attempt to try to explain everything in a lot of detail, but I think the Khan academy on YouTube has a very good video about bond yields. So go and check them out, the whole idea of bond yields. They’ll give you a better idea because… got drawing, got everything. It’s much more facilitated.
This is the idea because the bond becomes less valuable into the future as inflation rates go up. Which brings me back to the point of you can bet against the market. So if you believe that inflation is not going to be higher, you can buy bonds and you may be able to make very good percentage, 5, 6, 7, 10% just because you decide to bet against the market. You believe that inflation is not going to be higher.
Wow, welcome to the world of investments. It gets very exciting. These are… some of these general ideas as to how expecting higher inflation rates is going to affect your investments, all centred on one idea that money into the future becomes less valuable than it is today.
So I’m going to sum up today’s episode. I hope you are still here with me, following through. Number one is growth stocks are going to be discounted because the dollar they’re going to make in the future is going to be much less valuable in an environment of higher inflation rate. So you see all these discount factors coming in and you see growth stocks coming down.
Number two is cash flow generating assets today are gonna be becoming more valuable because every dollar that you make today becomes more valuable. You can invest that dollar and then you can potentially beat inflation rate because every dollar is coming in now.
Number three is debt instruments that are already issued becomes less valuable. But like I said, you can always bet against the market and you may be right, right? Investing is a world of wonders and rainbows and all these interesting things. There’s an endless discussion. I hope you learnt something useful today. See ya!
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Woo! That was a long one, yes. Like I said, I did my best to try to give you my thoughts about the potential inflation. How is it going to affect your investments? It all leads back to one idea, right? I’m not going to repeat again. I know, I keep saying the same thing, but yes. Take this idea and look at all the investment tools and you will be able to get a much clearer idea as to what is going on.
Also, I want to really take this time to shout out for our members backend. You will keep hearing ads about members backend going forward, but yes. At this moment in time, we are trying to make this a sustainable venture so that we can continue to build great content for you. Instead of just wooing advertisers and constantly back and forth discussing with them, I really want to build this platform focused on you.
So if you want to help us and empower us to continue great content for you, to empower you, then hey, join our members backend. Join the community so that we can continue to build great content for you. You can get to know people in the community and we can organize live discussions amongst ourselves and just focus on ourselves and not talk about consumer agenda, blah, blah, blah, blah, blah.
When we talk to advertisers, always got this kind of stuff. Okay, not all advertisers are bad, but they always have their own goals and sometimes it’s just very tiring to try to talk to them about understanding where we come from, blah, blah, blah. But that being said so far, our advertisers are very, very nice with us and they’re very cool. Because if they are not cool, they will not use us.
The idea is: support the backend, support us and yay. What are you waiting for?
Later this week, I’m going to be spending time with Max Keeling from Providend and by the way, Providend has been great. Very liberal with us. They let us say whatever we want to say… everything, so that’s cool stuff to them. Shout out to Providend.
So yeah, later this week, I’m going to be spending time with Mex Keeling, which is the head of expat advisory in Providend. He’s the only one… [laughter] he’s quite funny, but yes, we’re going to talk about the power of early retirement or mini retirement to be exact. So he believes that you go through a lot of career changes and I also believe that you will go through a lot of career changes. This is a new normal, right? 10 years will be a new career cycle or 15 years, or maybe even shorter will be a new career cycle. And in that sense, people will go through multiple retirements.
So if you go through multiple retirements, hey, why not make use of it, right? How can we live our lives better as we go through these multiple retirements? What is the benefit of mini retirements? That’s what we’re going to cover later this week.
Next week, I’m going to be talking a little bit about investing in yourself. I actually am very against this idea of investing with yourself. So next week will be a quite a fun episode. We can talk about this mindset of investing in self.
I have a lot to say about that. You are not an investment, okay? Just to make my stance clear. You should love yourself for what you are. Don’t keep thinking of yourself as a productivity machine that you’ve got to invest and keep producing more. Okay, that’s it for today. Next week, we’re going to spend time to talk about why I don’t believe you should invest in yourself. Meanwhile, take care! Stay healthy and see you for our lives.
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