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Inflation Nation

By Logan Flatt, CFA

    It’s more than just Texas springtime temperatures and global warming you may be feeling: the U.S. economy in 2007 is on the verge of overheating.

Real Estate Bird Watching

    As I travel on business to cities across the United States each week, I spot large flocks of cranes hovering over many a new oasis of Class A office towers and luxury high-rise condominiums. Dallas is no different. Take a drive along Woodall Rogers Expressway near downtown and count all the cranes and newly-built towers you see in the skyline around you. That infamous verb from Dallas’ real estate history – “overbuilding” – comes to mind.

    After its six-year injection of cheap, easy money into the veins of the U.S. economy, the Federal Reserve Board has cut back the economic steroids of low interest rates by yanking the Fed funds rate up 17 times since June 2004, from a 46-year low of 1% up to today’s 5.25%. Yet, like a doped-up bodybuilder, the U.S. economy rages on: corporate earnings are at record levels; consumer borrowing and spending remains profligate; the Dow Jones Industrial Average floats above the psychologically important (but fundamentally meaningless) 13,000 threshold; the U.S. unemployment rate hovers at a six-year low of 4.4%; and real estate developers continue to put new cranes high into the sky. Clearly, our American sense of optimism is flexing mightily, showing off its muscles from all the best angles.

The Pressure Builds

    Unfortunately, exuberance extracts a price. America’s tightening labor supply is requiring companies in many industries to pay higher wages to attract and retain employees with the right skills and talent. In turn, some companies are raising the prices of their products and services to help offset the higher wages.

    At the same time, politics and violence in the Middle East, Venezuela, and Russia keep adding to the global uncertainty that is pushing up the price of oil and natural gas. Breakneck growth in the developing economies of Brazil, Russia, India, and China continues to put upward pressure on prices of other key input commodities as well.

    To make matters worse, the U.S. dollar has weakened severely against other major currencies over the past year. The U.S. dollar just doesn’t buy as many Euros, Yen, and Pounds as it used to. So, Americans must use more dollars this year to buy the same imported goods from Europe and Japan that they bought last year.

    Perhaps most damaging of all, our elected officials in Washington, D.C. keep spending hundreds of billions of our hard-earned tax dollars – from both this year and, through debt financing, many years to come – like drunken sailors on shore leave. All of the billions our federal politicians bond out and then push into the U.S. economy through government procurement contracts only pours gasoline on an already raging economic fire.

    In short, we have a U.S. economy awash in cash, a U.S. dollar beaten down by foreign currencies, and global commodity prices near record highs. The specter of a dastardly economic demon – inflation – rears its ugly head.

The Ravages of Inflation

    Over time, inflation degrades the purchasing power of a $1 bill. Decades ago, the price of a loaf of bread was a mere nickel. Back then, you could buy 20 loaves of bread for $1. Today, the price of a loaf of bread is at least $2.00. For a $1 bill today your baker will hand you back just half a loaf. The bread didn’t change; the value of the $1 bill declined.

    The erosion of purchasing power caused by inflation is why investing for the future is an absolute requirement for a financially successful life. For your investments to maintain for the future the purchasing power you enjoy today, the average annual rate of return on your investments must exceed the average annual rate of inflation in the general economy. To get ahead financially over the long term, your investment returns must trounce the rate of inflation by a wide margin.

    We could run into real trouble if inflation accelerates and spirals out of control. Remember the hyperinflation rates of the 1970s and early 1980s? If inflation in the United States takes off in 2007 like it did from 1973 until 1983, the Fed will be compelled to crank interest rates up significantly – not unlike what Federal Reserve Board Chairman Paul Volcker did back in 1980 - 1982 to squelch rampant price inflation.

What If Interest Rates Increase?

    A significant increase in interest rates could be disastrous for investors in stocks, bonds, or real estate. When interest rates go up, holding on to stocks, bonds, or real estate becomes relatively less attractive: why leave your cash tied up in assets that carry a real risk of loss when you can instead stash your cash in low-risk money market funds or FDIC-insured bank CDs now paying an attractive rate of interest? Consequently, market prices of stocks, bonds, and real estate could fall dramatically as owners wanting to exit these investments struggle to find buyers willing to enter them.

    What can you do to help insulate your investment portfolio? Ask your financial adviser about investment alternatives that can offer positive rates of return during periods of high inflation and interest rates. Short-term Treasury Inflation-Protected Securities (TIPS) and inflation-adjusted Series I Bonds are the safest. Some riskier alternatives include publicly-traded investment trusts that quickly translate price increases into benefits for their unit holders, such as oil and gas royalty trusts; gold, silver, iron ore, and other commodity trusts; and real estate investment trusts based on short-term leases and rental periods, like many apartment, hotel, and storage unit REITs.

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NOTE: This article first appeared in the Spring 2007 issue (Volume 5 Issue 2) of The Swan, a publication of the Lake Forest Community Association, Inc., a nonprofit Texas corporation (www.lfhoa.com).

Copyright 2007 PowerWealth.com. All rights reserved.

To Consume, Save, Invest, or Speculate? That Is The Question.

By Logan Flatt, CFA

    I believe it was Shakespeare who once mused:

        Many Americans know not where their money goes

        To consume, save, invest, or speculate?

        That is the question to be posed

        Before thy money is gone

        To question early in life is to see thy freedom grow

        Save a nickel, a penny more

        To consume, save, invest, or speculate?

        That is the question to explore

        Before thy breath is gone

        To question later in life is to depart ‘mid the poor

    Okay, perhaps Shakespeare never penned such awful poetry, but the message is sound. To consume, save, invest, or speculate? It is an excellent question. Before you answer, consider your options.

You CONSUME when you choose to exchange your money for something of little lasting value.

    We are all consumers. We must buy products and services just to get by. However, consuming destroys our wealth. When we buy a product or service, we shift a bit of our wealth into the pocket of the seller by handing him more dollars than he spent on the product or service he hands over to us. The difference in dollars is the seller’s profit. In exchange, we end up with a product or service worth less than what we just paid the seller for it. Worse, its value falls rather quickly – even down to zero if we consume the product or service in full.

    Profit is not a bad thing. Sellers deserve a profit for providing value to consumers. A bad thing is consumers consuming excessively. Too many Americans today give too many dollars – even dollars borrowed from banks – over to sellers in exchange for products and services of little lasting value. Across billions of transactions each year, sellers collect mounting slices of our wealth. Consumers, in turn, collect mounting piles of worthless objects and wistful memories.

You SAVE when you choose to avoid, reduce, or delay exchanging your money for products and services.

    Many of us are savers. We save money when we keep a little – or a lot – of our cash income in our bank accounts by taking control of our exchanges with sellers. Just because sellers offer us cool, fun, or interesting things doesn’t mean we must possess or experience these things to live a fulfilling life. How many times have you rushed out to see the latest Hollywood movie only to leave the theater thinking, “Well, that was a waste of time and money”? Yet, the time is lost forever and your money is in the pocket of the ticket seller.

    Time and money are essential ingredients to building wealth. While many Americans seek to “get rich quick” with “no money down,” financial freedom begins with our own cash savings and a large dose of patience. Compounding interest, dividends, earnings, and gains from wise investments will, over time, offer us a greater chance at financial freedom than years of playing the lottery ever will.

You INVEST when you choose to exchange your savings for an asset you know is worth far more than its price.

    Some of us are investors. We invest when we exchange our savings for assets worth significantly more than the price we pay for them. Why would someone want to exchange his valuable assets for our smaller cash savings? Time and money. The assets may be valuable because, over time, they are expected to put significant cash flows – dividends, interest payments, royalties, net rental fees, etc. – into the pockets of their owner. However, the owner may not want to wait for time to pass before he can pocket the cash flows himself. Instead, he prefers to pocket our smaller cash savings right now.

    Think of it as paying $10 for a $20 bill. No doubt the $20 bill is worth $20, but the seller’s price is only $10. We pay the seller’s $10 asking price and instantly own an asset worth $20. Such an exchange is how we wisely invest our savings in assets like stocks, royalty trusts, small businesses, and rental properties. If we repeat these exchanges over and over again, we become wealthy. This is how the world’s wealthiest investor, Warren Buffett, invests his billions. How does he find such great deals? Speculators hand them to him.

You SPECULATE when you choose to exchange your savings for an asset you have not reasoned its worth.

    Many of us are speculators. We speculate when we willingly exchange our cash savings for assets the worth of which we do not know. Speculators do not take the time to study an asset and determine its worth. Instead, they just pay the seller’s price and hope that the price will be higher later. Some speculators speculate and make millions. Many, however, lose their shirts by hoping that luck – the gambler’s unreliable friend – will save them from total loss.

    Ironically, speculators make America a great place to invest. The speculator soon forgets the valuable assets he owns when he jealously watches an asset he does not own increase dramatically in price. To quickly raise the cash he needs to buy the increasingly expensive asset he covets, the speculator willingly sells his valuable assets at discounted prices. Always on the lookout for a bargain, the investor stands ready to scoop up the speculator’s valuable assets at prices well below their worth. This is how speculators transfer their wealth to investors like Warren Buffett, who patiently grows wealthier every year.

    If you consume in moderation, you create cash savings, which you can invest in assets sold to you at bargain prices by those who speculate. To consume, save, invest, or speculate? How you answer the question is up to you. May I suggest you leave the poetry to Shakespeare?

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NOTE: This article first appeared in the Winter 2007 issue (Volume 5 Issue 1) of The Swan, a publication of the Lake Forest Community Association, Inc., a nonprofit Texas corporation (www.lfhoa.com).

Copyright 2007 PowerWealth.com. All rights reserved.