All about Inflation

October 18, 2020

My Dear Reader,

With all of the talk surrounding additional stimulus packages and increased government spending, I believe that we should have a general financial baseline from which we can start to understand some of the most complex financial topics on the table today. To start, we ought to have a good idea of what inflation is. The straight line definition is that: Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some period of time. Basically, inflation is the appearance of rising prices over time, as a currency is devalued.
This is why old quotes can be so entertaining, for instance, my Grandfather used to complain about how much people would spend on cars in the 1980s.

“5,000 dollars for a used car?! I don’t care if it’s a Cadillac, you could almost buy a house for that much!”

Or the old advertisements for diners, when hamburgers cost just a dime, can be a bit jarring when we consider a 4 dollar deal to be cheap. On a small scale, this is the cost of inflation. On a larger scale, it means that even the average citizen must continuously make more money each and every year to stay at the same level of effective income that they enjoyed in the year prior.

However, there is a benefit to the constant presence of inflation and that is a benefit to a debtor. This is only when the debt is a fixed price over a period of time, but the most common example is when the average citizen buys a home with a mortgage. The effect is more pronounced with a 30 year mortgage, so we’re going to assume a 30 year loan term in this scenario
In our first scenario, we will assume that a family purchased a home in 2010, worth $200,000. Their mortgage term was 4.6, making their monthly payments worth 1,036 at the start of the loan term. However, as the years go by, the purchasing power of the dollar goes down, and yet the mortgage payment stays the same. In fact, assuming the inflation rate stays steady, by 2040, that mortgage payment will effectively be worth half of what it was in 2010. This could leave the debtor with more spendable income to use on other investments, such as their own real estate.
In order to fully understand this inquiry, I reached out to my friend Ben Mcnett and asked him, as a real estate professional, what his thoughts were on loan terms and inflation.

“Currently, the cost of 30-year fixed rate loans [sic] is lower interest cost than what most financial consultants figure into their clients retirement accounts for annual cost of living increases. That means borrowing money is cheaper than usual. As of today (15 October 2020) a 30-year fixed rate mortgage is at 2.9%, the annual return on the S&P 500 is 5.13% and closed/sold property values in Williamson County (‘Wilco’) are up 7.8% year on year from 2019.”

I believe that Ben’s points in this situation point to the fact that real assets are even stronger when paired with historically low rates. This is because the effects of inflation do not directly affect the economics of a local area that impacts a piece of real estate.

To punctuate my article to you, I also want to explain the effect that inflation has had on traditionally safe investments. With Junk Bonds negative yields also in the news, and in order to make sure we’re on the same page I’ll throw out a simple definition of a junk bond. As the name implies these are bonds that are not up to the same standard that typical government or corporate-issued bonds are. However, because of this, they have a typically higher yield than other bonds. So when these bonds start going negative, we can safely assume that regular bonds are going to have a negative yield shortly. It could mean that there will be trouble down the road for those who have a slightly safer portfolio position, and for those who use junk bonds to act like little “morganizers” The incentive to purchase the debt on the performance of a company becomes less and less attractive. We can see this trend play out among the larger portfolios that many Americans rely on.
To wrap up this discussion, I reached out to Brian Adams, to talk about the added effect of inflation, due to government spending, and he made this point:
“Government debt has soared to levels not seen since World War II, as countries worldwide boost spending to battle the new coronavirus. Among advanced economies, debt rose to 128% of global gross domestic product as of July, according to the International Monetary Fund. In 1946, it came to 124%. Real rates can’t go higher because our debt service would be impossible This is why we are in a low / no rate environment until GDP rises enough to grow out of our debt problem”

Essentially we’re stuck with low mortgage rates and no safe place in many traditional funds. This is great for those who may want to be aggressive, but not so for those who want to play it conservatively, moreover, I believe that it will further push those who are not financially literate behind those who are.

To Your Freedom and Potential,

Kevin Prendiville