Inflation can do to your financial health what Diabetes can to your bodily health

Inflation can do to your financial health what Diabetes can to your bodily health

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Understanding inflation has to be our first step when we wish to build a holistic life plan for ourselves – I say this because it has this horrible habit of sneaking up on us from the back and derailing our financial workings. 

We are currently going through one such cycle in the global economy; when inflation is down at an all time low following (amongst other things), the drying up of Chinese demand for commodities. So much that, deflation (when prices fall, depressing the economy) is feared and central banks in the world’s three most developed economies (the US, Euro Zone and Japan) are struggling to bring back inflation so that, they could revert back to normal monetary policy.

An economic concept: Inflation is a sustained increase in the general level of prices of goods and services in an economy.

  • This also means that, your savings deplete in value. Therefore, if you have cash in hand of Rs 100 and you get no interest when the inflation is 10% – your savings will end up being worth Rs 90 only.

The Reserve Bank of India too has declared that our retail (Consumer Price Index) inflation plunged to its lowest reading in June 2017.

So, can we now rush off to the roof tops and declare “Inflation to be dead”?  Wait! 

Don’t be in a hurry to answer that before you examine the graph below.

You will see that, the inflation rate in India averaged 6.97 % between 2012 and 2017; with a high of 12.17% in November 2013; as against the record low of 1.54%. in June 2107.

Looking forward, we estimate Inflation Rate in India to stand at 3.80% in 12 months’ time. In the long-term, the India Inflation Rate is projected to trend around 4.80 % in 2020, according to our econometric models. Click here

Why am I sure that, inflation will never die? because

  • Economic growth is invariably cyclical, when higher demand happens and also sees more money chasing the lesser goods. That’s because wages go higher during good times and consumption goes up as people in that economy gain confidence in their future economic well being and therefore, save less and spend more..
  • Moderate inflation is easy to pass on to consumers by increasing prices, leading to higher corporate growth and profits  .
  • More importantly, governments also want inflation because, it reduces the value of their borrowings. Many governments therefore, stealthily follow a negative real rate policy (economically repressive monetary policy) to pay for the fiscal profligacy resulting from populous actions.  In such cases, retaining negative real interest rates for a longer time, results in people losing faith in financial instruments and move into physical assets like real estate and gold ( something clearly demonstrated during India’s previous political regime).

What is the relationship between rates of inflation and interest?

Interest rates can be seen as a compensation paid for “renting” your money to banks or companies who borrow it in form of “deposits” (of course, it’s a bit more than that because you have to also get paid for the liquidity you give up, the credit risk you take and so on – but that’s not the point here).

It would suffice to say that, interest has to compensate you for the value you lose (over the period of your investment) due to inflation.

That brings us to the concept of “Real rates of interest”.

Therefore, unless the interest rate paid on your bank deposits, company deposits or bonds – is more than the inflation rate on a post-tax basis – your money is losing value.

So, can we predict how inflation rates will move in the future and over the time horizon of our life plan?

I am not sure about others, but I am absolutely certain that, I cannot – because, whenever I have seen data on historical inflation rates, I haven’t  been able to identify any secular trend in the short to medium time periods. However, I would never hazard a guess and bet the financial viability of my life-goals on a prediction even if I did make one.

“Equities ‘the only hedge’ against inflation, according to top investment trust manager”

“Nifty may double within 3-4 years: Lower interest rates in recent times have prompted local investors to invest in equities, shunning traditional investments such as bank deposits. “As interest rates come down, as the deposit rates come down, people will begin to look at other alternatives, other ways to make money. That will also drive people to equity markets,” Published by a leading India financial paper: Sun, Aug 06 2017 and mouthed by a high profile emerging markets, fund manager. These guys almost make it sound as though there some sort of fire driving me out of my safe bank deposits!

This warning sign is meant for exactly such times when you come across advice like this.

REMEMBER THAT, A DROP IN THE RATE OF INFLATION DOES NOT MEAN THERE IS A DROP IN PRICES – IT ONLY INDICATES THAT PRICES ARE NOW GOING UP AT A LOWER RATE !

Therefore, when interest rates fall in response to reduction in inflation, it naturally reduces the income generated by their bank deposits, even when prices and cost of living stays the same. It’s those conservative senior citizens and retired folks who get impacted the most and will sadly be left with no choice other than to reduce their cost of living.

The fear of dropping standards of living or even cutting on essentials, has driven many a hapless retail investor straight into the arms of the Wolves of Wall Street (or should I say Dalal Street?) – who make headlines and high profile TV appearances, aided by their PR machinery driven by huge ad-spends to hard sell the myth that, interest bearing investments (especially bank deposits) are inappropriate whilst, investments in equity are a panacea of sorts for all their income/returns woes.

These retail investors, retired folk and senior citizens should remember not to “risk their savings capital” in the pursuit of increased income which is more a hope riddled with uncertainty.

I have always believed that, such misleading headlines are actually far more harmful than any “mis-selling” which financial product distributors are accused of. The bubble head to whom such quotes are attributed to will undoubtedly mouth a few well crafted lines to cover his grandiose headlines from crossing regulatory borders.

However, the money spent on this multi-media push hardly surprises me because retail investors are aggressively sold equity when its almost the wrong time and worse still without any reference to personal preferences, risk taking ability, financial limitations and life-goals. Why? Because, equity products are the most paying to the distributors, asset managers and their staff !

My back of envelope analysis of historical data of past 29 years (1987/88 to 2015/16) shows that;

  • Average of, yearly average appreciation in BSE 100 = 16.09%
  • Average of, yearly average appreciation in CPI = 7.90%  (Max 13.5% and Min 3.4%)
  • Number of times the CPI has beaten the BSE 100 = 14 years
  • No. of times the BSE 100 has beaten the CPI = 15 years  (Totaling  up to the 29 years)

Yeah – it does look deceptively true when we look over 29 years!!

However, it’s occurrences in the shorter and medium term which actually impact the thinking of ordinary investors; simply because we cannot exercise the high level of unemotional discipline associated with professional investors when reacting to economic and market events. And therefore, any bets on equity, for being an all seasons hedge against dropping interest rates and inflation , are at best evenly squared.

To conclude: 

  • The only thing I am certain of when it comes to predicting the future is that, I will be wrong. That’s because, the future is uncertain and inflation is one of the important reasons which makes it such.
  • A conservative rate of inflation (ideally 25% over forecast by a reputed economist – today I would work with say 5%) should be assumed when working out the financial aspects of your life plan. Needless to say, I will always be willing to review and adjust this assumption.
  • Earning “post-tax real returns” should be the most important goal for an investor and I can assure you that, it shall prove to be an extremely challenging task when we invest based on our risk taking ability and keeping in mind the safety and liquidity of our investment.
  • Our common sense tells us that, we cannot as a rule say that, equities as an asset class will always beat inflation and debt as an asset class shall not. This means that, among other things our money has to be judiciously spread between debt and equity in the hope of making real returns on a post-tax basis. 

How is this achieved? .…………………… Well, the answer to that will have to wait for a few more posts.

 


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3 Replies to “Inflation can do to your financial health what Diabetes can to your bodily health”

  1. analogy is good and analysis is very correct. “your money is losing value ” set me thinking for myself and more importantly for those daily earners who save thro’ everyday deposit into banks’ pigmy deposit a/cs –after a few years they get a lumpsum amount but value ? my heart goes out for them.

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