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Investing

A Review Of Current Risks

I had hoped to hold onto my NZX and ASX listed stocks for years to come and ride out any dips in the markets, with the view that my stocks were of such quality and a good balance that I could just get a nice dividend return to cover my retirement.

Also, the planned exit from one of my private equity holdings would be significant enough to cover any losses and secure my position. However as inflation unfolds around the world, with some countries experiencing hyper inflation and comments from the BoE saying that they’re not going to shy away from generating a recession to curb inflation, I had a moment of panic yesterday and sold some stocks. Specifically my panic was that as my private equity exit isn’t happening as early as planned (and I might end up holding for more years to come), if the RBNZ were to put rates up this could mean that I am unable to service my mortgage in future and my stocks could become so undervalued that I would be bankrupt with a negative equity situation on my home.

As I’m feeling a bit calmer today, I decided to reconsider things with a goal of holding on to as many of my stocks as possible, particularly the more resilient ones, while diminishing the possibility of bankruptcy from my future.

The first thing to consider is a summary of what’s currently going on that might affect me, so I made a list:

  • Inflation for all goods due to monetary policy and COVID related supply issues
  • Inflation of food and fuel throughout the world due to war related supply issues
  • Inflation of wages in NZ due to lack of labour supply
  • Wealth destruction from NZ housing policy
  • Wealth destruction from falling share market due to all of the above
  • … and it’s going to be a contentious one, but I’m going to add an incompetent NZ government to this list, too.

Looking at how this might play out, it seems that COVID is here to stay for a few more years; and while the war in the Ukraine is a bit of a wild card, from my research into Russia’s military losses vs stock, when considering the time it takes to resupply their losses, it seems that Russia can keep up their invasion indefinitely if they choose to do so. This means that consumer price inflation is likely to stay for a while – certainly at least as long as the war and sanctions persist.

From what I can see (with the limited research I’ve done), the media’s reporting of house price falls lags significantly (about a month). The superior data that I’m fortunate enough to have access to suggests that things might be a lot worse than reported, with houses similar to mine having fallen by 23% where I live (based on a limited dataset – I should probably do more research on the other data). What’s worrying about this, is that it’s likely common consensus that the housing market is in a downward trend, which becomes a self fulfilling prophecy, pushing prices down further. The same can be said for losses in the stock market, though this is forward looking in a different way.

Wage inflation is in my opinion, the only thing that’s allaying a recession. Here’s why I say that and why I was panicked yesterday.

Inflation results in high interest rates (aimed to reduce spending) which results in less spending by consumers. This results in less company revenue and then poor company outlook, which results in less company investment. When companies invest less money, they hire fewer people, resulting in less demand for labour and fewer jobs. This results in less money in the hands of the public, which results in less spending by consumers (which loops back to the start, causing a downward economic spiral that is difficult to manage. Even if this is managed well by our current government (I say government rather than RBNZ because there are problems in supply that cannot be fixed by monetary policy alone), this difficult challenge will have to be handled well by more than most governments of the world to avoid global contagion of financial issues.

To compound the problem, the above also results in lower house prices, due to less buyer capacity. Lower house prices are a particular problem for NZ because a lot of wealth is held in houses. The loss of the wealth effect from people having value in their houses looks like this:

House prices go down, which means that people have less borrowing power (think: LVR). This results in less spending which is the cause for the downward economic spiral I mentioned in the former paragraph.

As I mentioned before, wage inflation is the only thing that can allay a recession because it enables people to keep spending, and gives them enough money to pay more for goods and services, which means that companies can pass on their costs, keep their profits up and therefore keep investing, which means more people hired… etc. In other words, it breaks the downward spiral.

Because of this, I am keeping a sharp eye on retail stats which I believe are a bellwether for wage inflation. Unfortunately, even though I have things like Paymark stats that can give indicators, I can’t tell if costs are being fully passed on to consumers until retail stocks publish their NPAT figures. I believe that a fall in consumer spend reported by Paymark is an early recession indicator, but a flatline or below CPI increase is an indicator of a possible recession.

In terms of my strategy (without discussing the specifics), I will:

  • Assume my exit from the private equity will not eventuate
  • Assume that my 6 figure shareholder loan will be paid back at the start of next year
  • Use that money and other money from yesterday’s fire sale to reduce my mortgage as terms allow
  • Consider locking in a multi year term for my mortgages that come off fixed rates
  • Continue to hold onto my high quality stocks for the long term – which includes a retail stock that will likely struggle, but has a history of always paying a dividend
  • Not bother selling the remaining handful of lower quality stocks whose value is sufficiently low that it’s wouldn’t change my financial position to sell anyway (The value of which is about $4,000)

In the event that I lose my job during a particularly bleak recession, I will use the value in my listed stocks, savings and hopefully shareholder loan, to try to outlast the recession.

Risks to my strategy are:

  • I lose my job AND (the shareholder loan defaults OR stocks drop in value by >60% from their current position and I can’t get another job for 6 months)
  • Interest rates go crazy after next year when my largest mortgage expires and I don’t get pay rises. The level of “crazy” depends on what other failures happen in my investments that prevent me from paying down my mortgage.
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Investing

Thoughts On OCR Increases And Inflation In 2022

I’m feeling bearish about the economic impact of the RBNZ’s position on increasing the OCR.

The OCR is typically increased to reduce the economy’s propensity to spend money (AKA reduce demand) to cool an overheated economy, but also to put the central bank in a position where they can drop the OCR to stimulate demand in future, as required.

Inflation is a key indicator (and cause for concern) of an overheated economy; hence the RBNZ has started on the path of OCR increases to cool the inflation before it creates instability in the economy.

However I do not believe that OCR increases are the right tool to reduce inflation in this case, and I believe that OCR increases may actually harm the economy.

I say this because while increasing the OCR is a great way to keep price increases in check that result from a flourishing economy, that’s not what’s happening here. Instead we have a performant economy that is threatened by high prices due to supply issues.

The difference is subtle until you consider a supply and demand diagram.

If we consider a supply and demand diagram, we can see that as an economy performs well, participants have an increased propensity to buy (increased demand) and this pushes up prices. In this scenario, increasing the OCR is a great way to keep demand in check by presenting buyers with a more preferable alternative of a higher ROI for their money in the bank and reducing their debt levels. The below supply and demand diagram illustrates an increase in demand due to a flourishing economy.

A flourishing economy results in an increase in demand, causing prices to increase. This can be remedied by increasing OCR to decrease demand to a more desirable level.

Unfortunately our economy isn’t suffering from increasing prices due to increased demand (much). By far the greatest pressure on prices is due to a lack of supply caused by COVID related logistics issues and other supply constraints (lack of lorry drivers, shipping queues at ports, labour shortages, semiconductor shortages, etc.). This is represented in the below demand and supply diagram, which depicts the effects of a reduction in supply.

A reduction is supply causes increased prices and lower quantities of sales.

Let’s have a look at what happens when the OCR is increased to reduce demand along with the already reduced supply.

Reduced supply causes less to be bought and increases price. Reducing demand reduces the price, but at the cost of reducing quantities bought. Reducing demand to drop prices back to levels seen before a decrease in supply causes a massive reduction in quantity traded.

As we can see from the above diagram, when the OCR is used to tackle price increases from a reduction in supply, one of two things can happen:

  • The demand isn’t reduced enough, resulting in high prices and lower quantities traded
  • The demand is reduced (at least) enough to match prices before supply decreases, resulting in larger drop in quantities traded

In both scenarios we see a drop in trade and most likely this won’t fix the inflation problem (at least not without significantly damaging the economy). A drop in trade means a poor economy, job losses, business closures / contractions, etc.

I would argue that as the economy isn’t overheating and is performant, that minimal interference is appropriate. Also, as a lack of supply is causing price increases and the government can’t fix the lack of supply (I won’t discuss policies that could help remedy this situation right now), we’ll just have to try to cope with the increases in prices for now and suffer the consequences (which could mean permanently higher prices in some industries).

Finally, I will leave you with a definition of poverty, where poverty is described as people not having things (lack of supply) and not being able to afford things (high prices).

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Investing

How Will US Inflation Affect NZ Companies?

Inflation seems to be kicking off in the USA, according to the news. I expect that this will cause the Fed to increase interest rates, which will cause the USD to increase in value as currency traders flock to benefit. This could be good for companies selling to the USA and converting their currency back to NZDs, and other companies that benefit from a strong USD.

Of course that’s not to say that any company that trades in USDs will automatically be a good investment or that it will be correctly priced for a purchase.

Can you think of any companies on the ASX or NZX that could benefit from a strong USD? Please mention them in the comments below.

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Investing

Inflation Risk In NZ

As I approach retirement, inflation (which was formerly my friend) is becoming my foe. While saving for retirement I’ve used cheap debt (mortgages) to fund various investments which have returned higher rates than the cost of the debt. Essentially I’ve leveraged the bank’s money to profit, rather than my own (comparatively pitiful) savings. This has had a two-fold benefit over the years. Firstly it has enabled me to get rich from someone else’s money, and secondly inflation has made the cost of my debt lower as time goes by. For example, a $240k mortgage to buy a $300k house 10 years ago isn’t much when the house is now worth $1m and my salary is double what it was.

Unfortunately inflation is the enemy of the retired. The value of the savings a retiree has are eroded by inflation. So as a “young” retiree (I’ll be nearly 40 when I retire next year) my retirement strategy will have to consider inflation. Whilst my strategy does consider inflation (I plan to have a component of my income to cover my costs and another component to grow), recently proposed political policies have made me concerned. Specifically I’m concerned that inflation may not be evenly spread across all asset classes, which creates risk to business (and therefore potentially my investments) and risk to my future living costs / lifestyle choices. I’m also concerned that inflation may be greater than the growth on my income.

It’s important to be aware of inflation whether you’re retired, planning retirement or currently investing because it will probably affect your strategy / opportunities.

Lewis Hurst

Let’s look at the inflation risks that are present in the current economic and political environment (existing policies put in place by the current government are in darker text, while policies proposed in the recent Climate Change Report are accented in a lighter colour. As I’m an opinionated fellow, I couldn’t help adding my opinion of the policy, but I’ve put this in italic so you’re free to ignore the italic text if you wish):

  • Increased minimum wage. This should cause general inflation as people have more money to spend, which creates increased demand and an ability to pay more for any particular goods or services. It has been hypothesized by economists that distributing more money amongst the poorest of the populace is the best way to spur an economy as all the extra money gets spent, vs. more affluent people who may save some of the additional money.
    At the time I thought this was a bad policy because the inflation would cancel the some of the gains, and therefore there are better ways to achieve what the policy set out to achieve. Additionally the policy was risky because it could put many businesses out of business. The policy also came at a really bad time with COVID19. However, after the policy was implemented, most businesses seemed to be able to handle the new costs, so it was probably the right thing to do (although I think there was a lot of luck in the success of this policy).
  • Quantitative Easing (QE, AKA Printing Money). There is currently a massive amount of QE going on in NZ and around the world. Both QE and increasing the minimum wage are policies that create general inflation.
    I believe that Western countries around the world have been using QE in a battle to reduce the value of their currency, in order to make themselves more competitive exporters and at the same time deflating their debt with the inflation that goes along with QE.
  • Banning oil exploration. This policy is inflationary because it reduces supply of oil, which therefore pushes the price up.
    I believe that this is another of Labour’s policies that does the opposite of what was intended because it doesn’t reduce demand, so demand will just be fulfilled from oil imports – which will create more strain on the environment as extra fuel is used to import the fuel. The argument for the policy was to create strain on the market to produce motors that use alternative fuel sources, but as NZ has no such motor industry, will import the fuel anyway, and is too small to influence foreign motor industries, I believe that no such technology will emerge from this change. Again, there are better ways to achieve what this policy set out to achieve.
  • KiwiBuild. This policy is inflationary because builders were attracted away from the NZ private sector (who would have otherwise been building houses) to build houses for the government. This inflates the price of builders as it creates extra demand, while at the same time not increasing supply as those builders would have otherwise been fulfilling private demand for housing. Increasing the cost of builders makes new housing more expensive.
    Additionally the government bought houses from the private sector for political reasons, so they could tout the success of the failing build rate of the KiwiBuild policy. This temporarily inflates the price of housing because it creates temporary extra demand as the private sector bids for housing against the government.
    Another Labour policy that did the opposite of what it was intended to do, whilst at the same time adding inefficiency into the market in terms of admin cost, and in the case of houses that were built as part of the KiwiBuild policy, placing houses where people didn’t want them – further increasing house prices due to an effective reduction of supply due to lack of housing in areas that required it.
  • Reducing the amount of dairy cows to reduce methane emissions. This will reduce the supply of meat, which will inflate the price.
    I imagine it would be better to put restrictions on the thing they are trying to regulate (the emissions) rather than the thing creating the emissions. That way the free market can find the best way to reduce emissions, leaving the reduction of herds as a last resort.
    There is talk suggesting that NZ dairy farms have lower emissions than foreign farms. If this is true, this will be another Labour policy that does the opposite of what it intends, because demand for dairy will not decrease, so foreign supply will fill the gap, resulting in an over all increase in emissions.
  • Phasing out natural gas. This will decrease the supply of energy, increasing the demand on other sources such as green electricity. Probably a good thing, but this will cause inflation in the price of alternative sources as supply decreases.
  • Ban the importing of cars with combustion engines. Again, reducing supply increases prices.

Regardless of political views, these policies are inflationary. Having a quick look at the list, it seems that existing policies are generally inflationary, with a leaning towards inflating transport and housing; while proposed policies could cause inflation in food, energy and transport.

To summarize my position, as I intend to get part of my income from rental income, NZX.SUM, NZX.SCL and gentailers, I only have transport costs to worry about. Still, with all this additional inflation, I may need to ensure that the growth rate of my income is more heavily weighted. This means that I may need more money to be able to retire safely. As usual, I’ll be playing it by ear, and evolving my strategy to my situation as it changes.

Sources:

Categories
Investing

Thought Of The Day: Could Financial Stimulus Cause Inflation?

Today I’ve been thinking about all the financial stimulus going on around the world. There is a tremendous amount of money being “printed” around the world. Will all this financial stimulus cause inflation? If so, where is the best place to put your money?

Barring any recessionary effects, I wonder if a good thing to be investing in could be property and other finite assets that do well during inflationary environments. Another thing supporting the property outlook is the low interest rates that are available currently.

Perhaps I’ll do some analysis on REITs, retirement villages and other listed options that suit this strategy. If there’s anything that takes your fancy that you’d like me to analyse, or any opinions / tips you’d like to share, please leave a message in the comments below.