Inflation Archives - Page 7 of 12 - the patient investor

July 17, 2014

Gold retreats as Dollar strengthens

Treasury yields remain weak
The Dollar strengthens
Inflation looks weak despite rising TIPS spread
Gold retreats

Interest Rates and the Dollar

The yield on ten-year Treasury Notes continues to test support at 2.50 percent. Failure would indicate a decline to 2.00 percent; follow-through below 2.40 would confirm. 13-Week Twiggs Momentum below zero continues to warn of a primary down-trend. Recovery above 2.65 is less likely, but would suggest the correction is over, with a medium-term target of 2.80 and long-term of 3.00 percent.

10-Year Treasury Yields

* Target calculation: 2.50 – ( 3.00 – 2.50 ) = 2.00

The Dollar Index found short-term support at 80.00. Follow-through above 80.50 indicates another test of 81.00. Recovery of 13-week Twiggs Momentum suggests a primary up-trend. Breakout above 81.00 would strengthen the signal; above 81.50 would confirm. Breach of 80.00 is unlikely at present, but would warn of another test of primary support at 79.00.

Dollar Index

Low interest rates and a stronger dollar suggest inflation expectations are falling, but this is not yet evident on the TIPS spread (10-Year Treasury Yields minus 10-Year Inflation-Indexed Yields).

10-Year Treasury Yields minus 10-Year Inflation Indexed (TIPS) Yields

Gold

Gold is nonetheless falling, in line with weaker inflation expectations. Follow-through below $1300 would test support at $1240. And breach of $1240 would threaten another primary decline, with a target of $1000*. Oscillation of 13-week Twiggs Momentum around zero, however, suggests hesitancy, with no strong trend. Recovery above $1350 is unlikely at present, but would indicate another test of $1400/$1420.

Spot Gold

* Target calculation: 1200 – ( 1400 – 1200 ) = 1000

July 12, 2014

Growth or Income?

Most investors face a decision as to how much of their portfolio to allocate to growth investments and how much to income investments. The mind-set of many income investors is that they cannot afford the volatility of growth investments. The following example illustrates how income investors can use growth investments to protect their portfolio against inflation and enhance overall returns.

Growth investments, historically, have outperformed income investments, but at the expense of greater volatility. They are typically favored pre-retirement by investors with long time horizons who seek to maximise their capital on retirement. Other than improved performance, growth investments also generally receive more favourable tax treatment than fixed income, further enhancing after-tax returns. Income investments historically exhibit lower volatility and are favored by retirees for their consistent income, also by risk-averse pre-retirees who wish to reduce the volatility of their overall portfolio.

Historic Returns

These historic returns to Australian investors from 1981 to 2009 illustrate the differences in returns and volatility. Data was originally provided by AXA:

Asset class:	Australian stocks	Australian fixed interest	International stocks	Australian REITS	Australian cash
Annualised return (%)	11.38	10.41	10.81	10.49	9.18
Inflation (%)	4.41	4.41	4.41	4.41	4.41
Real return (%)	6.97	6.00	6.40	6.08	4.77
Standard deviation	23.32	7.60	21.41	18.75	4.95

Not all investment strategies are likely to match the broad asset classes, but they are a good starting point for developing an investment strategy.

What the future holds

One thing about the future is certain: it is not going to match the past. It also is not going to match our projections. Without a magic crystal ball, the best we can do is adjust past performance for expected changes and hope we are not too far off course.

My own expectations are that we are entering a low inflation environment. Central banks, after the global financial crisis, are likely to be far more vigilant about rapid credit expansion and asset bubbles. I have therefore adjusted my inflation expectation down to 2.0%. I also expect that low inflation will have greater impact on fixed interest and cash and have adjusted their returns accordingly.

Asset class:	Australian stocks	Australian fixed interest	International stocks	Australian REITS	Australian cash
Annual return (%)	9.00	7.00	9.00	8.00	5.00
Inflation (%)	2.00	2.00	2.00	2.00	2.00
Real return (%)	7.00	5.00	7.00	6.00	3.00
Standard deviation	25	10	25	20	5

These projections are no more than an educated guess and are used for illustration purposes only. Make your own projections, but understand that unrealistic projections will yield unrealistic results.

Investing for Income

We can now determine how much to allocate to income investments and how much to growth investments.

Take a retired investor whose objective is to earn $60,000 per year (after tax) from investments while protecting capital from inflation.

If he/she earns an average return of 7.0% p.a. on income investments at an average tax rate of 15%, with 2.0% inflation, we arrive at a net return of 3.95% and a required investment of $1.519 million:

Average return:	7.00%
Less tax at:	15%
After tax:	5.95%
Deduct inflation:	2.00%
Net return:	3.95%
Required income after tax and inflation:	$60,000
Required capital (60,000 x 100/3.95):	$1.519 million

Adding growth investments

If we recognize hedging against inflation as a long-term goal and not an immediate cash flow need, we can consider funding the inflation element of the portfolio with higher-yielding growth investments.

Income Component

First we calculate the capital required to meet current income needs:

Average return on income investments:	7.00%
Less tax at:	15%
After tax:	5.95%
Required income after tax:	$60,000
Required income investment:	$1.009 million

Growth component

Growth investments typically enjoy higher after-tax returns because of improved performance as well as a lower tax component — through capital gains concessions and franking credits on dividends (for Australian investors).

Average return on growth investments:	9.00%
Less tax at:	10%
After tax:	8.10%
Deduct inflation:	2.00%
Net return:	6.10%
Required income from growth investments ($1.009m x 2.0%):	$20,180
Required growth investment ($20,180 x 100/6.1):	$0.331 million
Total required capital:	$1.340 million

Using growth investments to fund the inflation component reduces required capital to $1.340 million, a reduction of $179,000. Alternatively, if we invest the previously determined capital amount of $1.519 million, we should average close to $11,000 of additional income (after tax and inflation) each year. With higher inflation rates, the difference is even greater.

Remember that this example does not take into consideration your personal needs and circumstances. Also, taxation and investing for retirement are complex subjects and we recommend that you consult a professional adviser before making any decisions.

July 11, 2014April 16, 2018

Growth or income?

Historic Returns

These historic returns to Australian investors from 1981 to 2009 illustrate the differences in returns and volatility. Data was originally provided by AXA:

Asset class:	Australian stocks	Australian fixed interest	International stocks	Australian REITS	Australian cash
Annualized return (%)	11.38	10.41	10.81	10.49	9.18
Inflation (%)	4.41	4.41	4.41	4.41	4.41
Real return (%)	6.97	6.00	6.40	6.08	4.77
Standard deviation	23.32	7.60	21.41	18.75	4.95

Not all investment strategies are likely to match the broad asset classes, but they are a good starting point for developing a broad investment strategy.

What the future holds

Asset class:	Australian stocks	Australian fixed interest	International stocks	Australian REITS	Australian cash
Annual return (%)	9.00	7.00	9.00	8.00	5.00
Inflation (%)	2.00	2.00	2.00	2.00	2.00
Real return (%)	7.00	5.00	7.00	6.00	3.00
Standard deviation	25	10	25	20	5

Investing for Income

We can now determine how much to allocate to income investments and how much to growth investments.

Take a retired investor whose objective is to earn $60,000 per year (after tax) from investments while protecting capital from inflation.

Average return:	7.00%
Less tax at:	15%
After tax:	5.95%
Deduct inflation:	2.00%
Net return:	3.95%
Required income after tax and inflation:	$60,000
Required capital (60,000 x 100/3.95):	$1.519 million

Adding growth investments

Income Component

First we calculate the capital required to meet current income needs:

Average return on income investments:	7.00%
Less tax at:	15%
After tax:	5.95%
Required income after tax:	$60,000
Required income investment:	$1.009 million

Growth component

Average return on growth investments:	9.00%
Less tax at:	10%
After tax:	8.10%
Deduct inflation:	2.00%
Net return:	6.10%
Required income from growth investments ($1.009m x 2.0%):	$20,180
Required growth investment ($20,180 x 100/6.1):	$0.331 million
Total required capital:	$1.340 million

July 9, 2014

Gold strengthens on Dollar weakness

Treasury yields weaken
The Dollar continues to test long-term support
Gold is strengthening

Interest Rates and the Dollar

The yield on ten-year Treasury Notes is again testing support at 2.50 percent. Failure would indicate a decline to 2.00 percent. Follow-through below 2.40 would confirm. Market expectations favor low interest rates and 13-Week Twiggs Momentum below zero continues to warn of a primary down-trend. Recovery above 2.65 is less likely, but would suggest the correction is over, offering a medium-term target of 2.80 and long-term of 3.00 percent.

10-Year Treasury Yields

* Target calculation: 2.50 – ( 3.00 – 2.50 ) = 2.00

The Dollar Index tests short-term support at 80.00. Respect of zero by 13-week Twiggs Momentum warns of continuation of the primary down-trend. Breach of 80.00 would indicate a test of primary support at 79.00. Recovery above 80.50 is unlikely at present, but would suggest an advance to 81.50.

Dollar Index

Gold

Low interest rates and higher inflation expectations favor a stronger gold price and a weaker Dollar. Gold is consolidating in a narrow band below medium-term resistance at $1325/$1330, suggesting continuation of the rally. Breakout would signal a test of $1400. Recovery of 13-week Twiggs Momentum above zero hints at a primary up-trend; breakout above $1400 would confirm. Retreat below $1300 is unlikely, but would test support at $1240.

Spot Gold

July 2, 2014

Gold rallies as inflation expectations rise

Overview:

Treasury yields are recovering
Inflation expectations rise
The Dollar weakens
Gold rallies

Interest Rates and the Dollar

The yield on ten-year Treasury Notes found support at 2.50 percent. Recovery above 2.65 would suggest the correction is over, offering a medium-term target of 2.80 and long-term of 3.00 percent. 13-Week Twiggs Momentum below zero continues to indicate weakness. Reversal below 2.40 would signal a decline to 2.00 percent* — confirmed if yield follows through below 2.40 percent.

10-Year Treasury Yields

* Target calculation: 2.50 – ( 3.00 – 2.50 ) = 2.00

Long-term inflation expectations, indicated by 10-Year Treasury Yields minus 10-Year Inflation-Indexed (TIPS) Yields below, turned upward after 12-month CPI jumped to 1.8 percent in May, but are still range-bound between 2.0 and 2.50 percent.

10-Year Treasury Yields minus 10-Year Inflation Indexed (TIPS) Yields

The Dollar Index continues to head for primary support at 79.00 after retreating below 80.50. Respect of zero by 13-week Twiggs Momentum warns of continuation of the primary down-trend. Recovery above 80.50 is unlikely at present, but would suggest an advance to 81.50.

Dollar Index

Gold

Gold is testing medium-term resistance at $1325/$1330. Breakout would signal a test of $1400. Recovery of 13-week Twiggs Momentum above zero hints at a primary up-trend; breakout above $1400 would confirm. Retreat below $1280 is unlikely, but would warn of the opposite; confirmed if support at $1240 is breached.

Spot Gold

July 1, 2014

Full Employment and the Path to Shared Prosperity | Dissent

Great summary of the current political gridlock by Dean Baker and Jared Bernstein:

There are many policies that can reduce inequality, but there is none as straightforward conceptually and as difficult politically as full employment. The basic point is simple: at low rates of unemployment, the demand for labor allows workers at the middle and bottom of the wage distribution to achieve gains in hourly wages, annual hours of work, and thus income.

Levels of unemployment are not the gift or curse of the gods; they are the result of conscious economic policy. The decision to tolerate high rates of unemployment is a choice. It is one that has enormous implications not just for the millions of people who are needlessly unemployed or underemployed but also for tens of millions of workers in the bottom half of the wage distribution whose bargaining power is undermined by high unemployment.

It is pretty obvious that low unemployment would enhance wage growth amongst middle- and low-income workers. But the policies to create low unemployment are not as clear:

Raising inflation to lower real interest rates would not get strong support in many quarters. It would seem that you are manipulating market signals to dupe business investors to act in a fashion that may not be in their long-term best interest.
Infrastructure spending is the key to a sound recovery, but beware of raising public debt to fund anything other than productive assets that can generate a market-related return (to service the debt).
The trade deficit is a big part of any solution. We need to penalize currency manipulators like China (Japan before them) for buying US Treasurys to suppress their exchange rate and undermine US manufacturers.
Job sharing is not a long-term solution, but it does enable unemployed workers to retain skills that would otherwise be lost.

Overall, an excellent summary of what needs to be done. But it omits one vital piece of the puzzle. How do we get politicians and interest groups to act in the best interest of the country rather than their own?

July 1, 2014

Full Employment and the Path to Shared Prosperity | Dissent

Great summary of the current political gridlock by Dean Baker and Jared Bernstein:

There are many policies that can reduce inequality, but there is none as straightforward conceptually and as difficult politically as full employment. The basic point is simple: at low rates of unemployment, the demand for labor allows workers at the middle and bottom of the wage distribution to achieve gains in hourly wages, annual hours of work, and thus income.

Levels of unemployment are not the gift or curse of the gods; they are the result of conscious economic policy. The decision to tolerate high rates of unemployment is a choice. It is one that has enormous implications not just for the millions of people who are needlessly unemployed or underemployed but also for tens of millions of workers in the bottom half of the wage distribution whose bargaining power is undermined by high unemployment.

It is pretty obvious that low unemployment would enhance wage growth amongst middle- and low-income workers. But the policies to create low unemployment are not as clear:

Raising inflation to lift real interest rates would not get strong support in many quarters. It would seem that you are manipulating market signals to dupe business investors to act in a fashion that may not be in their long-term best interest.
Infrastructure spending is the key to a sound recovery, but beware of raising public debt to fund anything other than productive assets that can generate a market-related return (to service the debt).
The trade deficit is a big part of any solution. We need to penalize currency manipulators like China (Japan before them) for buying US Treasurys to suppress their exchange rate.
Job sharing is not a long-term solution, but it does enable unemployed workers to retain skills that would otherwise be lost.

July 1, 2014

Will Inflation Remain Low? | FRBSF

From Yifan Cao and Adam Shapiro at the Federal Reserve Bank of San Francisco:

The well-known Phillips curve suggests that future inflation depends on current and past inflation and a measure of economic slack or resource utilization. Using the unemployment gap to measure slack, a simple Phillips curve currently predicts that inflation will remain quite low through 2015. Two variations of the model, which impose a higher anchor for inflation expectations or focus only on a short-term unemployment gap, still predict that inflation will remain low, albeit higher than implied by the basic model.

June 27, 2014

US inflation: Will the recent uptrend persist?

From Elliot Clarke at Westpac:

…it seems as though these price movements have not been driven by demand. This is particularly true for food services, which has seen growth in consumption volumes fall from 5.3% in November to –0.6% in May. Housing and utility demand has remained highly volatile, but there was no evidence of a ‘break out’ move in this component of personal consumption in early 2014, and growth has since slumped back to 0.2%. This is not to say that rents have not contributed materially to the level of housing inflation in recent years; more below.

This then points to an exogenous shock being to blame for the recent jump. Further, the coincident nature of the inflation uptrends for food and housing services alludes to a common cause: the cost of energy. The 6.1% gain in total PCE energy prices from April 2013 to May 2014 corroborates this belief. To the extent that shifts in energy costs typically prove temporary, this inflationary impulse will likely dissipate in coming months – leaving aside current geopolitical concerns.

March 19, 2014

Yellen takes the heat out of gold

Janet Yellen held firm on the Fed taper and unsettled markets somewhat with her throwaway “6 months” remark.

The Fed said the change in its rate hike guidance did not mark a shift in its intentions and that it would wait a “considerable time” after shuttering its asset purchase program before pushing borrowing costs higher. Yellen, who had fielded numerous questions without a hitch, hesitated when asked what the Fed meant by “considerable.”

“I — I, you know, this is the kind of term it’s hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends — what the statement is saying is it depends what conditions are like.” (Reuters)

That is not a firm commitment to raise rates any time soon. More like: “We are keeping our options open”.

The Dollar Index jumped, along with Treasury yields, but only 13-week Twiggs Momentum recovery above zero would indicate a trend change; confirmed if there is a breakout above 81.50.

Dollar Index

* Target calculation: 79.0 – ( 81.5 – 79.0 ) = 76.5

Spot gold retreated to support at $1320/ounce in response to the stronger Dollar. Breach of the rising trendline would warn of another test of primary support at $1200, while respect would signal another attempt at $1420/$1440.

Spot Gold

* Target calculation: 1400 + ( 1400 – 1200 ) = 1600