Inflation

Inflation

Resource Stocks provide long-term gains and inflation hedging

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Including good stocks for long-term investment gains from the Resource section can be especially helpful in times of inflation. Learn more below.

For most investors, resource stocks should make up only a limited portion of their portfolios. That means that while we think you should maintain some exposure to resource stocks, you should still aim to balance your portfolio across most if not all of the five economic sectors.

If you want resource stocks in your diversified portfolio, then you need to know how to find good stocks in that sector for long-term investment gains.

Resource stocks, though volatile, tend to rise with inflation and can be good stocks for long-term investment gains

The resource sector is subject to wide and unpredictable swings in the prices it gets for its products. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up. This balloons profits at resource companies. When the economy slumps, resource prices fall, and this drags down resource profits and stock prices.

In addition to rising and falling with the business cycle, however, resource stocks have a history of rising along with long-term inflationary trends. This gives them a rare ability: they provide a hedge against inflation.

Back in the inflationary 1970s and 1980s, investors used to see this hedge-against-inflation ability as the main reason for buying resource stocks. But until recently, they rarely thought of it. That’s because inflation had waned for three decades.

Inflation peaked at a yearly rate around 13% in the early 1980s. It fell by two-thirds from that level by the middle of the decade. It went through a series of peaks and valleys, but had been working its way downward ever since.

However, after years of relative stability, inflation has come back to levels not seen in decades.

While the cost of just about everything has gone up, nobody can predict trends in inflation or interest rates with any consistency. And we disagree with investors who think we are on the verge of a huge outburst of never-ending price increases.

Even so, adding top Resource stocks to your portfolio lets prosper two ways: you can profit even without inflation — and these stocks will also provide an added boost in inflationary times.

It’s important to know your risk tolerance when investing in good stocks for long-term investment gains — including Resource stocks

There are several considerations that go into a successful growth investing strategy. Still, many investors overlook a number of important factors that can lower their risk.

In the end, there’s no such thing as risk-free investing. The tips below for lowering your growth investing strategy risk have long been part of the Successful Investor approach.

  • Balance your cyclical risk
  • Be skeptical of companies that mainly grow through acquisitions
  • Don’t overindulge in aggressive investments
  • Keep an eye out on a growth stock’s debt
  • Keep stock market trends in perspective
  • Look for growth stocks that have ownership of strong brand names and an impeccable reputation
  • The best long-term growth stocks should have the ability to profit from secular trends

Meantime, we continue to recommend that you cut your risk in the volatile resource sector by investing mainly in stocks of profitable, well-established mining companies with high-quality reserves. And as mentioned, resource stocks (and this includes oil and gas, of course) should make up only a limited portion of your portfolio. Continue Reading…

Retired Money: Inflation and some compensations in federal tax brackets and contribution limits

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My latest MoneySense Retired Money column has just been published and can be accessed by clicking the highlighted headline: Inflation and investments: Heads up if you’re retired or retiring soon. 

It looks at the anxiety of would-be retirement savers in the light of soaring inflation and in particular, a recent Leger Questrade poll that looked at how inflation is affecting Canadians’ intentions to contribute to TFSAs and RRSPs. My Hub blog on this includes 4 charts on the topic.

Not surprisingly, inflation is a particular concern for retirees and those hoping to retire soon. The 2023 RRSP Omni report found that while 87% of Canadians are worried about rising prices, it also found 73% of RRSP owners still plan to contribute again this year, and so do 79% of TFSA holders. That’s despite the fact 69% fret that inflation will impact their RRSPs’ value and 64% worry about their TFSAs’ value. Seven in ten with RRSPs and 64% with TFSAs are concerned about inflation and a possible recession: 25% “very” concerned.

A Silver Lining

The MoneySense column also summarizes some of the compensating factors that Ottawa builds into the retirement saving system: as inflation rises, so too do Tax brackets, the Basic Personal Amount (BPA: the tax-free zone for the first $15,000 or so of annual earnings), and of course TFSA contribution limits (now $6500 in 2023 because of inflation adjustments). This was nicely summarized late in 2022 by Jamie Golombek in the FP, and reprised in this Hub blog early in the new year.

Because tax brackets and contribution levels are linked to inflation, savers benefit from a little more tax-sheltered (or tax deferred) contribution room this year. The RRSP dollar limit for 2023 is $30,790, up from $29,210 in 2022, for those who earn enough to qualify for the maximum. And TFSA room is now $6,500 this year, up from $6,000, because of an inflation adjustment. As Golombek noted, the cumulative TFSA limit is now $88,000 for someone who has never contributed to one.

Golombek, managing director, Tax & Estate planning for CIBC Private Wealth, wrote that in November 2022, the Canada Revenue Agency said the inflation rate for indexing 2023 tax brackets and amounts would be 6.3%: “The new federal brackets are: zero to $53,359 (15%); more than $53,359 to $106,717 (20.5%); more than $106,717 to $165,430 (26%); more than $165,430 to $235,675 (29%); and anything above that is taxed at 33%.”

Another break is that the yearly “tax-free zone” for all who earn income is rising. The Basic Personal Amount (BPA) —the annual amount of income that can be earned free of any federal tax — rises to $15,000 in 2023, as legislated in 2019.

CPP and OAS inflation boosts in late January

 On top of that, retirees collecting CPP and/or OAS can expect significant increases when the first payments go out on or around Jan. 27, 2023. (I include our own family in this). There’s more information here. Continue Reading…

Searching for a Safe Withdrawal Rate: the Effect of Sampling Block Size

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Image by Mohamed Hassan from Pixabay

By Michael J. Wiener

Special to the Financial Independence Hub

How much can we spend from a portfolio each year in retirement?  An early answer to this question came from William Bengen and became known as the 4% rule.  Recently, Ben Felix reported on research showing that it’s more sensible to use a 2.7% rule.

Here, I examine how a seemingly minor detail, the size of the sampling blocks of stock and bond returns, affects the final conclusion of the safe withdrawal percentage.  It turns out to make a significant difference.  In my usual style, I will try to make my explanations understandable to non-specialists.

The research

Bengen’s original 4% rule was based on U.S. stock and bond returns for Americans retiring between 1926 and 1976.  He determined that if these hypothetical retirees invested 50-75% in stocks and the rest in bonds, they could spend 4% of their portfolios in their first year of retirement and increase this dollar amount with inflation each year, and they wouldn’t run out of money within 30 years.

Researchers Anarkulova, Cederburg, O’Doherty, and Sias observed that U.S. markets were unusually good in the 20th century, and that foreign markets didn’t fare as well.  Further, there is no reason to believe that U.S. markets will continue to perform as well in the future.  They also observed that people often live longer in retirement than 30 years.

Anarkulova et al. collected worldwide market data as well as mortality data, and found that the safe withdrawal rate (5% chance of running out of money) for 65-year olds who invest within their own countries is only 2.26%!  In follow-up communications with Felix, Cederburg reported that this increases to 2.7% for retirees who diversify their investments internationally.

Sampling block size

One of the challenges of creating a pattern of plausible future market returns is that we don’t have very much historical data.  A century may be a long time, but 100 data points of annual returns is a very small sample.

Bengen used actual market data to see how 51 hypothetical retirees would have fared.  Anarkulova et al. used a method called bootstrapping.  They ran many simulations to generate possible market returns by choosing blocks of years randomly and stitching them together to fill a complete retirement.

They chose the block sizes randomly (with a geometric distribution) with an average length of 10 years.  If the block sizes were exactly 10 years long, this means that the simulator would go to random places in the history of market returns and grab enough 10-year blocks to last a full retirement.  Then the simulator would test whether a retiree experiencing this fictitious return history would have run out of money at a given withdrawal rate.

In reality, the block sizes varied with the average being 10 years.  This average block size might seem like an insignificant detail, but it makes an important difference.  After going through the results of my own experiments, I’ll give an intuitive explanation of why the block size matters.

My contribution

I decided to examine how big a difference this block size makes to the safe withdrawal percentage.  Unfortunately, I don’t have the data set of market returns Anarkulova et al. used.  I chose to create a simpler setup designed to isolate the effect of sampling block size.  I also chose to use a fixed retirement length of 40 years rather than try to model mortality tables.

A minor technicality is that when I started a block of returns late in my dataset and needed a block extending beyond the end of the dataset, I wrapped around to the beginning of the dataset.  This isn’t ideal, but it is the same across all my experiments here, so it shouldn’t affect my goal to isolate the effect of sampling block size.

I obtained U.S. stock and bond returns going back to 1926.  Then I subtracted a fixed amount from all the samples.  I chose this fixed amount so that for a 40-year retirement, a portfolio 75% in stocks, and using a 10-year average sampling block size, the 95% safe withdrawal rate came to 2.7%.  The goal here was to use a data set that matches the Anarkulova et al. dataset in the sense that it gives the same safe withdrawal rate.  I used this dataset of reduced U.S. market returns for all my experiments.

I then varied the average block size from 1 to 25 years, and simulated a billion retirements in each case to find the 95% safe withdrawal rate.  This first set of results was based on investing 75% in stocks.  I repeated this process for portfolios with only 50% in stocks.  The results are in the following chart.

The chart shows that the average sample size makes a significant difference.  For comparison, I also found the 100% safe withdrawal rate for the case where a herd of retirees each start their retirement in a different year of the available return data in the dataset.  In this case, block samples are unbroken (except for wrapping back to 1926 when necessary) and cover the whole retirement.  This 100% safe withdrawal rate was 3.07% for 75% stocks, and 3.09% for 50% stocks.

I was mainly concerned with the gap between two cases: (1) the case similar to the Anarkulova et al. research where the average sampling block size is 10 years and we seek a 95% success probability, and (2) the 100% success rate for a herd of retirees case described above.  For 75% stock portfolios, this gap is 0.37%, and it is 0.32% for portfolios with 50% stocks.

In my opinion, it makes sense to add an estimate of this gap back onto the Anarkulova et al. 95% safe withdrawal rate of 2.7% to get a more reasonable estimate of the actual safe withdrawal rate.  I will explain my reasons for this after the following explanation of why sampling block sizes make a difference.

Why do sampling block sizes matter?

It is easier to understand why block size in the sampling process makes a difference if we consider a simpler case.  Suppose that we are simulating 40-year retirements by selecting two 20-year return histories from our dataset.

For the purposes of this discussion, let’s take all our 20-year return histories and order them from best to worst, and call the bottom 25% of them “poor.”

If we examine the poor 20-year return histories, we’ll find that, on average, stock valuations were above average at the start of the 20-year periods and below average at the end.  We’ll also find that investor sentiment about stocks will tend to be optimistic at the start and pessimistic at the end.  This won’t be true of all poor 20-year periods, but it will be true on average.

When the simulator chooses two poor periods in a row to build a hypothetical retirement, there will often be a disconnect in the middle.  Stock valuations will jump from low to high and investor sentiment from low to high instantaneously, without any corresponding instantaneous change in stock prices.  This can’t happen in the real world. Continue Reading…

All good things must come to an end: There by the grace of Paul Volcker went Asset Prices

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Image courtesy Creative Commons/Outcome

By Noah Solomon

Special to Financial Independence Hub

During the OPEC oil embargo of the early 1970s, the price of oil jumped from roughly $24 to almost $65 in less than a year, causing a spike in the cost of many goods and services and igniting runaway inflation.

At that time, the workforce was much more unionized, with many labour agreements containing cost of living wage adjustments which were triggered by rising inflation.

The resulting increases in workers’ wages spurred further inflation, which in turn caused additional wage increases and ultimately led to a wage-price spiral.The consumer price index, which stood at 3.2% in 1972, rose to 11.0% by 1974. It then receded to a range of 6%-9% for four years before rebounding to 13.5% in 1980.

Image New York Times/Outcome

After being appointed Fed Chairman in 1979, Paul Volcker embarked on a vicious campaign to break the back of inflation, raising rates as high as 20%. His steely resolve brought inflation down to 3.2% by the end of 1983, setting the stage for an extended period of low inflation and falling interest rates. The decline in rates was turbocharged during the global financial crisis and the Covid pandemic, which prompted the Fed to adopt extremely stimulative policies and usher in over a decade of ultra-low rates.

Importantly, Volcker’s take no prisoners approach was largely responsible for the low inflation, declining rate, and generally favourable investment environment that prevailed over the next four decades.

How declining Interest Rates affect Asset Prices: Let me count the ways

The long-term effects of low inflation and declining rates on asset prices cannot be understated. According to [Warren] Buffett:

“Interest rates power everything in the economic universe. They are like gravity in valuations. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on values.”

On the earnings front, low rates make it easier for consumers to borrow money for purchases, thereby increasing companies’ sales volumes and revenues. They also enhance companies’ profitability by lowering their cost of capital and making it easier for them to invest in facilities, equipment, and inventory. Lastly, higher profits and asset prices create a virtuous cycle – they cause a wealth effect where people feel richer and more willing to spend, thereby further spurring company profits and even higher asset prices.

Declining rates also exert a huge influence on valuations. The fair value of a company can be determined by calculating the present value of its future cash flows. As such, lower rates result in higher multiples, from elevated P/E ratios on stocks to higher multiples on operating income from real estate assets, etc.

The effects of the one-two punch of higher earnings and higher valuations unleashed by decades of falling rates cannot be overestimated. Stocks had an incredible four decade run, with the S&P 500 Index rising from a low of 102 in August 1982 to 4,796 by the beginning of 2022, producing a compound annual return of 10.3%. For private equity and other levered strategies, the macroeconomic backdrop has been particularly hospitable, resulting in windfall profits.

It is with good reason and ample evidence that investing legend Marty Zweig concluded:

“In the stock market, as with horse racing, money makes the mare go. Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major direction.”

To be sure, there are other factors that provided tailwinds for markets over the last 40 years. Advances in technology and productivity gains bolstered profit margins. Limited military conflict undoubtedly played its part. Increased globalization and China’s massive contributions to global productive capacity also contributed to a favourable investment climate. These influences notwithstanding, 40 years of declining interest rates and cheap money have likely been the single greatest driver of rising asset prices.

All Good things must come to an End

The low inflation which enabled central banks to maintain historically low rates and keep the liquidity taps flowing has reversed course. In early 2021, inflation exploded through the upper band of the Fed’s desired range, prompting it to begin raising rates and embark on one of the quickest rate-hiking cycles in history. Continue Reading…

Despite inflation, Canadians still prioritizing retirement and contributing to RRSPs and TFSAs

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While the vast majority (87%) of Canadians are worried about rising costs from Inflation, Questrade Leger’s 2023 RRSP Omni report finds that 73% of RRSP owners plan to contribute again this year, and 79% of TFSA holders plan to recontribute. That’s despite the fact 69% fret that inflation will impact their RRSP’s value and 64% worry about the impact on their TFSA’s value.

“The number of Canadians who are saving for retirement remains consistent with previous years,” the report says. “Among those who are saving for retirement, about three-in-five (58%) say they are very worried compared to Canadians who are not saving for retirement. Women are also more likely to be very worried about the costs associated with rising inflation.”

Seven in ten respondents who have RRSPs told the panel they are concerned about the rising costs associated with inflation and a possible recession: 25% indicate that they are very concerned. “A similar trend is observed among those who hold TFSAs for retirement purposes, with almost two-thirds (64%) indicating that they are concerned.”

 

Worries about inflation and recession “raise questions about the ability of Canadians to control their financial future, especially when it comes to retirement,” the report says. These concerns are most acute for those with an annual income of less than $100,000: “These Canadians are also more likely to agree that they will have to draw upon their savings or investments to cover their expenses in the coming year.”

Less than half are confident about their financial future

Less than half feel they are confident when it comes to their financial future: “Only those making over $60K have confidence in their own financial future despite the current state of the economy.”

The survey seems to imply that Canadians value TFSAs a bit more than RRSPs, based on willingness to max out contribution room of each vehicle. Of course, annual TFSA room only this year moved up to $6500 per person per year, less than a quarter of the maximum RRSP room of $30,780 in 2023, for those with maximum earned income.

Only 29% of RRSP holders plan to maximize their RRSP contribution room in 2023, compared to almost half (46%) who plan to max out their TFSAs. The most enthusiastic TFSA contributors are males and those aged 55 or older.

Given economy, most worry about rising cost of food and everyday items  

Day-to-day living expenses continue to be a concern in the face of rising inflation: 79% worry about rising food prices and 77% rising everyday items. The third major concern (for 45%) is inflation’s impact on savings/investments and fourth (at 30%) is rising mortgage costs. Depending on annual incomes, worry over inflation can centre either on investments or on debt:  those in the middle to upper income brackets ($60K or more) “are much more likely to find the impact on savings / investments and increasing mortgage concerns more worrisome than compared to those who make less than $60K.”

Ability to save impacted by inflation

Three in four (74%) agree that inflation has impacted their ability to save, at least somewhat. And half (47%) have had to draw upon their savings or investments to cover expenses due to rising costs, especially those under 55 and those who are not currently saving for retirement. Many Canadians also agree they will have to draw upon their savings/investments to cover expenses in the coming year (43%). Continue Reading…