"The Wealth Tax" or why inflation matters
I’m borrowing from Financial Times columnist Merryn Somerset Webb’s expression that inflation is a wealth tax because it so elegantly puts into relief what the current inflation risk actually means. We’ve been talking about it for some time now, and think the crucial message that needs to be constantly reinforced is that should inflation turn out to be anything but transitory, many investors will suffer significant and permanent real capital losses.
Let’s look at the US as an example - where despite markets broadly assuming inflation will be transitory, we have seen the breaching of the previous red line level of government debt at 100% of GDP, as well as the Federal Reserve’s increased tolerance for higher prices via its approach to targeting average inflation. With this debt still rising, we are already in a world where the nominal returns savers receive are below the rates of inflation. Today, the real, inflation-adjusted yield on all developed market bonds is negative, and the earnings yield on the largest equity market in the world is zero!
This impacts long-duration or ‘bond proxy’ stocks where the price paid now is on the promise of cash flow far into the future and is based on the idea that a dollar today is worth more than a dollar in a year’s time. With interest rates as low as they have been, this has been hugely supportive of the Tech sector, which, broadly speaking, makes a virtue of investing for growth and for payback at some time in the distant future.
But what if a dollar isn’t worth a dollar in the future?
It is imperative that savers recognise that the future may well not be like the recent past, and there will be impacts with savers likely covering them either through reduced purchasing power and/or higher taxes.
According to the maths, when the discount rate is zero, $100 today is worth the same as $100 in 10 years’ time. However, when for example the discount rate is 2%, $100 in ten years’ time is worth just $82. With rates at 4%, which is the long-run average on the US 10-year Treasury, then $100 in ten years is worth just $68. At higher rates, long-dated equities are far less attractive.
Savers will have less money, and investors in long duration assets will have less valuable assets – they could just as well have been taxed.
This argues for owning a range of securities that are not dependent on the level of interest rates to generate satisfactory returns. It makes interesting those companies that balance solid near term cashflows and returns to shareholders, with opportunities to invest at attractive returns to drive future growth and one way to achieve this shift is to reduce exposure to securities where the price paid now is on the promise of cash flow far into the future.
Perhaps re-framing the risk with different language will help investors see it more clearly. If inflation is like a tax on one’s wealth, suddenly there’s more urgency to do something about it.
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Chad is the Co-Chief Investment Officer and co-founder of Talaria Asset Management. He has more than 20 years’ experience in the financial services industry in the UK, South Africa and Australia. Talaria's investment strategy seeks to increase the...