Personal Finance 101

Economics 101: A Fiscal Policy Dilemma

Wednesday, July 16th, 2008

How Long Will Economic Recovery Take?

As troubling as these times look, we all assume that eventually things will change and the economy will once again be robust, financial markets will stabilize, and commodity prices will revert to the mean.

In the mean time, however, many financial pundits are taking their best guess as to how long the recovery process will take. We are constantly barraged in the media with a mixed bag of opinions, all of which are given without request mind you, and all trying to influence government policy makers to either reign in pricing or make borrowing money easier.

Will We See Stagflation?

The puzzling duo of slow growth and high inflation is extremely troubling for policy makers because combating one ailment only serves to exacerbate the other. A true economic Catch-22 if you will. It is widely thought that the central banks will leave the overnight rate unchanged until year end as a tightened credit policy may send the economy into a severe downward spiral.

The current state of affairs has even the most seasoned economists scratching their heads:

“That’s the dilemma that rapidly rising high oil prices create for central banks everywhere. It boxes them in,” said Douglas Porter, deputy chief economist with BMO Capital Markets.

“It has the nasty side-effects of crimping growth and driving up inflation. This is like a mini-version of what central banks faced in the 1970s when oil prices spiked.”

The era that Porter speaks of was marked by what has since been termed stagflation - a persistent period of economic stagnation and high inflation.

The Numbers Tell The Story

In uncertain times like these, it is even more prudent to look at the hard data to provide the “real” truth behind the economy. The following are sets of numbers that help us to understand the effect that skyrocketing energy prices are having on consumers:

• Consumer Prices were ups 1.1% last month - The largest monthly increase in over 25 years!
• Energy prices are up 6.6% since last month.
• Inflation adjusted average weekly wages dropped 0.9% last month. This was the largest drop in wages since 1984.
• Consumer inflation is up 5% over the last year - The highest since 1991.
• Airline prices were up 4.5% in June - The biggest one-month jump since early 2000.
• Vegetable prices were up 6.1% in June - The largest monthly increase in three years.

What Can Investors Do?

In any inflationary environment the common practice says to keep existing outflows down, skip new large expenses, and increase your emergency savings. I would like to personally add that we should continue to invest in equity markets as long as we have time on our side (7-10 years).

Increase emergency funds and review life and health insurance.

The 3-6 months’ worth of expenses that advisors suggest we keep stashed away in liquid assets such as fixed deposits or a high interest savings account could be increased.

Life and health insurance should be reviewed and could be topped up with low-cost term insurance if necessary. Shop around for no-obligation insurance quotes. InsureMe.com offers quotes on all types of insurance and are very competitive.

Prepay your mortgage.

As mortgage and interest rates may climb higher, prepaying your loans will give you a guaranteed return on your investment equal to the interest rate on the loan. Moreover, no single investment option is likely provide guaranteed returns greater than the rate of interest on your mortgage. In addition, the psychological satisfaction of reducing your overall debt can trump any financial return. This is especially true for the conservative investor.

If you are concerned about rates increasing, you might want to lock in the interest rate on your mortgage with a fixed rate loan. If you have a good credit score, banks will likely really want your business as lending regulations are tightening. This would be a good opportunity to have a service like LendingTree.com working for you to get the best rate.

Continue to invest in stocks.

The only opportunity that we have to combat inflation is to investing in equity. Carry on with your stock investment strategy and take advantage of buying opportunities in great dividend growth stocks. For the moderately conservative investor, seek out large cap stocks that are trading at least 30% off of their 52-week high and have stable earnings as they are likely to rebound first.

If you want to pick up stocks, invest in stages and go for value dividend growth buys. If your time horizon allows, a great buying opportunity may be upon us. Remember, history is on your side.

Diversify in precious metals.

While Gold and Silver are at high prices, some advisors still recommend that you invest 5-10 per cent of your portfolio in gold exchange-traded funds and gold mutual funds. Their reasoning for this suggestion is that, historically speaking, periods of high inflation result in a surge in gold prices.

What are your plans for this economy?  Are you buying, selling, or staying the course?

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Why You Need Dividend Growth To Beat Inflation

Saturday, May 10th, 2008

I recently had a conversation with a gentleman who really “gets” dividend investing and he provided me with a synopsis of what is going on on a macroscopic scale in the world today.  He came up with a “fictitious” conversation that will hopefully make sense to you all.  Maybe it will even assist you in determining that you should buy dividend stocks now?

A General Overview

The central banks around the world are dealing with a liquidity crisis by lowering interest rates or injecting money into the financial system.

The Fed has been the most aggressive in cutting rates and injecting dollars into the system, causing the U.S. dollar to fall.

To the U.S., this means that its exports become cheaper and imports become more expensive.

While the world is fighting a credit crunch, inflation is creeping higher. Over time, as the cost of goods and services increase, the value of the dollar is going to fall because people won’t be able to purchase as much with their dollars as they did previously.

The Conversation

(PS - I live in Canada,so the gas price is in liters or litres :))

“Wait a minute,” Bob said. “I recently read that both Canada’s and the U.S. CPI (consumer price index) is roughly two per cent.”

“You’re partially right,” I replied. “Core inflation is roughly two per cent, but it excludes certain items that are considered too volatile, including food and energy.”

“How can that be?” Bob asked. “Eve (Bob’s wife) told me eggs have jumped 62 per cent in price over the last two years and our food bill has increased more than four per cent over the last year.

“If memory serves me correctly, it cost 94 cents a litre to fill up my car last year.

“Now I am paying $1.18 per litre. If my math is correct, that’s roughly a 25 percent increase,” Bob said.
“Including food and energy, inflation in North America is running closer to four per cent,” I said.

“If oil and food commodities keep rising, then higher inflation and eventually rising interest rates will eventually follow. This is one reason why European countries are reluctant to cut their bank rates.”

A recent report from Bloomberg indicated that CPI in Ukraine was running at 19.4 per cent, in Vietnam it stood at 14.1 per cent, Russia was 12.6 per cent. Inflation in India is at 5.1 per cent and in China currently stands at 6.5 per cent.

These numbers are rising, not declining and there has been social unrest throughout the world because of rising food costs, even in some of the oil exporting nations.

“So what your are saying is that this sub-prime mess is temporarily forcing the central banks to reduce interest rates to help the economy get through this slowdown and credit crisis,” Bob said.

“But eventually, if food and oil costs remain high or continue to rise, interest rates will eventually follow suit.”

What this Means For Investors

(Hint: Buy Dividend Stocks)

As a result, the biggest dilemma savers face today is that at four per cent guaranteed investment rates on products, like GICs, they are only breaking even.

When you include income tax, these savers are likely losing money.

But an equity investor can invest in companies providing a four-per-cent dividend that also have growth potential at, or greater than, the rate of inflation.

So if inflation does rear its ugly head, ultra-conservative savers will be hurt, while with increasing dividends, equity investors will, at least, keep pace with inflation.

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