CPI, Your Cost Of Living And Your Investing Strategy

Gas prices were a big contributor to the headline CPI data for the last year to November of 2017, which increased by 2.1%. If you drive regularly, you likely experienced an uptick in your cost of living.

However, according to statistics Canada, it is not just what you consume, it is where you consume it as well: if you live in Saskatchewan and Manitoba, your year to year increase in the Consumer Price Index was 3.7% and 3.2% respectively.

Remember, everyone has their own consumption habits so your personal increase in living costs may not be what Statistics Canada's basket of "average" consumer purchases would be.

If you have the time to determine the change in your cost of living from year to year (to compare) it is a worthwhile exercise. Especially when it comes to projecting your living costs going forward, which is a very important assumption in a Wealth Forecast.

As I mentioned in yesterday's blog, a Wealth Forecast is an integral part of any investment strategy. Getting as accurate a read on your lifestyle expenses as possible is a very important  part of understanding how you will reach your long-term goals.

Having an investment strategy without that understanding is like travelling without a destination. You need an end-point and a map of how you are going to get there.  

If your advisor suggests that just having a balanced collection of ETF's (or even worse, expensive MER mutual funds) in your investment portfolio is enough (to get an annualized return of 6-7%), then she or he is driving you in an unidentified direction (and not considering all of the risk metrics that can come in to play). I have spent more than 35 years honing my skills in risk management, so I have a keen understanding in this department and get a huge rush from helping people avoid the potential mistakes that less experienced advisors might bring to the table.

You need to have a plan (at High Rock, we call it a Wealth Forecast) prepared by an expert, Certified Financial Planning (CFP) professional, that includes understanding what is coming in (income) and what is going out (cost of living) and is able to show you how you will get from where you are right now, to where you want to be in the end (your destination).

Why Oh Why?

Yesterday a client sent me an email with a list of holdings in their CIBC TFSA;

You may have to click on the above to see it in greater detail, but what stood out to me was the first line from the client: "I didn't realize how shitty this was!!" 

What is an "escalating" GIC? I wondered, so I decided to further educate myself: you can get more here: https://www.cibc.com/en/personal-banking/investments/gics/escalating-rate.html

But, in a nutshell, it is a "locked-in" GIC that escalates in payable interest over the 5 year time period. Check out the returns:

Again, you may have to click on the table above to see the detail, but pay attention to the far right column: "effective yield", at less than 1.5%.

If your personal level of inflation is at 1.5% (which is likely not the case, we use a 2.5% rate of inflation for our client Wealth Forecasts) then you are making absolutely no real return on this investment. Zero!

If you buy a GIC, you are effectively  lending money to the institution that sold it to you. If you have a line of credit (with the same institution), you are turning around and borrowing that money right back from them at prime or prime plus whatever extra they are tacking on. Prime is 3.2% at the moment, so you are giving that institution a "gift" of at least 1.7% of your hard earned money. 

Why?

Because you are not being properly looked after by that institution. Instead of saying: "oh, it would be a better use of your money to either pay down your line of credit or invest in something a little more advantageous (that might earn a return better than that which you are paying on your line of credit)", they are very comfortable and happy to take your money and add it to the other billions that they are sending to their bottom lines and paying out to their shareholders. 

Because I / we care, we asked our client (in this particular case) what the holdings in their other account were, because it is important for us to understand what level of risk they might have in their investments that they hold away (from our management).

Some believe that it is safer to have multiple advisors. Perhaps, but you also have to make sure that if you are paying them (and you are, likely more than you realize), that you know what you are getting in return.

That is why we prepare Wealth Forecasts, to take a holistic view of our clients current financial position, project how they are going to get to their end goals and create a strategy for the best possible risk-adjusted method to get them to their goals.

I can tell you that a bank that so easily takes a chunk out of your financial hide, does not have your best interest at heart.

So why work with them for anything other than your banking needs, when there are folks out there (like us at High Rock) who will work with you to find the best possible solutions to your financial challenges at a very reasonable cost, with great levels of service and a fiduciary duty to always do what is in your best interest.

2018 Predictions

At the end of 2016, most analysts were calling for US 10 year bond yields to hit 3.5-4% by the end of 2017. That did not happen. Currently they sit at about 2.35%. Bond traders had a tough year.

Inflation, according to the basket of goods that the statistics folks suggest is "average", has barely budged. Central bankers continue to believe that this is due to "transitory" issues, but are struggling to explain why wages are not going up with improving unemployment numbers (deferring to a lack of productivity as the culprit).

Most clients that I talk to (when we perform their Wealth Forecast reviews) will argue that their respective annual inflation rate (i.e. the increase in their cost of living from year to year)  is nowhere near and significantly higher than what we are told it is supposed to be.

This will certainly continue through 2018.

Central bankers will take heart and continue to focus on the "normalization" of interest rates and monetary policy (take Bank of Canada governor Poloz's comments yesterday as an example), removing financial liquidity from the system.

If the US government increases their deficits with tax reform and increased infrastructure spending and there is less liquidity around to support bond issuance (to pay for all the new debt and deficits), asset prices (bonds, stocks and houses) will fall in price.

I am not even going to try to predict the potential outcome from a breakdown in NAFTA, shifting power balances and possibly a war in the Middle East, the Trump factor, North Korea, China, Russia, cyber terrorism and bubbles.

When asset prices fall (and they inevitably will), investor portfolios and net worth will take a hit. Balanced ETF portfolios, which have been the latest rage, won't be enough to protect them.

Investor apathy and complacency (which has escalated with the prices of stocks with a false sense of security) has allowed risk levels in portfolios to reach lofty levels, significantly higher than most investors actually realize. 

The concept of risk management, which has taken a backseat to passive investing in recent years will move into the spotlight.

High Rock phones will be ringing (as they did in early 2016).

Want to get ahead of the herd, protect your net worth and financial goals before the drama begins (which is how we manage our own money, in the same way that we manage our client's money)? 

We have low cost, fiduciarily responsible, risk and wealth management with tailored, personal investment strategies to suit your specific goals.

Why put your financial future at risk?

More Debt For Canadians In Q3

Canadian households added to their debt burden in the third quarter of 2017. Household debt to disposable income is up to $1.71 for each dollar of income earned (a new high). Importantly, while debt is rising, the value of household assets (savings, investments and house prices) remained the same, which can be a dangerous situation if this uptick (chart above) continues (if the value of assets turns lower).  Definitely a concern for the Bank of Canada as it weighs the outlook for interest rates in Canada. The two 1/4% increases in Q3 does not appear to have had much of an impact on Canadian's desire for debt. In the short-term, rising debt levels are good as increased household spending helps economic growth. However, that debt can be a longer-term problem, especially if the economy slows and the ability to service the debt forces asset sales (and asset prices fall, see 2008).

Meanwhile, south of the border, The US Federal Reserve raised rates by 1/4% for the third time this year and appear to be prepared for another three 1/4% increases in 2018:

Should the Bank of Canada follow the Fed's example (and they are never really that far behind), that might also create debt servicing issues for Canadians. 

Our work (at High Rock) is to look beyond the current hype / noise built into "record setting" equity markets at those things (not necessarily good) that are not being given appropriate consideration in the current determination of value.

Our work is intended to find opportunities for growth while remaining aware of all the underlying risks and making prudent investment decisions for ourselves and our clients within the context of the goals that we have set for ourselves.

Bond Markets Lead All Financial Markets

So it is very important to pay attention to what they are telling us. Whether or not the over-used cliche that "this time it is different" is or is not the case.

The US Federal Reserve will announce that they are raising interest rates by 1/4% at 2pm today. Of that there is little doubt.

What will be more important will be the pace of future interest rate increases and how they will impact economic growth into the future.The flattening of the yield curve has been something that we have been discussing (and you all may think over-discussing) lately. We certainly bring it up on our most recent weekly video (dressed in our holiday appropriate attire).

Rising interest rates will not be benign as financing record amounts of US household debt becomes more difficult without rising wage growth to help it. It cannot help but deter the consumer and the consumer is 2/3 of the US economy.

The consumer has been very confident of late and unemployment is at multi-year lows and they have been told by their President that there is better stuff yet to come. There are, however, a number of pretty smart economic minds that might argue the impact of the new tax reform on the average consumer over time is not what it is being billed as. 

The flattening of the yield curve is the real story. Bond markets are telling us that as short-term interest rates go up (without economic growth spurring inflation), that there is the potential for economic slowing (despite the current level of consumer confidence).

Stock markets appear to be ignoring the bond market's warnings and focusing on all the apparent good news (expected earnings growth, etc.), while paying limited attention to whatever bad news lurks in and behind the headlines.

We (at High Rock) know that it is folly to ignore the warning signs and will be ultra-cautious heading into 2018 as to how we want our and our client's money to be put to work.

Stronger than expected economic growth for 2017 does not necessarily guarantee stronger growth (and earnings) for 2018 and the bond market is telling us that. It is a behavioural trait of us mere mortals to expect what has transpired in the recent past to continue on into the future and many of us who have not been on the current bandwagon may feel tempted to jump on board. 

We shall resist that temptation and allow our 35 plus years of experience in financial markets to be our guide.

Myth Busting Of The Bonds In Your Portfolio

We preach balance in your portfolio. Balance between stocks and bonds (fixed income). Most of us know how stocks work (more or less) and that they are considered to be somewhat more risky than bonds (which will ultimately depend on the issuer of the bond).

For the moment let's focus on government bonds because they are the safest: Moody's Investor Service grades Canadian Government Bonds as Aaa (which is the highest level offered).

Generally, the safer the bond, the lower the interest income that the bond issuer will have to pay. Interest is usually paid semi-annually.

The math for bonds can be complex and confusing, but basically, because the interest income is fixed (i.e. fixed income) at the interest rate attached to the bond when it is issued for a set maturity date: when interest rates rise, the bond gets discounted in price as new bonds are issued at the higher interest rates and the bond becomes less valuable (bond price falls) at that moment. The opposite occurs when interest rates fall: the price for the bond will rise.

If you bought the bond when it was issued and hold it until its maturity, you will receive your initial investment at the original purchase price (we call that par value) and for the number of years that the bond has existed you have received the semi-annual interest payments.

However, bonds trade daily in a secondary market and the prices for those bonds adjust relative to the state of the economy and most importantly inflation and future interest rate expectations.

So bond prices move, up and down (which adds another dimension of risk).

The questions that we seem to get asked rather often are related to:

1) The coupon or interest rate: why own a bond that is only paying 1.5%? 

2) What maturity is best to own when interest rates are going up (or when they are going down)?

1) is relatively easy: in 2008 when all financial assets with any risk attached to them fell in unison, only cash and high quality government bonds were desired and prices rose (interest rates fell). It is wise to have the safety of those two asset classes when risk is high (as we believe it to be today).

2) is more difficult to understand, so lets use this chart:

The gold line is the yield (relative to the price and coupon) for Canadian government bonds for each of the maturity dates from 3 months to 30 years on January 1 2016 (we call this the yield curve).

The green line is the yield curve (same maturities) at the close of business yesterday. 

Between then and now, the Bank of Canada has raised rates 2x by 1/4% each time.

The myth that confuses most advisors and investors is that if interest rates are going up, then prices of shorter term bonds will go down less than longer term bonds and as a result you should own shorter (duration) bonds in your portfolio.

That has certainly not been the case this year: with inflation remaining low, longer term bond investors have not been demanding a premium (higher yielding bonds) for inflation protection and as the Bank of Canada tries to preempt future inflation (by raising short-term rates), longer term bonds (15 year maturities and beyond) have actually gone down in yield (up in price).

In essence, then, one should have had a longer term duration in their bond portfolio.

A client who recently joined us transferred in a portfolio full of short-term bond ETF's. Clearly, his advisor had mis-positioned him / her.  No wonder their portfolio was under-performing the benchmark.

If inflation jumps higher, then we need to be concerned about longer term bonds. However, at the moment, that does not appear to be the bond markets concern. In fact, as I mentioned in yesterday's blog, the flattening of the yield curve has potentially greater significance.

Bank of Canada Recognizes Risk Is High

As we suggested on our High Rock weekly client video, the Bank of Canada kept rates unchanged today.

"The global economy is evolving largely as expected in the Bank's October Monetary Policy Report (MPR). In the United States, growth in the third quarter was stronger than forecast but is still expected to moderate in the months ahead. Growth has firmed in other advanced economies. Meanwhile oil prices have moved higher and financial conditions have eased. The global outlook remains subject to considerable uncertainty, notably about geopolitical developments and trade policies."

Currency traders who were hoping for a different outcome after last Friday's employment report are abandoning their C$ bets (for now):

Uncertainties remain foremost in BOC decision making: NAFTA, Brexit, North Korea, the Middle East and a more aggressive US foreign policy are at the forefront of their radar screen and while optimistic (still) they are choosing to err on the side of caution.

Seems to make good sense. Investors should take note. The risks in financial markets are high and have been rising.

In US equity markets, price to earnings ratios are a good 23% above their 10 year average on a 12 month forward looking basis and that already has an expected 10% increase in earnings built in (for the next 12 months).

Every time we have a new client transfer in, I feel such a great sense of relief to be taking risk off of the table for them. They must feel the same way because we have seen an increase in Assets Under Management (new clients) this year by about 40%.

Bond markets are telling us something: yield curves are flattening and at the risk of becoming rather repetitious, flattening yield curves tell us of what is to come:

A flattening yield curve (the decline in the gold line) means that short term rates are rising and longer term rates are either rising less, remaining neutral or falling. Investors want the safety of long bonds, even in a low interest rate environment. The blue areas are times of recession (in the US) and you can clearly see the historical significance of what follows the declining gold line: the ensuing blue area.

In Canada the yield curve is doing this:

The spread between the 2 year and 30 year bonds has flattened to about 0.65%, the lowest since 2007.

Clearly, while not mentioning it, the Bank of Canada is aware and watching closely (so they are not raising short term rates today, which would push this flattening further).

We (Paul and I) have been trading and / or managing wealth through turmoil in 1987, 1998, 2001 and 2008, so we have a little bit of experience with these things.

What I see a lot of these days are portfolios with way too much risk relative to the signals coming from forward looking indicators (as opposed to backward looking economic data).

Want to know if you have too much risk in your investment strategy?

scott@highrockcapital.ca