Inflation – A further Examination of its Causes, Outlook and Impact




February 23, 2011

To our dear friends and clients,

We had recently published our first article on Inflation as I felt this would be or become topic that would impact both lives of investors and also their portfolios. Given the price increased in commodities I felt that there would be underlying inflationary pressures that would impact our lives. This has so far not occurred to a great extend. I subsequently analysed what is called the Produced Price Index. The Producer Price Index is a wholesale price index, the cost that producers pay for their goods and services. The Producer Price Index is sub-categorized in various groups, Industrial, Raw Material and Services.  Some of these show a different story which will lead into our next article and offer a further insight why inflation is a threat we will have to deal with in the near future. In this article Bernd, my partner, has been able to connect Economics 101 to the real world in this article in a very congruent and understandable manner in examining the Consumer Price Index, the price index that affects our daily lives.

Inflation: What causes it?

Last time we examined the calculation of the Consumer Price Index (CPI) and how it applies to the average Canadian household, but not necessarily to you. Now, we want to look more in detail what can cause it and how do the economic relationships work. You will say it is easy to determine what causes inflation, e.g. higher commodity prices, higher import prices, higher wages.

Yes, these are obvious items that have an effect and we will get back to it later. From a monetary economic point of view an important variable is money supply and how it is connected to other aggregate economic numbers. The quantity theory of money provides such a frame work, it looks at the relationship between the velocity (V), the money supply (M), the price level (P), and the output (Y). This is represented by the equation M * V = P * Y. The right part of the formula represents the nominal GDP (P * Y).

How does this help me in estimating inflation? Assuming that the velocity and output are constant a 3% increase in money supply would result in a 3% price increase. Is it really that easy? No, let’s take the US as an example. The money supply measured by the money aggregate M2 increased from end of 2007 to 2010 by 18.66%.

However, up to this moment this has not yet translated into higher prices as prescribed by the theory, as the price level increased only by 4.35% in the same time and the output was constant. Why, the velocity of money went down by 11.36%, as every solvent bank was sitting pretty, hoarding cash, cutting credit lines and therefore not increasing the circulation of money. In addition the consumer was suddenly concerned with their debt levels and started saving and paying down debt. Velocity can also be considered as an indicator of business activity, if consumers and businesses buy goods – money changes hands. The more active the economy, the more often money changes hand or is created through use of credit. This is why central banks across the world, especially the FED, have stepped in and pumped money into the economy and become true lender of last resort. This was good news during the recession, but what if the economic activity increases and the velocity starts to rise again. If the central banks cannot reduce the money supply this will end in higher inflation.

An additional point of view is to not only consider the monetary policy of a country but also at the fiscal policy. In recent years the fiscal theory of the price level, a new economic theory is quoted more frequently. It states that government fiscal policy can affect the current price level, by connecting the present value of future government tax and spending plans to today’s outstanding government liabilities through the inflation rate. For example, if it is expected that the government is spending more money in the future, than a higher inflation rate is necessary to off set this and create the same present value of all future spending plans. (Note: A higher inflation rate results in a lower present value of future cash flows.)

This causality has been shown in the past, however the effect on the inflation rate is not always as direct as expected and is highly dependent on the expectations if future governments can produce a balanced budget or even a surplus. Otherwise, we would be in deep trouble, given the current fiscal deficits in the developed world and future obligations due to an aging population.

We looked at the monetary and fiscal policy influence on inflation and its danger. What are other factors that impact inflation such as higher commodity prices? These factors will eventually be passed on to the consumer, if they are perceived to be permanent by the producer. Bad weather for example that affects the harvest in one region might not result in a direct overall price increase. But an increased demand or decreased supply due to permanently altered patterns will lead to higher prices. The recent uproars in the Middle East are partly attributed to higher food prices.

At the same time developed countries phase the danger of imported inflation because several emerging countries like Brazil, India, Indonesia or even China experience higher inflation due to the fact that their economies have expanded at a higher rate than they increased their capacity. As these countries manufacture many parts for industrialized countries, price increases are passed on; for example import prices in Germany increased by 12% in the last year.

From a Canadian perspective we are somewhat sheltered from this effect up to this point as the Canadian Dollar has appreciated against most other currencies and this absorbed some of the price increases; on the other hand it reduces our competitiveness as our goods become either more expensive for foreigners to buy or our companies earn less money on it.

Another big influencing factor on inflation are increases in wage levels. In recent years wages in developed countries have been stable or have even declined. As the economy will pick up, we will see that people will ask for higher salaries. Currently, the main argument against this is that the unemployment rate is too high and therefore employees and unions don’t have the negotiation power to demand higher wages. This argument might have some validity for unskilled work, but in professions where skilled labour is needed and cannot be replaced by a random unemployed person, employees will start to push for higher wages. These factors are already apparent in the Producer Price Index.

All these factors raise concern, so watch out for inflation, but don’t expect that it will materialize in one big jump. However why worry about inflation other than more expensive goods. It will also impact interest rates and therefore mortgage rates. Several recent articles have already stated that the average consumer debt level is higher than ever before since it has been measured at more than 145% of income.  Can all the consumers that have purchased expensive homes continue to afford their mortgages if mortgage rates increase by 2%. This would represent almost a 50% increase on a 5 year mortgage. What will happen when these come up for renewal ?

As always, should you wish to discuss this further or would like us to review your portfolio please call us at 416.572.2265 or email us.

Bernd Henseler                                               Albrecht Weller ……………………………


Overview of equity markets and Schwaben’s investments in 2010



February 3, 2011

To our dear friends and clients,

We have now completed our first year of operation and have started a track record of our Canadian stock model portfolio. Our model portfolio is a portfolio that has been set up with a quote vendor that track positions when we purchase or sell these in the model portfolio. The actual purchase and sale in our clients portfolios may differ from when we purchase and sell securities in the model portfolio due to risk and other portfolio restrains. The model portfolio however offers a good representation of what a portfolio would look like if we had invested the funds starting January 4, 2010 and it had no restraints. A model portfolio is not eligible for an official performance track record thought, based on the CFA Institute guidelines or as it is official referred to the “Global Investment Performance Standards” or other regulatory organizations as it cannot be audited and does not meet some of the rules and guidelines that are required when calculating investment returns for official performance guidelines. It offers a good indication though how well all of our selections have performed.

The return on our Canadian dollar model portfolio including dividend and distributions was 25.5%.  Our portfolio was fully invested for almost the entire year.  The only sale we made was our position in Western Coal on November 18, 2010. We purchased Western Coal at $3.86 at the beginning of the year and sold it on November 18 for $10.75, with a 178% gain, after a takeover bid from Walter Energy pushed the stock as high as $11.00. The stock has since appreciated to over $12.00 however we were happy with the return that we achieved as we did not want to be exposed to a potential decline should the takeover bid have fallen through. We put Enbridge on our watch list, were we will not add the position to any portfolios as we feel it may be a bit expensive and we want to review the position to determine to what extend and how much more upside there may be in Enbridge.

Last year we also established some selected positions in the US to offer some of our clients where appropriate some exposure to the US. This year we established an entire model portfolio that will allow us to track our US performance. One of the positions that we established last year in the US was Apple. We have sold Apple earlier this year at U$342.00, for a 36.8% gain, after Steve Jobs indicated a medical leave of absence. It was our concern and opinion that a complete absence of Steve Jobs would have a sever impact on Apple. Steve Jobs has had two major medical complications since he has taken the helm at Apple. Initially he was a survivor of on of the least lethal forms of pancreatic cancer in 2003 and he recovered in 2009 from a liver transplant operation. While we hope that Mr. Jobs recovers from his current medical ordeal we feel that we do not want to risk the potential price volatility that may occur if he does not. The Chief Operating Officer Tim Cook is not a very well known personality and in the total absence of Steve Jobs would likely not attract the instant confidence of many investors. A further point is that growth expectations for Apple have increased significantly and with the increased competition in the smartphone and tablet area, we feel that Apple could miss the market expectations.

While we feel that equities have appreciated significantly over the past 6 months, in fact since the bottom of last August at just above 11,000 on the TSX and just above 9500 on the Dow and just above 1,000 for the S&P every Index has marched straight North to levels not seen since 2008. In the last two quarters equities in all sectors across the board have surprised investors as well as Analysts with stunning results. This has resulted in an almost 30% appreciation in the S&P 500, a 25% appreciation in the Dow Jones Industrial Average and an almost 23% capital appreciation since then. You may ask yourself why your portfolio did not achieve such spectacular results.

1.)  Your investment period was most likely longer than July 2010. January 2010 equities levels were higher than the low point in July of last year. Returns from December 31, 2009 to December 31, 2010 on equities were significantly less, in fact 12 months 12 months return have only been 14.1% for the Dow Jones and 15.1% for the S&P 500. Please see the statistics below for further insight,

2.)  Our equity selection is skewed away from cyclical equities such as resource based stock. Resource based stocks have done extremely well over the past 6 months with metals and Oil appreciating significantly since then. We do not believe in specific market timing, resource based and cyclical stocks generally can add significant volatility to portfolios. Our focus is to achieve solid returns with smaller troughs and peaks. We prefer that our clients sleep well at night. We think there are still enough reasons to have ups and downs that we don’t need to add volatility created by commodity speculation.

3.)  The asset allocation to equities and fixed income including preferred shares in your portfolio most likely resulted in less than 100% exposure to equities. In many cases we have used high yielding, high quality preferred shares to obtain income in lieu of actual bond. We feel that the yield premium and the preferential tax treatment of dividends more than make up for the extra interest rate risk or credit risk that high quality preferred shares may have.

In spite of all these facts our twelve months return December 2009 to December 2010 on our model portfolio, of which our clients portfolios are partially made up, was 25.5%.

Although the last six months have had very significant capital appreciation we feel that many equities are still not overvalued and that with proper stock selection this may be a time when active stock selection can still be of significant value.

In spite of many political and economic hurdles, equities seem to continue to march higher both in Canada and the US. There may be some volatility over the next few months however we believe that since equity markets have broken new highs and established new support levels the downside should be limited at this point in time.

Performance of North American indices and

Schwaben Canadian $ Model Portfolio

in 2010

Price Return Total Return
TSX 14.4% 17.6%
S&P 500 12.8% 15.1%
Dow Jones 11.0% 14.0%
NASDAQ 16.9% 20.1%
Schwaben Model Portfolio n/a* 25.5%

* There is no price return performance measured for the Schwaben Model Portfolio because of purchases and sales of securities.