Interest Rates, Inflation and Physical Gold

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1 Interest Rates, Inflation and Physical Gold It s no surprise that cash and term deposits have played such a big role in SMSF portfolios, as they offer trustees a regular income stream, and are of course unaffected by the volatility that frequently besets growth assets like shares. But with cash rates now sitting at an all time low of just 1.50%, and inflationary forces beginning to stir around the globe, trustees may benefit from looking at alternative assets. Won t Interest Rates Rise Soon? Whilst higher rates would be welcome news for those with cash in the bank, we wouldn t expect any meaningful increase for years to come. Australia faces a handful of economic challenges in the coming years, all of which will exert downward pressure on interest rates, with bond yields suggesting that the cash rate will remain low for the next decade. Our personal view is that the RBA will end up being forced to cut interest rates to just 1%, a level we think they d already be sitting at were it not for the RBA s concern regarding the rampant acceleration in East Coast capital city home prices that we ve seen in the last few years. This view regarding a 1% cash rate is in line with the current forecast from Capital Economics, whose Australian Economist Paul Dales was rated the top forecaster for 2016 by the Australian Financial Review. How Big an Issue is Inflation Anyway? If you are willing to take the official statistics at face value, then inflation is incredibly low, with the annual rise in consumer prices to end 2016 coming in at just 1.50%. This continues a prolonged period of official low inflation rates, with the decline in the rate of CPI growth evident in the table below, which covers 2006 to 2016 inclusive.

2 Source: Australian Bureau of Statistics The problem is of course that none of us actually purchase the inflation basket our statisticians use, with every Australian having different needs and wants, which influence their consumption patterns. Given this, it should be no surprise that many Australians themselves don t completely believe we are in such a benign inflationary environment, with a January 2017 ANZ Roy Morgan poll on consumer confidence and inflation expectations suggesting that Australians expect the cost of goods and services rise by 4.3%, a level essentially triple that of the latest official CPI reading. This Roy Morgan result should come as no surprise, for whilst it s true that there are a number of goods and services that have seen very little inflation in the last decade, there are also many big ticket items, such as healthcare, childcare and energy costs, which have spiralled higher. This was a subject we covered in detail in our 2015 book; Dire Straits: Money for Nothing, Debt for Free, which looked at the root causes and

3 unresolved challenges of the GFC, and the implications for investors going forward. In that book, we observed that in our opinion, whilst the official inflation story may well be dead cost of living pressures for everyday Australians is very real, and included the following chart, which showed the cumulative increase in prices between 2008 and 2014 for child care, utilities, education, healthcare, insurance, house prices, rents, and official CPI. Source: Australian Bureau of Statistics, Dire Straits: Money for Nothing, Debt for Free You can see how significant the price increases were in things like child care and utilities, which rose by close to 45% in that five years period, versus the official CPI figure, which rose by less than 15% in the same time period. In the 2 years since the above graph was created, nothing has changed, with price increases between 2014 and 2016 in childcare, health care and education running at 3-4 times the rate of overall CPI growth. Given this backdrop, it should perhaps come as no surprise that the average Australian is saving less (the household savings ratio has fallen to just 5.2% today, down from 10.2% back in December 2011), or that

4 they have had to dedicate an ever larger percentage of their income to spending on essentials, leaving less money for discretionary spending. This much is made clear in the following graph, which tracks the amount of money (out of every $100 spent) spent on essentials, and discretionary items, and how this has evolved over the last 15 plus years. When looking at the graph, it s important to realise that the two lines are on different axis. Source: Australian Bureau of Statistics, ABC Bullion As you can see, back in 2000, Australians were spending $62 out of every $100 on essentials, leaving close to $38 for discretionary spending. Today, essentials are consuming closer to $67, leaving just $33 for discretionary spending. That is a near 15% in reduction (from $38 to $33) in discretionary spending as a percentage of total spending in the last 15 years. No wonder discretionary retailers in Australia are feeling the pinch, or why companies like Aldi have had such success penetrating the Australian market.

5 What Happens Next With Inflation Whilst no one can be 100% certain what will happen with inflation (or GDP growth, retail sales, corporate profits, stock market performance, etc.) in the coming years, the risk most certainly seems tilted to the upside. Indeed using the United States as a proxy, we can see that inflation rates look like they will break meaningfully higher, with the latest CPI result showing an annual increase of 3.30%, a rate not seen since just before the GFC hit. Considering central banks in Europe, Japan and the United Kingdom continue to print money, it is only prudent to recognise the threat of higher inflation in the coming years. This threat is relevant for SMSF trustees too, as Australia has had several periods of time in the past where inflation rates have gone from relatively benign levels (below 3%) to exceptionally high levels (+15%) in a short period of time. That kind of inflation surprise would be a major challenge for anyone with a large portion of their wealth sitting in cash and term deposits. Gold and Inflation Whilst it s true that gold doesn t pay an income, it s equally true that it protects investors against inflation. The increase in the price of gold over the years has more than compensated for the lack of cash flow it generates, with the yellow metal s long run price from the early 1970s to the end of 2016 tracking at around 9% per annum. Perhaps most importantly for SMSF trustees, physical gold tends to perform strongest whenever real interest rates, which are calculated by subtracting the inflation rate from the official cash rate, are low. Indeed, over the last forty plus years, the AUD gold price has recorded average annual gains in excess of 20% whenever real interest rates are 2% or lower, outperforming shares in the process. Today, the real interest rate in Australia is just 0.00%. As such, whilst cash remains stable, it is going and will continue to go nowhere, if not backward, in real terms. With gold, you ll have the chance

6 of participating in solid long-term returns, though you ll be giving up the income stream (however tiny) that your cash or term deposits pay. That decision to allocate a portion of their portfolio to precious metals is one that more and more trustees in Australia are making every day. Jordan Eliseo March 2017 Disclaimer This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.