Wednesday, January 19, 2011

Random musings about inflation

Inflation is back. Inflation expectations are back. However, neither inflation nor inflationary expectations are being reflected in deposit rates (still close to zero), mortgage costs (still below 1%) or bond yields.

If one could expect this state of affairs to continue indefinitely, the obvious strategy would be to borrow money and invest in assets which show yields higher than the interest rate being paid on the borrowings (with a suitable buffer to guard against disruptions to the inward cash flow). Of course, negative real interest rates will not be with us forever. At some point monetary and economic conditions will change. The most likely change is the US Federal Reserve ending its protracted stimulus programme and adopting a tighter monetary stance to combat inflation. Another possibility is rising interest rates in other countries leading to outward capital flows from Hong Kong.

Rising nominal interest rates would obviously impact on the cash flows of investors (like myself) and affect valuations of real estate, equities and bonds. In effect, they will result in reduced cash flows as floating rate mortgages are reset at higher rates and may result in lower asset prices - a bad combination. They may - historically there have been periods when this has happened and there have been periods when this has not happened. Other factors can and do also influence asset values. Over the longer term, I would expect risk assets (real estate and equities) to be better preservers of wealth than less risky assets such as bonds and bank deposits.

Since I can't predict what will actually happen or when it will happen, I intend to continue my strategy of holding mostly risk assets and not making accelerated repayments of my mortgages. I will continue to be a mostly value investor in the equity markets - buying where I see value. If I can't find value then I shouldn't buy (historically, I have not been very good at holding myself back).

Once I transition into retirement, I will of course need to keep 2-3 years of living expenses in the form of cash or near cash to avoid putting myself into a position where I have to sell assets to meet expenses. If the market takes a dive I can always use some of this money to invest.

The harder issue which I am grappling with is whether to pay off the home mortgage or not. As long as the interest rate is less than the rate of return on investments, then I am better off keeping the mortgage. Given how low the interest rate is (less than 1%), this is a very low standard to meet. That said, the mortgage will have to serviced every month and once I stop working that introduces an element of risk to my retirement plan.

One of the most important lessons I have picked up from my reading and retirement planning is that having a financially successful and low stress retirement does not involving attempting to maximise the return on assets but avoiding unnecessary risks. This principle suggests that, while paying off the mortgage is likely to involve a loss of potential gains in wealth, it is more important to remove the risk associated with carrying that mortgage.

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