Author Topic: Advice on my investment strategy for high inflation environment  (Read 1335 times)

k290

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Over the past several years on this FIRE journey, I've started to realise that the typical investment strategy in the US and UK does not seem to work in my country due to high inflation.
Can you please check my reasoning below.

Inflation in my country is around 6%.

Relatively secure government bonds in most countries returns like 4% max. So that is completely out! If I include bonds in my portfolio I'll be losing money. And any government bonds returning over 6% are wayyy too risky/high chance of defaulting. I know that in the 80s 10 year US treasury bonds yielded around 12%. But in searching around I cant find any good bonds yielding anywhere close to that these days.

Stock market in my country returns roughly the same as the global stock market. So a global ETF is a no brainer at 9%. Unfortunately thats pretty slow growth compared to if I lived in America and inflation was much much lower.

Due to the high inflation, when interest rates are high, banks offer cash fixed deposits for 5 years at about 11% and practically risk free. Thats pretty good. Much better than the stock market. So I lock up about 50% of my portfolio in a 5 year CD.

The other 50% of my portfolio is in the world ETF.

How is my logic here? Anything I'm missing? Any advice?



« Last Edit: August 16, 2019, 02:34:46 PM by k290 »

PDXTabs

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Re: Advice on my investment strategy for high inflation environment
« Reply #1 on: August 16, 2019, 04:49:40 PM »
I personally would put most of you money into global market cap weighted index funds like VT.

Radagast

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Re: Advice on my investment strategy for high inflation environment
« Reply #2 on: August 16, 2019, 07:01:41 PM »
Seems good to me. CD's are an acceptable and common substitute for bonds in any case. If they are yielding inflation+5% they may even be a substitute for stocks! Although they may not be as riskless as they seem, that yield is probably high for a good reason (as far as anybody knows). And for that reason, I would personally probably increase the global stock allocation to be more like 60-75%. Then the CD's could double as bonds and exposure to your own currency, without taking too much risk in that single area. But you know more about your situation than I do!

Also try to use an ongoing series of CD's, perhaps 1 per year or 4 per year. That way you are not overly exposed to the interest rate of any single time. Yes it will be very nice if rates and inflation head lower and you lock in that yield while it is high. But what if inflation and yields head higher? Time diversification is your friend in the face of uncertainty.
« Last Edit: August 16, 2019, 07:05:23 PM by Radagast »

Andy R

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Re: Advice on my investment strategy for high inflation environment
« Reply #3 on: August 16, 2019, 09:01:26 PM »
k290l

Generally, higher interest rates lead to currency depreciation.

It is called Covered Interest Parity.

If you have an investment of comparable risk (eg government guaranteed bonds in developed country, same level of credit and duration risk), then the expected return after inflation should be the same.

For instance, if you get 1% more in currency A but 2% in currency B, with all else being equal, then at maturity when you convert the currencies back, they should have the same value, so you aren't actually getting a higher return just because it's a different number.

Of course, there is the Uncovered Interest Parity anomaly where currencies with higher interest rates don't decline and there are extended periods when the exchange rates have moved in the wrong direction, but as it can move away from the expected amount either way, your expected return has not changed, just the range of possible returns, which is the definition of risk.

BicycleB

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Re: Advice on my investment strategy for high inflation environment
« Reply #4 on: August 16, 2019, 09:09:10 PM »
Can't be certain of any advice, not knowing what country, but am guessing you're already getting good answers. Some thoughts:

It's possible you're missing where the risk is on those bank deposits. It seems strange to me that you could have 6% inflation in a country, yet a fixed 5 year investment is "practically risk free." How do you know inflation rates won't go up during the 5 years? How can you even be certain that a bank won't fail?

I would check carefully about the returns in the quote below.


Stock market in my country returns roughly the same as the global stock market. So a global ETF is a no brainer at 9%. Unfortunately thats pretty slow growth compared to if I lived in America and inflation was much much lower.


Not sure exactly what you mean in the above quote.
1. How did you decide that global ETF returns 9%? Stock returns vary widely over long periods of time, such as decades. How long a measurement period is producing this 9%?
2. Is this an ETF consisting of stocks from across the globe, or something else?
3. Is the 9% in terms of dollars, or your local currency?
4. It seems to me that a "global ETF" will, in terms of a specified currency, yield the same no matter where you live. For example, if the 9% is in your local currency and your local currency inflates 6%/year, the net return is 3%. If you bought the ETF in US$ and received your returns in US$, you would still get a net return of 3%.

I think you're asking good questions. Possibly Radagast already gave the best answer, but keep learning until you can be more certain.

EvenSteven

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Re: Advice on my investment strategy for high inflation environment
« Reply #5 on: August 17, 2019, 12:23:12 AM »
Quote
Relatively secure government bonds in most countries returns like 4% max. So that is completely out!

But those other countries aren't issuing bonds in your currency, so the rate of inflation of your currency shouldn't matter.

vand

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Re: Advice on my investment strategy for high inflation environment
« Reply #6 on: August 17, 2019, 01:11:05 AM »
Real Estate works well in a high nominal inflation environment provided that real incomes are also growing.

This happened in the 1970s and 80s in the UK where were had bouts of higher inflation.

The asset keeps pace with inflation while the debt is eroded at a significant rate each year.

also see this thread: https://forum.mrmoneymustache.com/investor-alley/stocks-are-not-an-inflation-hedge
« Last Edit: August 17, 2019, 01:41:00 AM by vand »

k290

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Re: Advice on my investment strategy for high inflation environment
« Reply #7 on: August 17, 2019, 07:15:06 AM »
Quote
Relatively secure government bonds in most countries returns like 4% max. So that is completely out!

But those other countries aren't issuing bonds in your currency, so the rate of inflation of your currency shouldn't matter.

It seems to matter. The exchange rate between South African Rand and US dollar hasn't changed much in 3 years. In january 2016 it was trading at 16 ZAR to the US Dollar. Now it is trading at 15.30 to the US dollar. So its actually strengthened in spite of local inflation!

But the price of goods and services here is definitely going up consistintely by between 4 and 6% per year, and this is the target range for our reserve bank/government.

It seems local inflation is not fully correlated to the strength of the currency.
I suppose this is the Uncovered INterest Parity that Andy R mentioned in his response
« Last Edit: August 17, 2019, 07:25:06 AM by k290 »

k290

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Re: Advice on my investment strategy for high inflation environment
« Reply #8 on: August 17, 2019, 07:27:31 AM »
Seems good to me. CD's are an acceptable and common substitute for bonds in any case. If they are yielding inflation+5% they may even be a substitute for stocks! Although they may not be as riskless as they seem, that yield is probably high for a good reason (as far as anybody knows). And for that reason, I would personally probably increase the global stock allocation to be more like 60-75%. Then the CD's could double as bonds and exposure to your own currency, without taking too much risk in that single area. But you know more about your situation than I do!

Also try to use an ongoing series of CD's, perhaps 1 per year or 4 per year. That way you are not overly exposed to the interest rate of any single time. Yes it will be very nice if rates and inflation head lower and you lock in that yield while it is high. But what if inflation and yields head higher? Time diversification is your friend in the face of uncertainty.

Thank you, this helps a lot

Andy R

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Re: Advice on my investment strategy for high inflation environment
« Reply #9 on: August 17, 2019, 07:44:07 AM »
It seems local inflation is not fully correlated to the strength of the currency.
I suppose this is the Uncovered Interest Parity that Andy R mentioned in his response

You left out an important word in what it is called

Uncovered Interest Parity anomaly.

Anomaly meaning it is abnormal and not the way it generally works.
Be careful assuming it will continue or that it won't adjust with a big drop back the other way.

k290

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Re: Advice on my investment strategy for high inflation environment
« Reply #10 on: August 17, 2019, 08:36:57 AM »
It seems local inflation is not fully correlated to the strength of the currency.
I suppose this is the Uncovered Interest Parity that Andy R mentioned in his response

You left out an important word in what it is called

Uncovered Interest Parity anomaly.

Anomaly meaning it is abnormal and not the way it generally works.
Be careful assuming it will continue or that it won't adjust with a big drop back the other way.

Thanks I have done some reading now on UIP and this has been incredibly helpful in understanding the impact of my country's weakening currency and how interest rates interplay with this.

k290

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Re: Advice on my investment strategy for high inflation environment
« Reply #11 on: August 17, 2019, 08:41:27 AM »

It's possible you're missing where the risk is on those bank deposits. It seems strange to me that you could have 6% inflation in a country, yet a fixed 5 year investment is "practically risk free." How do you know inflation rates won't go up during the 5 years? How can you even be certain that a bank won't fail?


I've done some reading on this and it seems there are two reasons.

Reason 1: The banks here offer high interest rates to meet Basel III compliance. A lot of the country is in poverty, and so not many people are saving for retirement. This means the banks liquidity isn't high enough to meet  Basel III and so they offer higher rates to attract some long term liquidity.

This has resulted in short term interest rates (1 year CDs) dropping and long-term interest rates (5 year CDs) increasing.

Reason 2: The government increases interest rates of the central bank in order to lower inflation and keep it below the 6% target. This trickles down to private banks who then also raise interest rates.

Anyone have any thoughts on this bit of info?

Also there is a bit of sovreignty risk
« Last Edit: August 17, 2019, 09:03:34 AM by k290 »

bwall

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Re: Advice on my investment strategy for high inflation environment
« Reply #12 on: August 17, 2019, 10:04:45 AM »
Keep in mind that you can invest in non-ZAR denominated currencies/businesses via your local stock market.

For example Naspers earns most of it's money outside South Africa, so any earnings that they report will be safeguarded from any local currency depreciation and thus protected from high inflation.

JAYSLOL

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Re: Advice on my investment strategy for high inflation environment
« Reply #13 on: August 17, 2019, 11:58:33 AM »
Quote
Relatively secure government bonds in most countries returns like 4% max. So that is completely out!

But those other countries aren't issuing bonds in your currency, so the rate of inflation of your currency shouldn't matter.

Agreed, if you have a US bond fund, you are getting paid out in US dollars, so the inflation of your currency shouldn’t affect that

k290

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Re: Advice on my investment strategy for high inflation environment
« Reply #14 on: August 18, 2019, 12:10:43 PM »
Quote
Relatively secure government bonds in most countries returns like 4% max. So that is completely out!

But those other countries aren't issuing bonds in your currency, so the rate of inflation of your currency shouldn't matter.

Agreed, if you have a US bond fund, you are getting paid out in US dollars, so the inflation of your currency shouldn’t affect that

I don't understand. A 4% yield is a 4% yield, whether its in my currency or in USD. And so any yield needs to exceed my local inflation rate or else I'll be losing money. If I gain 4% on my investment in USD, but local goods prices rise by 6%, then my investment isn't getting me any closer to FIRE. I'm getting poorer, by 6% - 4% = 2% per year.

As someone else pointed out, due to Covered Interest Parity, my currency should weaken against the dollar too due to the inflation, offsetting the issue above. But this doesn't seem to be what you and EvenSteven are pointing out?
« Last Edit: August 18, 2019, 12:20:48 PM by k290 »

BicycleB

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Re: Advice on my investment strategy for high inflation environment
« Reply #15 on: August 18, 2019, 12:15:24 PM »

It's possible you're missing where the risk is on those bank deposits. It seems strange to me that you could have 6% inflation in a country, yet a fixed 5 year investment is "practically risk free." How do you know inflation rates won't go up during the 5 years? How can you even be certain that a bank won't fail?


I've done some reading on this and it seems there are two reasons.

Reason 1: The banks here offer high interest rates to meet Basel III compliance. A lot of the country is in poverty, and so not many people are saving for retirement. This means the banks liquidity isn't high enough to meet  Basel III and so they offer higher rates to attract some long term liquidity.

This has resulted in short term interest rates (1 year CDs) dropping and long-term interest rates (5 year CDs) increasing.

Reason 2: The government increases interest rates of the central bank in order to lower inflation and keep it below the 6% target. This trickles down to private banks who then also raise interest rates.

Anyone have any thoughts on this bit of info?

Also there is a bit of sovreignty risk

Re Reason 1 - sounds like a good reason for the bank to offer high rates. I don't think it takes the risk of bank failure down to zero though. Just my somewhat uninformed opinion. In USA, there is a very well run govt agency that guarantees consumer deposits against bank failure of ordinary banks, and an agency that provides a more disputed level of assurance regarding "too big to fail" banks. Does your country (South Africa?) have something similar? How well financed is it?

Re Reason 2 - This scheme can work well, but also could fail. In my country, similar schemes failed for nearly a decade while inflation rose from maybe 3 or 4 percent to about 15 percent. At that point, the govt basically tried harder, plunging the nation into a deep recession with severe unemployment through govt lending rates as high as 18 percent, which finallly reduced inflation. I suspect your risk is low but not zero.

Not an expert here by any means. Still guessing that a combination of stock ETFs and your bonds is wise, weighted somewhat toward stock. I'd go 2:1 based on what you've said, but of course your more detailed continued study should inform you better than my guesses could. Keep up the learning process.

Andy R

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Re: Advice on my investment strategy for high inflation environment
« Reply #16 on: August 19, 2019, 04:48:04 AM »
I don't understand. A 4% yield is a 4% yield, whether its in my currency or in USD. And so any yield needs to exceed my local inflation rate or else I'll be losing money. If I gain 4% on my investment in USD, but local goods prices rise by 6%, then my investment isn't getting me any closer to FIRE. I'm getting poorer, by 6% - 4% = 2% per year.

As someone else pointed out, due to Covered Interest Parity, my currency should weaken against the dollar too due to the inflation, offsetting the issue above. But this doesn't seem to be what you and EvenSteven are pointing out?

Just to highlight the whole sentence from my earlier post (bold added):

It is called Covered Interest Parity.

If you have an investment of comparable risk (eg government guaranteed bonds in developed country, same level of credit and duration risk), then the expected return after inflation should be the same.

So there is also the fact that emerging markets offer higher interest because the credit risk is higher.
For instance, the world would have to decay into armageddon for the US government to default on US government bonds, so they are about as safe as you can get.

In developing countries (or even some developed ones like Italy, Greece), there is clearly a higher chance of government defaulting and not not paying back that money back. It might be a small chance, but it is higher, and because investors around the world would not invest in those if they offered the same return as US government bonds, they have to offer a higher return.
This higher return is not free - you are paying for it with a higher risk.
The same way that corporate bonds offer a higher yield (for a higher chance of default).
The same way P2P lending has a very high interest rate (for an even higher chance of default).

So you may be getting a higher rate after inflation is taken into account if the quality of the investment is not comparable, but of course if this is the case, it is not a free lunch, you are paying for it with the safety of your investment.

I don't know if this is the case in your country, just wanted to point out that higher return (especially with credit) is pretty much always priced-in and any higher return will certainly come with some type of higher risk.

This article from monevator might be useful.
What is the minimal risk asset?

BussoV6

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Re: Advice on my investment strategy for high inflation environment
« Reply #17 on: August 19, 2019, 07:12:10 AM »
Keep in mind that you can invest in non-ZAR denominated currencies/businesses via your local stock market.

For example Naspers earns most of it's money outside South Africa, so any earnings that they report will be safeguarded from any local currency depreciation and thus protected from high inflation.

+1.  There are many Rand-hedge shares available on the JSE. Also, there are many ETFs tracking outside market indices (FTSE, S&P500, EU and global). These are Rand denominated but if the Rand depreciates, you get the gain.

ChpBstrd

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Re: Advice on my investment strategy for high inflation environment
« Reply #18 on: August 19, 2019, 10:05:14 AM »
Look into whether you can set up an account with Interactive Brokers. There will be a steep learning curve, but depending on the laws you may be able to choose to convert your currency into other currencies and hold assets such as stocks or bonds in other exchanges/currencies rather than your home country. This is complicated stuff and there may be a lot of tax documentation involved, but nobody said becoming an “international financier” would be easy!

Also keep in mind there is a worldwide “everything bubble” that has made it hard to safely beat inflation anywhere in the world. You might not find attractive deals in dollars, yen, or euros. Indeed, it may be investors in those home currencies who are buying up the assets in your country and hedging the currency risk in the futures market.

Good luck getting your eggs in multiple baskets!

bwall

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Re: Advice on my investment strategy for high inflation environment
« Reply #19 on: August 19, 2019, 10:28:52 AM »
I don't understand. A 4% yield is a 4% yield, whether its in my currency or in USD. And so any yield needs to exceed my local inflation rate or else I'll be losing money. If I gain 4% on my investment in USD, but local goods prices rise by 6%, then my investment isn't getting me any closer to FIRE. I'm getting poorer, by 6% - 4% = 2% per year.

Perhaps a real life (extreme) example might provide more clarity. Next door to you in Zimbabwe, inflation was running somewhere between 100% and 1,000,000 % . Banks there in Zim could hypothetically offer you 1,000,000 % interest vs 11% in your local SA bank. Let's say you have 10,000R to invest and the exchange rate at the beginning of the term was..... $100 Zim to 1R, so you'd change your Rand for $1,000,000 Zim and invest it at 1,000,000 %. At the end of a year, you'd have a gazillion Zim dollars which you could trade back for maybe 1 Rand, if you're lucky. Even though you had a huge interest rate of 1,000,000 %, when the time arrived to get your money back, it was a bad transaction for you.

So, this is what we are talking about with USD interest rates vs. Rand interest rates. Because the interest rate differential isn't as extreme (and SA is well run vis-a-vis Zimbabwe), there are wacky times when the exchange rate theory doesn't hold, thus the phrase 'uncovered interest parity anomaly'.

BicycleB

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Re: Advice on my investment strategy for high inflation environment
« Reply #20 on: August 20, 2019, 11:25:44 AM »

I don't understand. A 4% yield is a 4% yield, whether its in my currency or in USD. And so any yield needs to exceed my local inflation rate or else I'll be losing money. If I gain 4% on my investment in USD, but local goods prices rise by 6%, then my investment isn't getting me any closer to FIRE. I'm getting poorer, by 6% - 4% = 2% per year.

Like bwall, I don't think so.

A 4% yield in US dollars is only a 4% yield in rand if the exchange rate stays the same. If South Africa has 6% inflation and the US has 2% inflation, the exchange rate isn't going to stay the same. It's likely that after a year, the US dollar will buy about 4% more ZAR than it did at the start. Your yield in rand would then be about 8%, because you would get a 4% return in your dollar-denominated asset, plus a 4% rand gain from currency adjustment.