Where do we go from here?
From the June 2018 print edition
I received the following e-mail from a good friend who occasionally comes to me for financial advice:
“Would you recommend exiting our current equity positions? Given the yield movements, I am considering moving my savings into GIC accounts…it’s not much but I’d like to protect it. Also, do you think this is a good moment to invest in real estate in downtown Toronto?”
This is a good friend. So I took time before responding because the answer to both of those questions hinges around one variable: interest rates.
Interest rates have been going up on both sides of the 49th parallel in the past year. In summer 2015, Canada’s Bank Rate was pared from 1 to 0.75 percent and then held steady for two years. Last summer, the rate edged back up and then there was a further hike in September and it now stands at 1.25 percent. To get an idea of how a-historically low these rates remain, consider that the lowest rate seen in the 1990’s was 3.25 percent. This could suggest that there are still many interest rate hikes to go before we get back to “normal”.
Something similar has happened in the US. In December 2016, the Fed Funds rate was hiked a quarter point, and now the current target range is from 1.5 to 1.75 percent. Members of the Federal Reserve Board have indicated that more rates hikes will be forthcoming later this year. So there is a pretty good argument to be made that interest rates will be higher—even significantly higher in the near future—which would lead me to tell my friend to exit her equity positions and avoid real estate right now, because higher interest rates lead investors to rotate out of stocks and into bonds and make carrying a mortgage more difficult.
However, before recommending that, it’s important to understand that it is inflation that ultimately leads to higher interest rates. The rule-of-thumb is that everything else being equal, central banks would like to keep interest rates as low as possible to facilitate economic growth. Banks should only raise interest rates for two reasons: The economy is growing at an unsustainable rate and/or inflation is rearing its ugly head.
How strong is economic growth right now in North America? The evidence seems mixed. On one hand, unemployment in the US is at a 17-year low. Yet during the first quarter of 2018, the economy grew at a somewhat tepid 2.3 percent. And the Canadian economy seems even cooler than the US. You can’t justify raising interest rates based on economic growth.
It’s hard to conclude that interest rates should go up based on inflation. The “ideal” inflation rate for the Canadian economy has been pegged at 2.0 percent. As of the latest StatsCan report inflation is 2.2 percent. Inflation seems to be more of a problem in the US. The latest number is 2.5 percent. But dig deeper into those numbers, and you’ll see that it’s largely due to higher oil prices. Fuel oil is about 20 percent higher than a year ago and gasoline is up 15 percent. If we assume this levels out, 12 months from now inflation is a non-issue in the US.
This should lead us to a deeper examination of what causes inflation in the first place. In a developed economy there is only one thing and that’s wage inflation. My argument is that we are in the very early stages of the greatest wage killer that mankind has ever seen and that is Artificial Intelligence (AI).
When you look back at the sweep of economic history, you see that mechanization and machines democratized physical strength. Before power tools, a larger, stronger man had a meaningful competitive advantage compared to the smaller, weaker man and could demand a wage premium as a result. Power tools leveled that playing field. It’s easy to imagine AI will have a similar impact on the more cognitive occupations. It seems virtually inevitable that the wage premium many of the intellectual elites enjoy is in the early stages of evaporation.
If this is true, inflation isn’t something we should be worried about: It’s deflation. I think that when the economic history of the 21st Century is written, scholars will recognize that the technological revolution unleashed deflationary pressures and that the norms of the 20th Century didn’t hold—and because these deflationary pressures will be reflected in low interest rates, I’m suggesting that my friend hold on to her equity holdings and consider strongly investing in real estate.