Back in the late 1980s, I was talking investments with an old friend when it came out that he was averaging returns on his portfolio that were twice the rise of the Toronto Stock Exchange.
I was a little envious. Yes, his father was a banker and, sure, he’d won his fair share of the Monopoly games we’d played as kids. But I was the economist, for heaven’s sake. He was a dentist. Actually, I was more intrigued than jealous. Only a very few of the best professional fund managers could achieve his performance. Because of fees, the majority of mutual funds can’t even match the TSE.
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“What’s your secret?” I wanted to know.
My friend’s answer, while simply put, is one of the most profound insights into economics that I’ve ever encountered. His reply was, “Brian, it is my belief that every now and then there is a big wave that runs through the economy and, while there, that wave is the dominant factor that influences everything.”
My friend didn’t have a crystal ball and didn’t try to predict the future. Rather, he looked at what was happening at the time and asked himself, “Can this go on forever?”
At the start of the 80s, the economy was racked by high inflation and my friend correctly concluded that it wouldn’t last forever. In the fall of 1980, you could buy a Canada Savings Bond bearing 19.5 per cent interest. Fifteen years later it would be under 5 per cent. My friend foresaw dis-inflation — that is, falling inflation rates — and profited. In times of high inflation, investing, speculating and even gambling on real tangible assets such as land and gold can make you rich. But if you’d followed that strategy in the 80s, you’d have lost your shirt. Instead, investors who locked in those long-term double-digit interest rates or bought bonds made a killing. They rode the wave instead of being swamped by it.
Big waves come along at the end of unusual times and are more like a rising tide than a tsunami. At first we barely notice the water is rising. When the Canadian dollar was under 70 cents U.S. from 1998 until the start of 2003, we got used to it. But those were unusual times and those who sold their products in American dollars and based their business strategy on favourable exchange rates were swamped.
Today we are again living in unusual times — a time when inflation and interest rates are near or at historic lows. We don’t need a lot of complicated data analysis and economic theory to know this is not the norm. We also know that governments are running up huge deficits. Right now China and a few other countries are willing to hold mountains of U.S. debt to finance ongoing trade and current accounts deficits. Can this last indefinitely? History is clear: Rising government debt fuels inflation and higher interest rates.
Of course, a re-emergence of last year’s financial crisis might delay this. My friend didn’t try to time when the tide would turn. He just respected its power to swamp those caught on low ground.
Does ‘swamp’ seem too strong a term?
Consider this simplified example: A farmer has just spent $500,000 on land and $500,000 on new equipment. As a good customer, his line of credit is two per cent over the current (at the time of writing) prime rate of 2.25 per cent for a total of 4.25 per cent. He could lock in a five-year fixed rate of 5.0 per cent but is reluctant. After all, the interest-only cost of his $1 million line of credit is currently only $3,542 a month, or $42,500 annually. Going to the five-year fixed term would cost him an extra $7,500 a year.
So he dithers and delays. A year from now, inflation is creeping up and the Bank of Canada rate has long since moved up from its historic low of 0.5 per cent. Another year goes by, inflation keeps rising, and interest rate hikes have become monthly occurrences. The floating rate is now several points higher.
Eventually, unable to stomach any more, our farmer friend locks in his $1-million debt at 12 per cent. His interest payments on the $1-million loan now total $120,000 annually. If he had locked in in 2009, they would have been $50,000. The $7,500 a year he was saving back in 2009 now seems like a pittance. “How could I be so foolish?” he asks himself again and again.
My guess is that you probably have a year to take advantage of these unusual times. But I have no idea what the interest-rate situation will be in three months — much less three years — from now. Quite frankly, I don’t think bankers have any clear idea either. But they’re obviously worried. At the time of writing, one leading lender’s best rate five-year rate was just 4.75 per cent but its best 10-year rate was 8.25 per cent (The equivalent of nearly 12 per cent for years six to 10.) That speaks volumes.
I do know that if I were carrying a big debt load, like most commercial-sized farmers, I would not want all my eggs in the floating-rate basket when inflation starts ramping up.
My friend died at a young age so whenever I think of his penetrating insight, I can’t help but also think about the passage of time and how quickly the years roll by.
Soon — before you know it — these unusual times will have passed, and a rising tide of high inflation and high interest rates will be all everyone is talking about.
Currently head of the department of agribusiness and agricultural economics at the University of Manitoba’s Faculty of Agricultural and Food Sciences, Brian Oleson has had a ringside seat for major developments in the grain business over the past four decades as a policy analyst for Agriculture Canada and both sales rep and senior executive with the Canadian Wheat Board.
