Will Technological Advances Keep Inflation Low?

Last update on Aug. 7, 2017.

Image Credit: Dmytro Zinkevych / Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also discuss how technological progress tends to suppress inflation, and how that could influence our investment decisions.

 

July Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of July 2017 were as follows:

 

Last Month

Last 12 Months

Since Apr 2013

Slightly Aggressive

-0.4%

+13.6%

+76.7%

Balanced

-0.4%

+11.9%

+63.8%

Slightly Conservative

-0.4%

+10.2%

+51.6%

Moderately Conservative

-0.4%

+8.5%

+40.1%

Very Conservative

-0.4%

+6.8%

+29.1%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

-1.0%

+7.7%

+54.5%

TD Comfort Aggressive Growth

-0.9%

+5.9%

+42.1%

CIBC Managed Aggressive Growth

-1.0%

+6.0%

+47.0%

Canadian Couch Potato Aggressive

-1.3%

+9.6%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free regular membership.

The Regular portfolios outperformed their competitors in July. This was largely due to XEG.TO, which went up by 3.3% during the month as oil prices recovered. BRK-B also performed well relative to the rest of the U.S. stock market.

Two related themes dominated the performance of a typical Canadian investment portfolio in July. First, the Canadian dollar rose by roughly 3.5% in relation to the U.S. dollar, which decreased the value of U.S. stocks in terms of Canadian dollars. Second, interest rates on Canadian bonds rose sharply. The interest rate on the 10 year Canadian government bond went from 1.75% at the start of the month, to 2.06% at the end. As readers of my book know, interest rates and the price of bonds move in opposite directions. Canadian bond funds, such as the popular ETF XBB.TO, recorded losses last month as a result.

Both the stronger Canadian dollar and the increase in interest rates were caused by the strengthening of the Canadian economy. Late last month, Statistics Canada reported that the Canadian economy grew by the strongest pace seen in the last 17 years. A strong economy indicates that Canadians are producing a lot of goods and services. Those who want to purchase such goods and services will need Canadian dollars, and so the increase in demand for the loonie drove its price higher relative to other currencies.

A strong economy also tends to cause higher inflation, which incentivizes the central bank to raise short term interest rates. The anticipation of higher short term rates led long term rates to rise as well, which decreased long term bond prices.

I have conscientiously avoided investing in long term bonds for a few years now. I argued that long term bonds are not necessarily safe because their prices can go down significantly if interest rates rise. Short term bonds are much less vulnerable to rises in interest rates, so I advocated investing in them instead. I also believed that stocks presented a much better risk/reward proposition compared to long term bonds.

However, my stance on long term bonds is beginning to change. The stock market rose significantly in these last few years, so much so that I’m becoming more and more worried about a potential bubble. Although bond interest rates haven’t moved much in the past few years, they’ve become more attractive compared to what stocks are expected to return.

The one risk factor that makes me hesitate is the potential for higher inflation. Stocks are relatively sheltered from the effects of inflation, whereas bonds generally are not. If inflation does rise significantly, then long term bonds will lose a lot of value. Therefore, whether or not we should invest in bonds depend in part on our outlook on inflation.

 

How Technology Affects Inflation

There are many factors that influence inflation, ranging from government policies to the state of the economy. While professional investors generally pay attention to most of these factors, there’s one factor that seems to get overlooked, and that’s the influence of technology.

I didn’t come to the realization of the significance of technology on my own. Rather, I got the idea from David Chilton, the author of the “Wealthy Barber”, whom I think may be the smartest of the “Dragons”.

What Chilton explained in a talk is that technology keeps making products and services cheaper. Take taxis, for example. A few years ago, everyone had to pay full taxi fares plus tips (unless you didn’t mind feeling like a jerk) for a trip across town. But with the introduction of Uber, the amount that riders must pay has gone down significantly.

Now, let’s say you’re a government official who’s trying to calculate the inflation of cab rides. To do your job, you’d consider two pieces of information: the change in price, and the change in quality. We know about the former, so let’s talk about the latter.

Quality matters because charging less for a lower quality product shouldn’t count as a decrease in inflation. Take cars, for example. Let’s say a company charges $50,000 for a car that goes from 0 to 60 in 4 seconds. Now, let’s say this company introduces another car with a weaker motor, that can do 0 to 60 in 5 seconds. Because the motor is cheaper, this car costs $40,000. Does this suggest that car price inflation is -20% (i.e. from $50,000 to $40,000)? No, because inflation only tracks the change in prices of similar quality products.

Therefore, when we think about the influence of technology on inflation, we need to keep in mind the quality of new solutions that technology brings, as well as the price. If new solutions come with lower quality, then technology’s influence on inflation will be small.

However, I’m not sure that these new solutions are necessarily of lower quality. An Uber ride accomplishes the same goals as a cab ride, for generally the same quality of experience. Netflix provides access to shows that are of similar quality as those provided by cable channels.

In other instances, technology didn’t bring new solutions to the fore, but it allowed existing goods and services to be priced more cheaply. Amazon, for example, allows customers to buy the same Huggies diapers for less.

Because the solutions made possible by technology are usually of similar quality, the lower prices that accompany these solutions generally influence inflation. I believe this trend will only continue - for example, the advent of the self driving technology could dramatically reduce cab fares. Thus, I expect technology to continue to force inflation downwards.

That said, it’s important to remember that technology isn’t the only factor influencing inflation. After all, technology advanced at a good pace in the 70s and 80s, yet inflation remained high. I think the real question is just how much influence technology will wield going forward. If technology advances rapidly, then its influence could be big, and vice versa.

It’s extremely hard to predict the pace of technological advances, but if I had to guess, I would think the pace will be quite rapid. The field of artificial intelligence in particular seems to hold a lot of promise in displacing a lot of human work. If I’m correct, then inflation could stay lower for a longer period of time.

If we choose to believe that inflation will stay low, then it may make sense to hold some long term bonds in our portfolios. I haven’t made any final decisions yet, but this is something I’ll continue to think about in the months ahead.

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