Brace your clients for higher inflation: Rubin

“Exploding transport costs may soon remove the single most important brake on inflation over the last decade — wage arbitrage with China,” says Jeff Rubin, chief economist and chief strategist at CIBC World Markets. “Not that Chinese manufacturing wages won’t still warrant arbitrage. But in today’s world of triple-digit oil prices, distance costs money.”

The report reveals that shipping a standard 40-foot container from East Asia to Canada’s east coast has tripled since 2000 and will double again as oil prices near $200 a barrel. Rubin says that high transportation costs will affect the Consumer Price Index and, in turn, will “cancel out the East Asian wage advantage.”

While rising inflation means your client’s day-to-day purchases will be more expensive, it also signals a possible rise in interest rates, which have dropped from 4.5% in March 2007 to 3% today.

In early May, Rubin said, “while the Bank of Canada may still have one more rate cut up its sleeve, markets will be surprised at how rapidly the Bank is compelled to take back those easings. We expect to see at least 100 basis points of tightening by the end of next year.”

If interest rates rise, your clients might find fixed income investments more attractive than stocks. Wayne Rothe, a CFP with Alberta-based Wayne Rothe & Associates, says some of his clients have become more risk averse, thanks to the up-and-down markets, so they’re looking at safer investment vehicles, like guaranteed investment certificates, in which to park their money.

However, he explains that higher inflation could offset the benefits of a GIC, even with the higher interest rate. “Clients have to understand that they’re losing any upswing on the inflation side,” he says.

Frank Wiginton, a CFP and senior financial partner at TriDelta Financial, says advisors should make sure their clients are in an inflation-protected investment like a bond or preferred share. GICs aren’t protected, so they’re not a good option during times of rising inflation.

“GICs are taxed at the highest rate,” he says. “There’s no way of having any sort of inflationary response, and all you do is end up losing money if half of your 3% return goes to taxes and inflation is 2.5%.”

Bonds are a better option, but if your client already owns 10- or 20-year bonds, and interest rates go up, the value decreases.

Wiginton says investors should consider short-term bonds when interest rates go up. “They’ll be less affected,” he says. “The client can hold to maturity and then reinvest in new bonds at the higher rate.”

While interest rates can influence investment choices, higher inflation can affect a client’s bottom line. “Higher inflation can have a dramatic impact on a client’s financial plan,” says Rothe. “It has an impact on their monthly cash flow, so clients will sometimes say to us, ‘I can’t put away as much into an RRSP because it costs me too much to live.'”

To avoid a planning disaster, Wiginton and Rothe both work inflation into their clients’ financial plans. Rothe sets inflation at around 4.5%, while Wiginton says most planners use rates between 2% and 3%. But with oil’s dramatic rise, he says it “may be time for planners to reassess what rates they use.”

Figuring out inflation numbers can be a tricky thing, though. Wiginton says advisors and clients need to avoid looking at core inflation, which excludes food and energy, and focus on headline inflation to get the whole picture.

“People need to be aware, even though the Bank of Canada keeps reporting inflation without the volatile commodities such as oil and gas and food, that these are the biggest factors that influence a person’s cash flow,” explains Wiginton. “Clients have to feed themselves, and most people drive cars, so these things have the biggest hit on pocketbooks. People need to disregard the ex-volatile index and look at the whole inflationary picture.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(05/27/08)