$12 Beers and How to Combat Inflation in Canada
You're lining up to get the first round of beers at the hockey game with your boy. You look up at the menu that's dressed like a scoreboard and see a selection of hip craft beers with names like "Summit Seeker" and "Mount Crushmore". To the right of these hip names you see the prices, $11.75 across the board. "Holy shit, that's more than I remember beers costing last season" you think to yourself. You get to the front of the line and place your order, "Two Mount Crushmores please". Your friend looks at you and says "First round's on JT". You give him a puzzled look, your friend doesn't have a job and you were under the impression that you'd be buying the beers tonight. "Who's JT?" you ask. Your friend bursts out laughing "JT, Justin Trudeau!, I've got those Trudeau bucks baby". You let out some nervous laughter and think to yourself "What the hell are Trudeau bucks? Why's the beer so expensive?". Your mind stops on a word you've heard your Uncle say a lot at family dinners recently. Inflation. "It's the worst tax because for most people they don't even take notice. The last thing you want in times like this is cash in hand, you ought to own some assets boy" you hear your uncle say to you. You make your way to your seats with your liquid gold in hand, sit down, and watch the game. But for all 3 periods your Uncle's advice lingers in the back of your mind. "I've got cash in the bank, is inflation going to eat it all up? What should I do?"
Inflation is the rate at which the purchasing power of a currency decreases. It's the reason why beers at the hockey game get more expensive each year and why having cash sitting idly in the bank is no good. Suppose you have $10k in the bank, which is enough to buy 1000 beers at today's prices. With a 5% inflation rate, the price of beer increases by 5% / year, and this time next year that same $10k only buys you 950 beers. In other words, your $10k can purchase more today than it can tomorrow. Inflation isn't a new phenomenon, it's been happening since the inception of financial markets, as you've probably noticed from your grandfather's stories of how "back in my day you could get a coffee, newspaper, bagel, and a mortgage for $2.25". So why are we hearing so much about inflation recently?
Because in September 2021, Canada recorded an inflation rate of 4.4%, an 18 year high. For context, an inflation rate between 2% and 3% is considered normal and what central banks aim for. And in Canada, we've been successful at keeping the inflation rate below 3% for the vast majority of the last 18 years. So what's the cause of the sudden hike? Covid? CERB? The Bank of Canada printing money? Political pundits, economists, and doomsayers alike will tell you with certainty what's causing the recent spike in inflation and why or why it won't continue. I'm not an economist or a doomsayer, so I won't attempt to convince you why Canada's going to become the next Venezuela. What I will do is highlight what causes inflation, and share what I do to combat it.
There are two main types of inflation. Cost-push inflation and demand-pull inflation. Cost-push inflation results from an increase in the production costs of goods and services, thus pushing up prices. An increase in wages or the price of raw materials can lead to cost-push inflation, as business owners will attempt to offload the price increase onto their customers by raising their prices. Demand-pull inflation occurs when the demand for goods and services exceeds the supply, thus pulling up prices. So what's going on right now? Likely a mix of both. As of Q2 2021, there were 731,905 vacant jobs in Canada, 178,425 more than the previous quarter. And naturally, when there are lots of unfilled jobs, employers raise wages in an attempt to attract candidates for those jobs, increasing their costs of production. On the demand-pull side of things, a global post pandemic hunger for oil has raised the average cost of fuel in Canada by 36.8% from 12 month's ago. Transportation costs are also up 9.1% from 12 months ago, likely in part to the global semiconductor shortage that's hampering the supply of new vehicles. Another contributing factor to Canada's inflation that falls under the cost-push category is our rapidly increasing money supply.
Money supply is the total amount of cash a country has in circulation. It includes all cash, coins, and money in bank accounts within a country. Inflation can occur if the money supply increases faster than the growth in output of goods and services produced by the economy. This is because there is more money in circulation for the same quantity and value of goods. Canada's M2 money supply in August 2019 was $1.65T, $2.06T in August 2020, and $2.28T in August 2021. That's a 38% increase in 2 years. In contrast, Canada's GDP was $1.645T in 2019, $1.573T in 2020, and is projected to be $1.67T in 2021, which would be a 1.5% increase over 2 years. This suggests that our increased money supply, which has far outpaced economic growth, is another reason for recent inflation.
As your uncle told you last Sunday, "You ought to own some assets boy". An asset is a resource whose value is expected to increase over time. Example assets include property or an ownership stake in a company (a stock). Unlike cash in the bank, an asset has the capability of increasing in value at a higher rate than inflation. I say capability because no asset is guaranteed to increase in value, and many assets decrease in value. If you want to avoid losing money to inflation, your assets will need to see a value increase equal to or greater than the current rate of inflation, which is 4.4%.
In the last 10 years, housing prices in Canada have increased 88.84%, substantially offsetting the 18.49% inflation that occurred over the same time frame. If that type of growth continues, purchasing property seems like a safe bet for combatting inflation. That being said, the housing market has historically followed periods of booms and bust, and many believe that we're in a 20 year bubble that's been building since 2002 (with dips in 2008 and 2017). Additionally, purchasing a house in Canada requires substantial effort and capital compared to alternatives like purchasing stocks, which can be done with a Wealthsimple account in about 15 minutes. The barrier to entry for purchasing property is also pretty high, as the minimum down payment required in Canada is between 5% - 20% of the purchase price. The current average house price in Canada is $716,828, which equates to an average down payment of $46,682 (5% on the initial 500k and 10% on the rest). Say you're like me and not quite ready to buy a house, your other option for protecting your cash against inflation is to buy ownership in publicly traded companies, i.e. buying stocks.
But before I talk about how to buy stocks and the strategy I use for determining what to buy, I need to acknowledge the enormous bull in the room. The current stock market is overvalued. The DJIA, S&P 500, and S&P/TSX Composite Index (measurements for the value of the stock market) are all at all-time highs. The Buffet indicator, a ratio developed by Warren Buffet for determining how overvalued or undervalued the stock market is, is also at an all-time high. The Buffet indicator is calculated by dividing the total market capitalization of the stock market by GDP. For the US, this value is currently 216% ($51.1T $23.7T), suggesting the market is Significantly Overvalued. For Canada, the Buffet indicator is currently at 183% ($3.957T $2.156T), also significantly overvalued. For historical context, the 20 year low of the Buffet indicator in Canada was 70.26%, which would be considered significantly undervalued. Herein lies the predicament. Will the stock market continue grow, greatly outpacing the destructive forces of inflation? Or will it crash hard like the dot-com bubble, which saw US stocks lose 50.2% of their value between March 2000 and October 2002. Nobody knows and nobody can know. My personal strategy is to hedge my bets by investing half my money in the stock market while keeping the other half in the bank. If the stock market continues to boom, half my wealth will reap the rewards, compensating for the other half that gets chewed up by inflation. And if the stock market crashes hard, I won't lose all my money and can swoop into the decimated market with my leftover cash to buy up some bargains.
Canada has an awesome program for purchasing stocks and avoiding the taxes associated with earnings from those stocks. This program is called the Tax Free Savings Account (TFSA), and if you're not already taking advantage of it, you should be. A Tax Free Savings account is a bank account for purchasing investments. Anyone over the age of 18 with a valid Canadian social insurance number can open a TFSA. (almost) All the money you make through investments in your TFSA is exempt from taxes, whether it be dividends paid by the stocks you own or capital gains of those stocks. This tax exemption differs from income made on investments outside of a TFSA, which are considered personal income and thus subject to taxes. The caveat with the TFSA is that there is a limit to how much money you can put into it. The program started in 2009 and had an annual dollar limit of $5k, meaning you could put an additional $5k into your TFSA each year. The limit has fluctuated from year to year and currently sits at $6k for 2021. Your TFSA limit is calculated by summing the dollar limits from each year for which you were over the age of 18. For example, if you turned 18 in 2018, your TFSA limit as of 2021 would be $23,500, since the contribution limit was $5,500 in 2018 and $6,000 in 2019, 2020, and 2021. You can view the TFSA contribution limits by year here. It's worth noting that you can withdraw money from your TFSA at any time, and that doing so actually adds to your contribution limit for the following year. For example, if you used all your contribution room for 2020, but then withdrew $1000, starting in 2021, your contribution room would be $7,000 ($6,000 limit for 2021 + $1000 withdrawal from 2020). Wealthsimple and almost all major Canadian banks allow you to open a self-directed TFSA where you can buy and sell stocks of your choosing. I personally use TD's investment platform, WebBroker, which has an awesome UI for buying, selling, tracking, and viewing the performance of stocks. TD charges $10 a trade, which users of platforms like Wealthsimple (which has unlimited free trades), tell me is absurd. But, what those same Wealthsimple users didn't tell me is that Wealthsimple charges a 1.5% currency conversion fee on US stocks, meaning you pay an additional 1.5% on top of whatever conversion rate from CAD to USD that Wealthsimple uses. For most trades that I make, this 1.5% fee is much greater than $10.
Now that you've got your TFSA set up it's time to make some investments. Again, I'm no expert so take what I say with a grain of salt, but I will share the core principles I use for buying stocks and some things I've learned from my brief 6 years of investing. My first principle is to buy stocks in companies that you want to own. "What other options are there?" You may be asking yourself. Well, in the era of extreme speculation where everyone's trying to get rich quick, the other option is to buy a stock solely on the belief that its price will rise in the near future, completely disregarding what the underlying company behind that stock does. You've probably heard horror stories from family or friends who've lost a colossal sum of money after buying some stock on a recommendation from someone. "Event X happened, so stock Y is bound to go up, you guys have to get in quick, it's a sure thing." their friend assures them. The problem is that in the stock market, as in life, there are no sure things. And the current market price of stock Y may already fully reflect event X. Buying stocks of companies you want to own mitigates this risk because you're in it for the long run. You're not betting on some single event to increase the price, after which you plan on selling. You're buying an ownership stake in what you believe to be a good company that will continue to prosper for years to come. What makes me want to own a company is based on two factors, a belief that the company is superior to the competition, and the company's value metrics.
I used to bank with RBC but I switched to TD over frustration with RBC's archaic online banking platform, $30 trading fees, and an abysmally slow process when trying to open up a business bank account. I was super impressed with TD's customer service and their online banking platform was decades ahead of RBC's. This experience spawned my belief that TD is superior to the competition. Next up was to look at their value metrics, namely Price-to-Earnings ratio (P/E) and Price-to-Book ratio (P/B). Price-to-earnings ratio is a company's current share price divided by their earnings-per-share, and tells you how much money the company makes relative to how much their stock is priced at. A high P/E ratio generally indicates that a stock is overvalued, whereas a low P/E ratio generally indicates that a stock is undervalued. A P/E ratio below 10 is considered low, between 10 and 20 is considered moderate, and above 20 is considered expensive. At the time of writing this, TD has a P/E ratio of 10.82, whereas Tesla, a highly speculative stock, has a P/E ratio of 332.12. Price-to-book ratio is a company's share price divided by its book value per share. It tells you how expensive a company's shares are relative to its assets. Similarly to P/E, a low P/B ratio indicates that a stock is undervalued and a high P/B ratio indicates that a stock is overvalued. Value investors generally aim for a P/B ratio under 3. Again, for comparison's sake, TD has a P/B ratio of 1.79, whereas Tesla has a P/B ratio of 41.88. The important part of my two-factor stock belief system is that I both believe the company is superior to the competition and see that the company has solid value metrics. I believe that Tesla is superior to the rest of the legacy automotive companies, especially when it comes to electric vehicles and autonomous vehicles. I think Elon is a revolutionary CEO who plays by his own rules and will continue to grow both Tesla and Space X. But I also believe a share price 332 times the annual earnings of those shares is insane.
So you've opened up a TFSA and invested your entire contribution limit into some value stocks, but you still have some cash leftover in the bank. Your two main options left for investing are to open a Registered Retirements Savings Plan (RRSP) or a personal investment account. The main pro of an RRSP is that any contributions you make (within your deduction limit) are deducted from your income at tax time. So if you make $90k, and put $20k into your RRSP, you'll be taxed as if you only made $70k. The main con of an RRSP is that whenever you want to withdraw money, you get absolutely obliterated by the taxman. RRSP withdrawals are subject to a 10% withholding tax for withdrawals under $5k, 20% for withdrawals between $5 and $15k, and 30% for amounts over $15k. On top of this withholding tax, the amount you withdraw gets added to your taxable income. So if you earn $100k for the year and withdraw $20k from your RRSP, your taxable income for the year will be $120k, and you'll only receive $14k of that $20k since it's subject to a 30% withholding tax. So how are you supposed to get money out of an RRSP without getting taken to the cleaners? You'll have to convert your RRSP into a Registered Retirement Income Fund (RRIF), which will then require you to pull out a certain minimum amount each year which will not be subject to the 30% withholding tax but will be added to your taxable income. This minimum withdrawal amount is . So if you open a RRIF at 50, you'll be able (and required) to withdraw 2.5% of your RRIF without paying the withholding tax, but that amount will still be added to your taxable income. If you withdraw more than 2.5% from your RRIF that year, you'll have to pay that dreaded withholding tax on all money over the 2.5% minimum withdrawal amount. Long story short, unless you're in your late eighties, you won't be able to take out substantial amounts from your RRSP without getting bodied. Although the immediate benefits that can be reaped in taxable income deductions from an RRSP are nice, the lack of control you get over your money is a big turn-off for me. For this reason, I'm much more interested in opening up a personal investment account after I've used up all my TFSA contribution room.
A personal investment account is exactly that, personal. No government-mandated contribution or withdrawal limits, just income tax on all the money you make through your investments. It's essentially a TFSA, without the TF. And good news, money earned from investments is taxed at a lower rate than normal income. There are two types of taxes you'll pay on investment income: capital gains and dividend tax. A capital gain is an increase in the value of an investment. Thus capital gains tax is a tax paid when you sell a stock at a higher price than when you bought it. In Canada, 50% of your capital gain is included in your taxable income. For example, if you buy a stock at $1000 and sell it at $2000, You'll have a capital gain of $1000, 50% of which ($500) will be added to your taxable income. You don't have to worry about paying capital gains tax until you sell. Dividend tax is charged as a percentage of the dividends you're paid and increases with each tax bracket i.e. the more your total taxable income, the higher your dividend tax will be. That being said, dividends are generally taxed at a lower rate than normal income in every tax bracket. For example in 2021, the federal tax rate on normal income between $50,197 and $100,392 is 20.5% whereas the federal tax rate on dividend income between $50,197 and $100,392 is only 7.56%. This means that someone who makes all their money off dividends pays less in taxes than someone who is paid by an employer. It's worth noting that US dividends are considered foreign dividend income and are taxed at the same rate as normal income, which makes owning US dividend stocks in your personal investment account far less enticing than Canadian dividend stocks.
And that's about all you need to know to buy some assets boy. My personal investment strategy can be summarized as follows:
- Only buy stocks you believe are superior to the competition and that have low P/E and P/B ratios.
- Use up all TFSA contribution room on a combination of US and Canadian stocks that meet criteria 1.
- Put half of my remaining cash into a personal investment account and buy Canadian dividend stocks that meet criteria 1.
- In case of market crash, use remaining cash to buy stocks that meet criteria 1 at bargain prices.
- I say almost because you still pay a 15% withholding tax on US dividend stocks, meaning if a US stock pays you a $100 dividend, 15% is automatically withheld from you and paid to the US gov, and you only receive $85, but this requires no action on your part when you do your taxes.