Inflation and Wealth: The Implications of One on the Other

Inflation is the highest in the US and most parts of developed Europe in more than three decades, so everyone is seeing their existing level of wealth being eroded. Even for those seeing wealth increases, the real value of that wealth isn’t what is used to mean.

Those on fixed-benefit plans and/or those who hold most or all of their savings/wealth in cash and bonds are most impacted.

Inflation is making essential goods more expensive, and inflation often eats into the amount of interest paid on investments.

Inflation tends to hit the lowest earners hardest, as more of their earnings go toward buying essentials. For most people, 50-70 percent or more of spending falls into necessities like housing, energy costs and utilities bills, transportation, food, and healthcare.

As inflation starts to become more material and real incomes decline, it makes bigger changes. It hits different demographics in different ways: retirees will be harder hit than those who have the ability to find work during inflationary periods; even those who can afford luxury goods might want to tamp down on their spending as inflation eats into their disposable income.


Inflation and investing/trading

The backbone of financial markets is the concept of the interest rate. This is the rate at which borrowers and lenders agree to enter into a financial contract where one side lends money and the other pays it back over time.

A higher inflation rate erodes the value of debts in real terms. Firms losing money on their fixed costs (e.g., wages are a big one) are squeezed the most.

With inflation reducing the value of money, lenders get hit twice: from the interest side and from the principal side from inflation eating away at loan values over time.

The entire idea of investing and trading is to earn more than what you put in. It’s important to at least retain purchasing power over time. So real returns matter when it comes to evaluating a portfolio and deciding what types of inflation protection should be chosen in one.

Inflation is high in the US and developed Europe, and most in these economies haven’t experienced any level of material inflation during their lifetimes.

This is not unexpected.

At this point in time, there’s the confluence of several factors:

1) Governments are creating a lot more money, which has been ongoing since March 2020 in response to the Covid-19 pandemic.

2) People are receiving a lot more money directly (different from interest rate and QE policies, where income is only indirectly impacted).

3) The money and credit people are getting are being used to buy things that are producing more inflation.

4) Most people don’t have adequate inflation hedges in place, as inflation generally hasn’t been a problem for many decades.


Illusions of increasing wealth

Some believe they are getting wealthier because they see their assets like stocks and houses going up in price.

But they typically don’t pay enough attention to how their buying power is going down.

This is also why when there’s a shortfall of money to cover debts and expenses coming due, governments will make up for a revenue shortfall by trying to print money.

It’s the most politically discreet way of doing it. Instead of trying to take more money directly through higher taxes (which is hard past a point), they can devalue it instead.

As people get nearer to retirement, they typically become more conservative in how they allocate assets. These investors are generally hurt most because the returns on their safe investments don’t keep up with their cost-of-living expenses.

With inflation and inflation protection in play, investors and savers will likely start to realize why inflation matters when it comes to a portfolio.


Real wealth is not financial wealth

Wealth is buying power. Wealth is not simply the amount of money or credit or financial assets. Those can be created out of thin air, but don’t represent actual wealth.

Financial assets are a claim on goods and services.

When people invest, they put up a lump sum for the expectation of a stream of income in return. That income is produced by the entity producing more in resources than it consumes. The shareholders get that “excess return” over time.

If those goods and services aren’t produced – and produced in an economic way such that there’s an economic profit – there’s a problem with the valuation.

The inflation issue in the real economy is going hand in hand with asset bubbles in the financial economy.

Many types of inflation-fighting assets have inflated rapidly in price because of inflation hedging investing/speculation. This includes certain types of stocks, real assets, commodities, and other areas of speculation (e.g., altcoin cryptocurrencies).

So capital is diverted from productive areas to inflation hedges and pure speculation.

The cycle continues, where speculation fuels inflation and more money chases certain types of assets well in excess of their fundamental value.

Inflation… asset bubbles… then currency devaluation

There’s an issue past this point where asset inflation has gotten so far ahead of real economic growth that there’s no way for financial markets to maintain their current valuations without an essential devaluation of currencies.

Inflating assets are essentially just a form of currency devaluation.

The asset goes up in money terms and the value of money goes down in terms of the asset.

Gold is the standard example of this “inverse of money” phenomenon but it also holds true with respect to stocks, commodities, houses, real assets, and other alternative stores of value (e.g., cryptocurrency).

The value of money and credit change

Financial wealth is not real wealth because of the fundamental reality that the value of money and credit changes over time.

When a lot of money and credit are created without offsetting supply of real goods and services – as has been happening – they go down in value.

So having more money doesn’t necessarily mean more wealth (buying power).

Real wealth

Real wealth is what people can physically buy, because they need it or want it. This includes food, housing, basic necessities, luxuries. and so on.

This “stuff” has intrinsic value, unlike money and credit and other financial assets, which inherently don’t.

Financial wealth is made up of financial assets whose purposes is to:

1) receive a stream of income in the future, and/or

2) later be sold to get the real assets that are needed/wanted.

When inflation goes up, the financial value of inflation-fighting assets goes up as well because there’s a premium on inflation hedges.

This happens for a variety of reasons:

1) The general public wishes to save against inflation by buying into inflation hedging investments or commodities that are sensitive to inflation, like gold.

2) Governments need to provide more money through printing currency to cover debts and expenses coming due, so they print more money which devalues it. So traders and investors want to get ahead of that.


inflation and wealth

(Source: Nordea)


There’s a lot of talk these days about how the government can never make due on its promises, which will require the creation of a lot more money going forward.

While this is true, it’s also true in the private sector as well.

Currently, there is a lot more financial wealth than can ever be converted into real assets.

Therefore, the prices either need to come down, which is painful.

So, it’s inevitable that money and credit will be devalued over time to ensure those “promises” are effectively kept.

When your financial wealth is going up, that shouldn’t be mistaken as a large gain in real wealth when your buying power is going down.

In the 1970s, a stocks and bonds portfolio made quality gains in nominal terms. But those gains were negative in real terms.

Portfolio Returns: Jan 1972 to Dec 1979 (50/50 stocks and bonds mix)

Portfolio performance statistics
Initial Final CAGR Stdev Best Year Worst Year Max. Drawdown Sharpe Sortino
$10,000 $15,269 5.43% 9.38% 21.67% -11.88% -23.87% -0.08 -0.12


1970s portfolio


While a 50/50 stocks and bonds mix grew during this period in nominal terms at a CAGR of 5.43 percent, the annualized inflation rate was 8.11 percent, leading to a loss in real value of nearly 3 percent per year.

In other words, despite the risk that investors took on, standard stock/bond portfolios provided less buying power at the end of the decade than at the beginning.

(Portfolios that balanced their risks better by having commodities and gold exposure did much better as those assets excelled in that environment.)

Wealth is productivity

In the short term, the credit and money cycles matter a lot in terms of the direction of financial assets.

But over the long term, wealth and buying power is a function of productivity.

Historically, wealth that was taken or seized doesn’t last long. For example, during the Russian revolution of 1917-18, there was an uprising where wealth was forcibly taken from some.

However, Russia itself didn’t become rich. Instead they became poor because they weren’t very productive. They lacked a system that incentivized people to take their creativity and inventiveness and turn it into output.

Inheritances also rarely last. Those who typically receive them were generally divorced from the process that created the wealth in the first place. Though they will want to live off them, it generally doesn’t take them very long to squander it. Lottery winners are another example of wealth windfalls that weren’t generated from productivity.

Those that generated a lot of wealth but couldn’t keep it up also fall into this territory. Successful professional athletes in popular mainstream sports are a common example. They may earn a lot over a limited period of time, but their physical skills decline and their incomes generally dry up and they have difficulty transitioning into a second career or turning their savings into a sufficient incomes stream. Most end up broke shortly after their playing careers end.


Productivity = wealth = power

When a society or empire is less productive, they become less wealthy. Therefore, they are less powerful.

Spending on productive investments and infrastructure tends to lead to stronger productivity. Accordingly, investment is a generally strong leading indicator of increasing real wealth.

On the other hand, societies that focus on consumption and decadent purchases tend to be less productive over time.

Creating money and distributing it without being productive doesn’t raise real wealth. Though these policies are necessary to some extent to support demand and maintain minimum acceptable living conditions, what the spending goes into is important when thinking about the implications of policy developments.

The government acting as a lender of last resort is perfectly acceptable as an investment engine so long as the money and credit goes into the things that help raise productivity in excess of the amount being spent.

Wealth equates to power

If one has wealth, one has the potential to buy lots of different things. It can go into financial assets, workers, education, healthcare, property, political influence, and so forth.

Those who have wealth, therefore, have the ability to influence policy. Throughout history, this has been true – those who have wealth and those who have political power often go hand in hand.

In previous centuries, the Spanish Empire was able to do things because they had the wealth and power to do them in the pursuit of more wealth and power.

Then came the Dutch, who wanted to have those advantages for themselves and eventually became superior to the Spanish.

The English rose in power, tangled with the Dutch for that dominance, and eventually had it for themselves.

Then came the American empire, which took over the top spot in the early-1900s (and indisputably by the end of World War II).

Now the Chinese are coming up to challenge the US in various ways.

In the meantime, the world is becoming more bipolar in various ways, with China increasing its influence over certain parts of the world and the US having dominance in other parts and seeing its overall dominance slip economically, technologically, militarily, and geopolitically.

Wealth changes = power changes

Wealth changes lead to power changes. So looking at who is doing what to create wealth changes matters a lot in terms of how the future will take shape.

That China places lots of focus on the development of new technologies is not an accident. Technological dominance tends to lead to economic dominance, which comes with it military and geopolitical dominance.

Inevitably, there’s a direct competition between the US and China on various front (trade, economics, capital, technology, military armament, geopolitics).

That competition is going to be a major factor in the future power structure of the world.


Power declines accompany wealth declines

Any entity that loses its buying power – individual, company/organization, country/empire – loses its power.

For any entity to be sustainable, it needs to have sound finances. That is, income needs to be at least on par with expenses and assets need to be above liabilities.

Earning a lot matters less than having basic surpluses.

When you examine a business, you care less about the absolute amount of revenue they are taking in and more about their basic expense structure.

Are they earning a profit? Are assets above liabilities?

This is more important than a business taking in a lot of revenue but having poor unit economics and perpetual deficits that need to be funded (i.e., must take on liabilities) for the company to keep going.

When an individual, company/organization, or country/empire is:

a) spending more than it earns and

b) has more liabilities than assets – a position the US is in now – …

…conflict and turmoil follow.

Those who spend modestly and maintain surpluses are those who are more sustainably successful than those who earn a lot but spend a lot.

The US is at a point where it’ll never pay for its expenses with the revenue it takes in.

That gap has to be filled by printing money. That, in turn, devalues it.

The only way to improve the situation is to increase productivity and increase social and political cohesion.



Policy factors are a big component of inflation.

In a policy world where 1) interest rates or 2) interest rates + QE are the primary lever, real economy inflation is generally not an issue.

But when going into a world where fiscal policy puts money directly in the hands of people and monetary policy supports this, then real-economy inflation becomes much more likely.

We are in this period now where inflation is picking up because fiscal policy is intimately paired with monetary policy.

This gap between demand and supply is now large enough that higher for longer inflation is more likely. This is especially true now that extremely easy policy is encouraging further demand rather than reining it in.

This has implications for portfolio construction – the need for assets beyond just stocks, bonds, and cash – and implications for how the world order is evolving.

The US is in a difficult position where its income is below its expenses and its liabilities are below its assets. Other countries, most notably China, are using this opportunity to gain ground and expand their influence globally.