Entries from October 2012 ↓

The big D

If the collapse in the price of houses from Florida to California should have taught us anything, it was deflation. It’s back. You should learn about this beast. It bites.

I’ve argued on this pathetic blog for more than a year that deflation’s what you need to worry about, prepare for and defend against. It’s worse than inflation. The latter we know how to deal with. The former’s a mystery. As far as economists can tell, there is no cure. Only attempts at prevention.

I was reminded of this in the last few days when the chief economist for the BC Real Estate Association broke down and admitted prices will be lower next year. That must have broken poor Cameron Muir’s heart, since it makes a lie of four years’ worth of media releases. At the same time, beware-deflation stories have started creeping into the mainstream media as central banks and governments everywhere jack down their growth forecasts, and commodity prices retreat.

Here’s the meat: Deflation is when prices fall, and continue to do so mostly because people expect them to. So, it’s inflation in reverse. Rather than buy a house quickly because you believe you’ll never be able to afford it later, deflation means you wait to buy since you’re sure it will soon be cheaper. If enough people agree, it’s a self-fulfilling prophesy. Sellers cannot sell unless they price below your expectation, which drags prices down more.

So deflation makes money more valuable. It buys more. In the US housing fell by 32% between 2006 and now. This asset deflation made money 32% more valuable. And along the way it cost about eight million jobs and destroyed the middle class.

As I’ve argued, you can have destructive asset deflation at the same time as price inflation. In fact, we have it now. Grocery bills keep rising in Victoria, for example, where the price of housing is falling. This pattern can last for some time, until deflation goes viral, starts costing jobs and profits, and everything trends lower. Hope that never happens. It’s called the Dirty Thirties.

While that extreme is unlikely, we don’t need a rerun of the 1930s to see what ‘moderate’ deflation can do to family finances. As I said, it’s already in front of us in the States, where 20% of all families owe more on their mortgages than their houses are worth and millions more have walked away from real estate they could no longer carry. About $5 trillion in wealth was destroyed when housing deflated – not bank money, but equity.

You see, when asset values fall and money gets more valuable, debts become harder to repay. Across Canada workers have been asked to take pay cuts in order to save jobs. The average wage gain is less than the price increase for food, which means people actually earn less. That’s deflationary. Now add in a decline in home equity as real estate values fade, and you can see where this might lead.

Central bankers know all this. It’s why emergency interest rates are still in effect four years after the financial crisis. It’s why the US Fed is spending $40,000,000,000 a month purchasing government securities, why the European Central Bank is on a bond-buying binge and why the American election is about tax cuts. If governments cannot stop deflationary pressures, they’re in serious trouble. So are most people reading this.

The telltale signs are structural unemployment, companies that take profits from productivity, not increased sales, sky-high bond prices, savings accounts that pay zip, government cuts, lower growth forecasts and, of course, falling real estate sales and prices. So, judge for yourself.

If it gets worse, the winners and losers are well-known.

Deflation destroys borrowers and rewards lenders. Mortgages can (as happened in the US) be worth more than the houses they financed, and homeowners forced to pay them back with reduced wages. Equity is erased. Now I hope you can see why I’ve spent so much time warning against 5% down payments, or encouraging those whose real estate soared to harvest those gains.

In deflationary times people who own bonds win. They mature and pay you 100 cents on the dollar, while preserving money which only grows more valuable. So, who needs to earn interest when the bond itself swells in purchasing power? See why trillions of dollars have surged into government paper that yields no return?

In deflationary times, real estate is usually crushed. Credit and liquidity dry up as the economy slows and consumer confidence fades along with jobs. The same with assets like gold and silver. Commodity values stagger as paper currency rises in potency. This is a reason why I have warned against over-exposure in both housing and PMs for a long time, since the future clearly belongs to those heavy in things that rise with cash.

Of course, this ain’t the Depression. It’s not even the USA circa 2009. Nor does it need to be.

Canadians are some of the most indebted people in the world, living in some of the most expensive houses with some of smallest savings on record. If there ever was a place where falling prices might suck, you’re in it.

Banking

In eight weeks you’ll be able to stick another five grand in your tax-free savings account. If you have a spouse, make that $10,000. If you have four children over 18, then shelter another $30,000. Finally, a valid reason to breed.

If you invest $10,000 in assets with a long-term return of 7% (what equities have given), and add in the annual TFSA contribution limit of five thousand, in 20 years you’ll have $243,674. Not bad for a hundred bucks a week. Of course, you can accomplish similar results with an RRSP, but the quarter mill will be nailed as income, and in 2032 you can bet tax rates will be higher.

I’m always gobsmacked by how many people think a TFSA is a ‘thing’ the bank sells. In fact, surveys show that eight out of ten people believe [email protected], and fill their tax shelters with a savings account. This is like making your new Boxster into a planter. Or marrying for love.

Fact is, with interest rates where they are, saving money is a losing proposition inside a tax-free account. Even moderate inflation wipes away the benefit. So all you accomplish is lending money to the bank at 2% so they can give it back to you as a car loan at 5%, and suppress snickers each time you walk into the branch.

I’m appalled at how the banks are misleading folks. So remember this:

The maximum annual contribution is $5,000 per taxpayer, or $10,000 for a couple. All unused contribution room can be carried forward forever, as with RRSPs. Unlike RRSPs, though, there’s no ability to deduct the money you put into a TFSA from your general taxable income, to net a refund. But, also unlike an RRSP, you can take money out of a TFSA at any time without generating any tax bill.

And any money withdrawn from a TFSA can be replaced, without affecting your ability to add another $5,000 every year. Most importantly, everything you stick in a TSFA (as with an RRSP) grows free of any tax. That means capital gains, for example, compound and swell. The best TFSA is a self-directed one, in which you can place a giant range of stuff from ETFs to bonds to stocks.

Here are eight strategies worth reminding.

  • Stick as many of your assets as you can inside a TFSA. Stocks, bonds, strips, T-bills, options—everything qualifies for a self-directed account opened with an advisor or a brokerage company.
  • Make the maximum annual contribution, and if you don’t have the money then simply transfer in assets you already own in the form of a contribution in kind. Remember to get things in first that are subject to the highest rate of tax, such as interest-bearing bonds or foreign securities that pay dividend income. (Also remember a capital gain could be triggered if you transfer securities on which you’ve made unrealized profits.)
  • Use the TFSA to do some serious income splitting. If you give your spouse $5,000 as a gift, for example, then he or she can open a TFSA and contribute the maximum amount, investing this money in growth securities. None of that income will be attributed back to you. And unlike a spousal RRSP, they can take money out at any time and use it for any purpose—even the day after your gift—and no tax consequences.
  • In fact, you could put money in your TFSA, make a big profit on high-growth stocks, withdraw the profits tax free, give them to your son or daughter or mother, and they could then use that money to establish their own TFSA—a great way to recycle tax-free capital gains.
  • You can also take tax-free capital gains out of a TFSA and use them to make an RRSP contribution, which will in turn get a sizable tax refund because of the deductible nature of the retirement plan payment. This tax refund can then be used to replace some of the money you took from the TFSA, which allows it to grow further without triggering any tax consequences.
  • In other words, you have used a tax shelter to create an untaxed capital gain, then withdrawn that profit, tax free, in order to contribute to another tax shelter. By doing so, you receive a very large tax deduction, which reduces your taxable income, with a refund that can be reinvested in the first tax shelter.
  • If you’re retired and worried that your investments could grow in value and throw off income putting you in a higher tax bracket, or cause some government benefits to be clawed back, then simply shelter them inside the TFSA. Then you can withdraw cash whenever you want, without tax and without even having to report it as a part of your overall income.
  • The TFSA can help with tax-loss selling. For example, if you dump a stock that’s lost value in order to claim a year-end capital loss against other capital gains, do it outside the TFSA. Then put the money inside your tax-free plan where it can be used to buy back the security and any future gains will be sheltered, while you circumvent the superficial loss rule.
  • In retirement, having a fat TFSA solves some of the problems you might need an RRSP meltdown strategy to solve. That’s because all withdrawals from a TFSA are free of withholding tax, and do not add to your taxable income. So, it makes perfect sense to draw the TFSA down before you start cashing in that RRSP.

So the tax-free savings account is destined to eclipse the RRSP, especially when contribution limits rise. (The feds promised to adjust them for inflation, but no word on that year. Plus during the last election came the commitment to double contributions when the budget is balanced. But don’t hold your breath.) The very first money you save should go into one of these. Every stock, ETF or mutual fund you own should migrate inside a TFSA, unless you have no room. Your spouse and adult children should have them, allowing you to income-split. The most volatile or growth-oriented assets you own should be here. And never, ever, ever, ever put a savings account, GIC or pathetic Canada Savings Bond inside this baby.

As a group, bankers should be ashamed for taking advantage of the ignorance of the masses. The masses, for their part, have no excuse.