We're in the foothills of the next big cycle

Each year I spend time reading through Warren Buffett’s annual shareholder meeting to see what’s on his mind and where he sees risks in the global economy. I remember attending the meeting in 2007 while working as a stock analyst at Morningstar. It’s a spectacle.

Buffett is not only a great investors but a master businessman. He doesn’t consider himself as a stock picker, instead as someone who invests in businesses. His 2021 meeting took place yesterday and something very important stood out to me.

"We are seeing substantial inflation," Buffett said at the Berkshire Hathaway annual shareholder meeting yesterday. "We are raising prices. People are raising prices to us, and it's being accepted."

Buffett called out much higher steel costs impacting Berkshire's housing and furniture businesses.

"People have money in their pocket, and they pay higher prices... it's almost a buying frenzy," Buffett said, noting that the economy is "red hot."

I’m dedicating this week’s note to inflation because it is the single biggest threat and opportunity to your wealth and quality of life. Inflation hasn’t yet been a problem, but it is about to absolutely explode.

A threat which can turn into an opportunity

John Rockefeller was the richest man in US history. What most people don’t know is before he got into the oil business, Rockefeller was in a partnership trading commodities — mainly agricultural products from a warehouse in Cleveland, Ohio. His first big business break came right after the civil war when inflation sent the price of everyday goods skyrocketing.

The northern US states faired much better and reaped the rewards of inflation. Rockefeller and his partners saw their profits quadrupled within the first year after the war had ended.

This reminds me very much of 2021 — where seeing a boom period following the severe economic shock of Covid-19. The global economy is starting to react as though we have just come out of a large world war. In fact, the economic downturn we saw early last year was sharpen than what we saw during the second world war.

The recovery is in the early stages and some of the world’s wealthiest and most successful investors like Buffett are telling us, explicitly, that inflation is here. Doing nothing and staying in cash is the single biggest risk to your quality of life and net-wealth position.

I’ve written here many times, through numerous posts, that inflation is a hidden tax which can quickly reduce your wealth if you aren’t ready for it. The price of goods goes up quickly and if you don’t have offsetting factors — like more money and rising asset prices, you can fall behind quickly.

Focus on income and diversified assets

The best way to prepare for inflation is to have sources of income which rise with inflation. Sales people generally earn a commission on goods and services sold. They’ll do even better if they earn their commission on the value of assets they buy and sell.

For example, a 2% real estate commission is relatively inflation safe. If the value of a house goes from $1m to $2m, the sales commission income rises in proportion from $20k to $40k.

It’s not just real estate, but many other assets or business services. It’s probably a good time to sharpen your sales skills if you’re in the workforce. By comparison, high services paying jobs, ripe for disruption will be hardest hit. If you cast your eye over to the last time we saw high inflation, it was jobs in the manufacturing industry which took a tumble.

Western countries have little manufacturing remaining as a proportion of their economy. So lazy services will be the first thing people stop paying for when inflation becomes rampant. If you’re a dentist, optometrist, architect etc then things could get tough if you start losing your pricing power to cheaper alternatives.

Start planning and investing now for higher inflation

My point here is this — start to think about the ramifications to your primary sources of income if we do see asset and goods prices start to rise. Supermarkets like Woolworths will be ok because most people will just end up paying whatever price is dictated. Government workers should in theory be protected by unions and bargaining positions, but there could be a lag and ceiling on income gains.

Having investments which generate income is very important. Real estate is the most obvious inflation hedged asset and rental income from residential real estate is relatively stable, so rising inflation should translate into higher rents. Dividend paying stocks like Woolworths are also a good idea.

Buying gold or other non income producing assets should be cautioned. The best way to do it is through a well diversified portfolio, just incase your assumptions are incorrect.

There are two types of assets you could own — ones that produces income (like real estate) and others which you buy with the aim of selling them higher in the future (like gold and art). Bitcoin is somewhere in between, because you can lend your coins out and earn interest.

Start thinking about your future income generation, any vulnerabilities you have in this area and how you can diversify your assets to benefit from rising inflation, rather than suffer from the consequences of not being prepared.