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Are you worried about inflation? There are few better ways to beat inflation than real estate, but even real estate isn’t all sunshine and rainbows. Learn about the red flags from PassiveInvesting.com.

DIVE DEEPER: DEATH OF THE PETRODOLLAR?

What’s a petrodollar? Petrodollars are oil export revenues denominated in U.S. dollars. The term emerged in the 70s as the U.S. went off the gold standard and desperately needed a way to continue having the greenback be the global reserve currency.

Ultimately, Saudi Arabia agreed to price and settle oil contracts primarily in USD in exchange for U.S. military protections and arm sales. Since oil underpins the global economy, this extra demand has artificially propped up the dollar’s value and ensured its role in the global economy.

What was the outcome? This arrangement has allowed the U.S. to print dollars, buy oil, and keep demand high for the USD as most global commodities are largely settled in dollars now. Correspondingly, this has pressured countries to hold U.S. treasuries on their balance sheets. In effect, instead of the dollar being backed by gold, it became quasi-backed by oil.

What’s going on now? In February, Russia and China agreed to a 30-year natural gas pipeline deal that will be settled in Euros, while Russia has also sought to sell oil to India for rupees. And in March, Saudi Arabia announced that they’re considering accepting the Chinese yuan for all oil exports to China, which buys 25% of Saudi oil. Additionally, the Saudis also snubbed a Biden request to increase oil production in April.

Why it matters? The petrodollar system made in the 1970s, which created a great demand for U.S. dollars and Treasuries, while enabling the country to spend far beyond its means for years, is under serious pressure.

In the past, the U.S. has used its military to enforce this agreement on countries attempting to settle commodity purchases without using USD (i.e. Iraq and Libya). Today, with countries like China, Russia, and India are beginning to settle outside the dollar, that option remains untenable.

Strategy Implications: If continued agreements outside the petrodollar system are made, there’ll be less demand for U.S. Treasuries, which restricts the government’s ability to borrow towards funding itself and for future deficit spending.

In this scenario, the Fed will likely have to grow its balance sheet (purchase Treasuries) to offset reduced external demand. This would make it difficult to follow its current plans of raising interest rates and tapering asset purchases through quantitive easing.

By the numbers: According to Luke Gromen, countries around the world have collectively reduced the percentage composition of U.S. Treasuries on their balance sheets from a peak of 72% to around 59% today.

Bottom line: The second and third-order effects of this feared breakdown in the petrodollar will be something to keep your eye on over the coming years.

This would be sure to cause geopolitical alliances to shift, and the Fed may be forced pivot and make up the difference through quantitative easing. In this new world order, hard assets like gold and even Bitcoin, may become more attractive as neutral currencies not tied to any single country and its political whims.

WHAT IS STAGFLATION?

As the debate over whether the U.S. is truly in a recession continues, with elevated levels of inflation currently, the term “Stagflation” is likely to be thrown around a lot.

But what exactly does that mean?

We turned to none other than Ray Dalio’s hedge fund, Bridgewater, for insights.

Bridgewater anticipates an environment where the large, stimulative fiscal deficits and low interest rates / quantitative easing programs of 2020 & 2021 create lasting higher prices with lower real economic growth.

This is because of persistent increases in nominal spending anchored by a large credit expansion, and they explain that, “stimulation was applied for too long, and the offsetting monetary tightening is coming too late, resulting in…monetary inflation.”

For an explanation of how the economy works and is driven by credit growth, and correspondingly money supply growth, which creates business cycles and inflation, we love this video from Dalio.

To bring down inflation they explain, the Federal Reserve will have to aggressively raise interest rates, which raises borrowing costs for individuals and corporations throughout the economy.

As borrowing costs rise, decisions that involve taking out debt, such as mortgages, car loans, small business loans, corporate projects, etc. become unviable with higher interest and are delayed.

Such reductions in spending (of borrowed money) and greater costs of debt ripple through the economy, creating unemployment broadly as companies seek to cut expenses.

Takeaway

When we have a period of high inflation then, where the money supply has increased more than the supply of real goods and services in the economy, while also having an economic downturn, with high prices and rising interest rates discouraging consumption and investment, then this is what’s known as stagflation.

In other words, stagflation is the (hopefully) transitory period that arises between periods of high inflation and high real economic growth, and the period where reduced economic activity actually relieves price pressures such that a new business cycle can begin.

During this time of stagflation, everyone is pinched from two sides: prices remain high and increasing which drains on your standard of living and savings, while the risk of being laid off due to the economic downturn increases.

Not to be an alarmist, but this environment is largely seen as a worst case scenario for economic planners like central banks.

On the bright side, markets generally are not anticipating such a dire situation yet and expect that the Fed can cool inflation without plunging us all into a deep recession.

Bridgewater, though, sees things differently and warns of an extended stagflationary period in our near future, so we ought to at least understand what this could mean for us.

For more on investing during periods of high inflation, check out our excellent Millennial Investing podcast on the topic.