The investments industry is obsessed with short-term returns measured against an arbitrary index or the peer group.
But in our view, little should matter more to investors than the long-term growth of their savings compared to inflation. How much more than inflation we should target will be up to individual investors’ unique circumstances and risk budgets. But we should measure our investment success relative to this goal only—everything else is meaningless.
The risk to one’s financial security from the inflation threat is clear, but seldom top of mind, because it is a slow and silent killer. At 2% inflation (the rate of inflation targeted by the US Federal Reserve and the European Central Bank, and psychologically a small number), a dollar or euro halves in value in 35 years. Add another 35 years, and it is worth only one quarter of its original value. All things being equal, even low levels of inflation erodes wealth by three-quarters in a lifetime.
But in most emerging market economies, inflation tends to be much higher than in developed markets, as we South Africans are aware. By way of example, the price of a single Chappies bubble gum was around one South African cent 70 years ago. Today, it is more than 60 cents. That equates to an inflation rate of 6,000% or 6% per annum. The destructive effect of 6% inflation on our savings is even more stark: it erodes the purchasing power of R1 to just 1c in 70 years. All things being equal, inflation destroys wealth completely over the lifetime of the ordinary South African.
Falling inflation has been an unprecedented tailwind to savers (and consumers) since the mid-1980s. The benefits to investors from falling inflation, falling interest rates and rising financial markets are undeniable. Real returns on global bonds and equities have been remarkable since Paul Volcker, then newly elected chairman of the Board of Governors of the Federal Reserve System, successfully tamed inflation in the early 1980s using interest rates as a sledge hammer (see Graph 1):
- US inflation fell from an average of 7% in the 1970s and 5.5% in the 1980s to an average of 2.4% since 1990
- The yield on 10-year US Treasury bonds fell from near 16% in 1981 to 1.3% today
- Global bonds delivered real returns of 4.4% since 1985 (when inflation stabilised)
- Global equities delivered real returns of 7.0% since 1985.
The benefits extend beyond the growth in asset prices alone. For most of the post-1980 period, interest rate adjustments often lagged the move lower in inflation. Savers therefore continued to earn positive real returns on bank deposits. This meant that their invested capital was protected (with little risk to the potential outcome) in real terms in what was thought to be, and for a long time effectively was, a risk-free asset (as an aside, is the US Treasury today still a risk-free asset? Discussion for another day).
But risk-free they were not. Enter the period of global financial repression in the principal developed markets—when central banks purchased large quantities of government debt to keep interest rates artificially low and below the rate of inflation, in a desperate attempt to escape the debt deflationary risks coming out of the 2008/9 global financial crisis.
Ultra-low rates come at a material cost to savers, especially retirees with a primary need for income. No longer can they rely on bank deposits to meet their income requirements, nor to match or exceed their rising cost of living. Savers in developed markets have for ten years been forced to look elsewhere for income to replace the erosion of their incomes from falling interest rates.
Financial repression is a relatively new development for South African savers, who nevertheless suffered a steady decline in real interest rates—from more than 5% on average in the 1990s, to 3% in the 2000s and 1% in the last decade. After sharp cuts in interest rates to combat the effects of the COVID-19 pandemic, real rates on call deposits are today about 2% below inflation, before any taxes that might be applicable.
For conservative investors, those with shorter investment horizons and especially those with high income requirements, negative real cash returns are devastating. We have seen how 2% inflation renders one rand into 25 cents over 70 years. Negative real cash rates destroy capital, with income shortfalls having to be met by capital drawdowns. Further cutting back on expenditures is tougher when belts have already been tightening for a while.
The key question for investors is how long can financial repression persist? Guidance from central banks suggests that it will be years, not months, before policy changes are forthcoming—despite the spike in global consumer prices. This is because monetary authorities view the rise in prices to be ‘transitory’ and not structural. That may well be the case, given that many of the price increases are in sectors heavily geared towards increasing post-pandemic consumption trends. And given the mountains of sovereign debt, it is likely that the politician cohort will be firmly in support.
But there are no guarantees that we will not see a more general increase in prices—or that inflation expectations may not become entrenched. That is the key feature of inflation compared to transitory price adjustments: inflation is more general, more lasting with expectations for future inflation entrenched.
My view is that the current inflationary trend is a bit of both and that inflation will settle at a structurally higher level after the economic reopening price fillip. If I am correct, there are important consequences for investors and their asset allocation decisions. No longer can they rely on a sizeable allocation to cash to fund their income requirements, while still protecting retirement capital. Other investment strategies must be found.
Fortunately for South Africans—and unlike much of the world—yields on longer duration government bonds are still very attractive. More importantly, the coupons on medium and longer dated government bonds are well above the current and expected future inflation rate.
On the face of it, bonds seem like a slam-dunk investment for South African pensioners. But be aware: there are significant risks in SA bonds which suggest that this asset class should not comprise all, or even most, of a retirement portfolio. After all, there are reasons that yields are high. Whilst not our base case scenario, money supply and credit growth, together with rising government social benefit payments, could cause longer term inflation structurally higher than current forecasts. In this scenario, capital losses from rising bond yields will offset the current income windfall—and this is before considering tax liabilities related to yield-to-maturity interest income.
The answer lies in using a mix of asset classes, including investment in share markets and global investments where gains from currency depreciation serve to hedge the risk of higher local inflation. The Nedgroup Investments Stable Fund’s investment objective of inflation plus 4% requires a meaningful investment in quality, earnings-compounding companies.
It is debateable whether the fund’s sector limit of 40% in equities and 30% offshore is sufficiently high given the current level of ultra-low short-term interest rates. However, this lower equity limit does provide comfort to risk-averse investors by limiting drawdowns and has prominently contributed to protecting capital over shorter time horizons.