Income-focused investments run the inflation gauntlet
South Africa is traditionally a high inflation economy. Going back four decades to 1969 our consumer price inflation has averaged 10% per annum. To illustrate the impact of price inflation consider that a Wimpy ‘Farmhouse” breakfast that cost R2.70 in 1983 will set you back R38 today – or 10% per annum over 27 years! Over the past decade we’ve enjoyed more benign inflationary conditions with an average annual rate of just 5.9%. And towards the end of last year the official consumer price index was pegged between 3.5% and 4%, a rate well within the Reserve Bank’s 3% to 6% inflation target.
“We consider inflation to be the most important economic variable as it has a profound impact on the lifestyle of income-dependent investors,” says Lourens Coetzee, Investment Professional, at Marriott Asset Management. The group offers a number of niche products aimed at retired investors and has adopted the ‘Income Focused Investing’ tag to match its investment philosophy. At the heart of this strategy is the impact of inflation on asset prices and yields!
Inflation is going higher...
It’s not difficult to present a case for higher domestic price inflation. Over the past year we’ve been protected by an incredibly strong rand. The rand was the third best currency against the US dollar through 2010 and experts say CPI would have been closer to 6% had the rand traded weaker instead... Over the short-term the local currency will probably remain strong as foreign investors pour their investment capital into our bond markets. But over the long-term the rand should head back towards the purchasing power parity (PPP) level of R8.80/$.
Local consumers were shielded from massive dollar increase in oil (+22%), cotton (+100%), food (+33%) and base metals (+19%) thanks to the rand. Any rand weakness through 2011/2 will trigger unprecedented inflationary pressures! There are also a number of structural inefficiencies in the domestic economy which will add to this inflationary pressure. Most of us appreciate the irony in the sub-4% official inflation rate when administered prices are increasing at multiples of this number. State electricity supplier Eskom has locked in a three-year 25% per annum price agreement (beginning 2010), while municipal services charges were hiked an unbelievable 48% across South Africa through 2010.
Two principles of income focused investing
How do income fund managers invest when consumer price inflation is so difficult to estimate? Marriott’s Income Focused Investing strategy embodies two key principles. First: The selection of securities that produce reliable (preferably growing) income streams. Second: The purchase of these income streams at appropriate prices. Coetzee stressed the importance of the phrase “appropriate price”. For bonds this price should provide a yield of inflation plus 3%, for property inflation plus 7%, and for equities inflation plus 8%.
Marriott believes inflation will move significantly higher through 2011, with a long-term average tending toward 7% rather than the 5.9% experienced over the past 10 years. This higher inflation outlook has serious investment implications, because investment managers now have to ‘squeeze’ additional returns across the available asset classes. The current bond yield of 8.7%, for example, is insufficient to satisfy the inflation plus 3% requirement as inflation moves to 7%. Likewise the total yield on listed property, comprising income yield (currently 8.7%) and capital appreciation (projected at 3% through 2011), is well short of the inflation plus 7% requirement. And the dividend yield on equities would have to almost double from today’s 2.6% to 5%.
Time to look after capital
Current yields on fixed bonds, equities and listed property suggest these asset classes are fairly expensive. For this reason the Marriott income funds are invested for minimum exposure to bonds and property. The group’s high income fund is positioned for high (or rising) inflation with 68% in cash, fixed deposits and Premium NCDs, 12% in inflation linked bonds, 7% in preference shares and 14% in floating corporate debt.
Marriott has also availed of the relative value in offshore versus local equities. The group’s equity funds are largely invested offshore to their maximum fund mandates in companies such as AT & T, Unilever and Johnson & Johnson. Their First World Equity Fund boasts a yield, after costs, of 3.2%!
Editor’s thoughts:? I left the Marriott “Solutions for Retirement” presentation convinced we will see a sharp spike in local consumer price inflation over 2011/12. Although this is great news for retirees who rely on interest income to get by, it presents challenges for asset managers who have a capital preservation goal in mind. Are you looking forward to an increase in inflation and interest rates – or would you prefer for South Africa Inc to remain in the 3% to 6% CPI range? Please add your comment below, or send it to [email protected]
