Beware the ravages of inflation

The primary objective of any investor is to preserve the purchasing power of their money.

Therefore matching the purchasing-power demands with the investor’s minimum time-frame is a crucial investment decision, says Paul Stewart, Head of Asset Management at Grindrod Asset Management.

"For this reason, short-term investors are more concerned about short-term risk, of which capital risk is the most critical. Conversely, long-term investors should be much more concerned about long-term risks, inflation risk being the most serious,” he says.

Most individual investors and many financial advisors confuse risk and time issues. While portfolios that focus on capital risk management are necessary, they should be limited to investors who have near-term time horizons. By far the bulk of discretionary and contractual capital in South Africa is medium to long term in nature. "The primary focus for most portfolios should therefore be to manage inflation risk and not short-term capital risk,” Steward adds.

While in the last ten years, all domestic asset classes have delivered returns well in excess of inflation, the global financial crisis has since fundamentally changed the investment environment. Cash yields that offered 13.6% ten years ago are now at 5.2%. Government bond yields that traded at 11.3% are now at 7%. Listed property yields fell by 7.5% over this period.

Stewart says the best way of beating long-term inflation risk is to identify assets that offer attractive starting yields relative to cash and inflation, and are able to deliver growth (dividends or distributions) equal to or above inflation.

Quality equities with strong dividend track records and sound financial positions meet these requirements, as do listed property companies with above inflation starting yields and above inflation distribution growth expectations.

Marcus Rautenbach, Head of Investment Consulting at Simeka Consultants & Actuaries, agrees. "Investment research shows that the after-inflation return of domestic equities over the long-term is 7% above inflation, property in South Africa produces 5%+ more than inflation, domestic bonds yield approximately 2.5% more than inflation and money markets a little more than 1% above inflation. Over the long term, real returns (in rand terms) from global markets range from 4% to 6% above inflation. Your client may therefore expect any combination of the above assets to produce inflation beating returns over the long-term.”

Rautenbach does however point out that even though the abovementioned represents long-term expectations, investors should be cautioned that the long-term results may not necessarily be achieved in the short-term.

Kevin Lings, Chief Economist at Stanlib, says a global environment of sustained low interest rates does not imply that the historical relationship between risk and reward has disappeared.

 

"Currently, most cash deposits are yielding a negative real return of around 1% or more. Even if the investor extends the duration of the deposit, the problem is not completely eliminated, although some financial institutions are offering a real return on deposits of up to five years for elderly individuals. There is of course no guarantee that interest rates would not be higher in five years’ time. While the investor would be advised to shop around for the best return amongst the various banks, it’s very likely that the returns will remain negative after inflation."

Lings says obtaining a positive real return requires one to take on more risk. Under current circumstances the only way an investor can beat inflation is to diversify their investment away from pure money market funds into products that derive income from riskier assets, such as government bonds, corporate credit, property stocks and equities. This implies that if an investor wants to continue with a low risk investment and still beat inflation, they will have to maintain a diversified portfolio that comprises longer dated fixed interest instruments that are blended with traditional money-market funds in order to boost returns.