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Inflation
Inflation is the measurement of the increase in the cost of living (the cost of goods and services). The increase in the rate of inflation is due to either the cost of producing goods and services increasing (so called, cost-push inflation) or an increase in the demand for goods (so called, demand-pull inflation – when there is an oversupply of money in the economy).
The infographic below illustrates how inflation has diminished what you could afford with R 1 000 over the years. What will we be able to afford with R 1 000 in the year 2030 or 2040?
Source: Old Mutual Wealth: Understanding Inflation
To continue affording goods and services while their costs increase, your wealth needs to outperform inflation and achieve a real return (a return above inflation).
How to achieve real returns
A portion of risk / growth assets should form part of your investment portfolio to increase returns above “safe” interest earned from the bank. These risk assets are most commonly in the form of equities (shares), property, and bonds, both local and offshore. As they have different risk and associated growth profiles, i.e. equities experience greater fluctuations than bonds, each asset class produces different returns with varying degrees of volatility.
Therefore, following a measured approach is necessary, including diversification between different low- and higher risk assets. The best investment strategy consists of the right mix of assets to meet your investment goals.
The graph below illustrates the different growth trajectories of these asset classes:
The chart above should be understood for illustrative purposes and does not constitute as a guaranteed outcome.
As an illustration, here are the nominal returns of different asset classes over the past 10 years (to 7 August 2021):
| Asset Class | 10-Year Return |
|---|---|
| SA Equities / Shares | 12.5% |
| Global Shares | 21.8% |
| SA Bonds | 8.1% |
| SA Money Market | 6.1% |
| SA Inflation | 5.0% |
Inflation and interest rate cycles
Inflation often drives interest rates as central banks try to keep inflation stable by increasing and decreasing interest rates when inflation rises and declines, respectively.
Lower interest rates promote borrowing which increases spending and drives economic growth and the converse with higher interest rates. Declining interest rates drive equities up in anticipation of higher economic growth and generally, conversely with higher interest rates. These changes magnify asset class returns leading to different levels of volatility through the cycles.
Getting the timing of these returns right is very difficult and therefore a diversified risk asset allocation is necessary to produce less volatile returns.
Determining the amount of your savings that should be allocated to each asset class depends on your personal risk profile. Your risk profile is established by matching your desired investment return with the amount of risk you can afford to take and your personal risk appetite (stomach for risk).
The risk of guaranteed products
Given that inflation rates vary over time, being invested in fixed products can put your capital at risk of underperforming inflation. This is especially prevalent in our current low interest rate environment.
Guaranteed returns – e.g. money market / cash
As inflation can rise faster than the fixed rate you are guaranteed, your investments can lose value in real terms. Currently the best short term (fixed for 3 months) cash deposit rate with a credible institution is 4.3% p.a. before deducting tax. However, with SA’s weak economic position its likely inflation rises at a faster rate over the next five years.
Guaranteed income – e.g. life annuities
As inflation can rise faster than the guaranteed income you receive from a fixed life annuity, you run the risk of being unable to continue affording the same lifestyle with the income you receive and essentially becoming poorer over time.
The inflation outlook
Inflation rates locally and globally are at historical lows, meaning the next move is likely up. The question is, how fast will inflation rise?
Offshore inflation
Currently, global markets are pricing in a moderate rise in inflation, which will be temporary, before stabilising into the lower 20-year historical lower band of 1% to 3%. The risk is that with the abnormal monetary stimulus since the pandemic, inflation will rise faster and longer, leading to far higher interest rates.
SA Inflation
Over the longer term, risks are mounting that inflation will rise higher and faster due to the weak economic and financial position of the country. This will weaken the Rand, leading to higher inflation and rising interest rates. As seen in the chart below, the cost of goods has already increased from their prices in 2020.
Conclusion
To beat inflation, you need to include an element of growth /risk assets in your investment portfolio. Having the correct asset allocation based on your personal risk profile, managed by investment specialists, should see you achieving real returns into the future.
Our financial planning process helps determine the correct risk profile aligned to your personal financial goals. Please see our previous newsletter on our digital financial planning process: The digital age of financial planning | Investonline
Speak to one of our Client Portfolio Managers to assist you in implementing the appropriate strategy.