By Anet Ahern
Inflation has been making a comeback. Not so long ago, it had seemed that we had vanquished (at least in the developed world) this sneaky foe of long-term wealth creators everywhere, thanks to tightly controlled central bank policies and the wonders of inflation targeting. Despite a post-financial crisis experiment called quantitative easing and pro-longed record low (even below-inflation) interest rates, inflation had remained controlled. Perhaps the inflation monster had been beaten after all.
However, in 2020 something changed. A virus emerged that shuttered economies around the world, and governments unleashed unprecedented levels of fiscal and monetary stimulus to combat its effects on their economies. Suddenly, the inflation monster was back (although one could say it had actually been simmering in the background for quite some time).
What seems to be different this time around, however, is who is leading the inflation charge. Over the past decade developed economies have been keeping their inflation rates in check and expectations remain anchored around continued low inflation rates. Locally, however, we still seem to anchor our inflation outlook and expectations higher, despite the fact that the South African Reserve Bank (SARB) has demonstrated credibility in managing the country’s inflation rate over the past decade. Our weak local macroeconomic environment also ironically means many of the pressures driving inflation higher in developed markets are likely to remain contained here.
US inflation continued its upward path, coming in at 7.0% for December 2021, while local inflation edged out at 5.9%. Of course, it is far too early to say that US inflation will be sustained at such a level, but what it does illustrate is that, when things are changing, anchoring on the past might be dangerous.
Stealth remains the biggest threat of inflation – because its impact on our purchasing power and wealth is not always self-evident. R1 is always R1, after all, but it is what you can buy with that money that really matters when it comes to consumer well-being and maintaining our living standards. Underestimating the impact of inflation on your standard of living can be especially detrimental in the long run as the effects of inflation compound.
What is particularly interesting when it comes to the latest round of inflation, is that the official figures may be underestimating its true impact. While the phenomenon of “shrinkflation” (exemplified by your chocolate or cola reducing in size but costing the same) has been a source of consumer chagrin for some time, we have also seen the post-pandemic rise of “skimpflation”. Just like other forms of inflation, skimpflation reduces consumer well-being through stealth. But while shrinkflation impacts by reducing the amount of goods you get, skimpflation has seen consumers being offered reduced or inferior experiences or services at the same cost. Examples include free shuttle services no longer being offered, longer lead times for deliveries and take-away restaurants no longer offering condiment sachets. Both shrink- and skimpflation are less likely to be measured through official inflation figures, again highlighting what an intricate concept inflation actually is.
Locally, investors have been spoilt by several years of inflation-beating returns (achieved at very little risk) in money markets and cash investments. But thanks to the steep rate cuts in 2020, those real returns have long since turned negative, even when considering the recent interest rate hike. The dangers for investors at this time is twofold: firstly, thinking that past strategies will result in successes even though the environment has changed to a significant extent and secondly, underestimating the long-run costs of not outperforming inflation by a substantial margin. Apply the wrong strategy, and you face a very tough obstacle to long-term real returns. Underestimate the consequences if inflation is sustained in the long-term, and you face a slow erosion of your long-term real wealth. Either way, the implication is clear – misjudge the importance of inflation at your own peril.
What is most often missed about inflation, however, is that it also changes the returns investors can expect to receive from the various assets in their portfolios. While the impact on fixed interest investments may be obvious, inflation also changes which equities will do well, and which will lag. Within the fixed income space, conservative investments outperformed inflation comfortably for a few years, but this is very unlikely to happen going forward. Investors should therefore take care to ensure their investment portfolios are correctly positioned to deliver on their needs and objectives, at appropriate levels of risk. Locally, due to a steep yield curve and the (excessive) risk premium investors attach to our sovereign bonds, there are still selected opportunities to secure real returns from fixed interest investments, a little further along the curve.
However, when it comes to beating inflation over longer time frames, investments into growth assets (notably equities) need to be considered, even if it does bring more risk. Typically, long duration assets (that take a long time to ‘repay’ their capital outlay through income) suffer once the higher discount rates are applied that are associated with higher inflation. This means we currently consider large tracts of popular, highly valued stocks to be vulnerable to the impact of inflation and a potential rerating in the market. On the other hand, low duration assets could potentially benefit – but these are typically the stocks that many investors have shunned over the past few years. These would include stocks which have suffered from the economic cycle, but have the potential for good cash flow and dividends in the longer term.
While many investors still tend to shy away from the local equity market, it is always helpful to remember that investing is not an ‘all or nothing’ game. Often, the addition of carefully selected risk assets can enhance overall investment outcomes, while keeping overall portfolio risk within acceptable levels.
A crucial investment lesson all investors need to learn is that inflation moves by stealth and lulling you into a false sense of security. Therefore, the important first step investors need to take, is in recognising the potential impact of the various ‘faces’ of inflation present to us. Then, take action, and review your portfolio composition to benefit from the opportunity this brings to invest in specific areas of the market.
Anet Ahern is CEO of PSG Asset Management.
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