Surviving SA inflation

Paying the price for years of cheap capital

Years of easy monetary policy and bloated central bank balance sheets are catching up with us. Central bankers are starting to wake up to the realisation that their balance sheets can’t keep expanding endlessly. While the problem was brewing, supply chain disruptions and the Russia-Ukraine war were the tinderboxes that lit the inflation fuse. There is a price that must now be paid for years of low-cost capital and rising wealth.

Inflation is where we’re starting to feel it most. So much so, that ‘transitory’ has unofficially become a four-letter word. Unfortunately, South Africans are now suffering the pain of inflation without having benefited from a significantly stronger economy. We have gone from low growth and low inflation to almost no growth and high inflation, as global economies pass on rising costs and our currency weakens. This combination has serious consequences for long-term savings.

The single biggest risk to spending power

When inflation was low and cash was generating a real return, conservative investors sought out money market funds and fixed income assets. It was simple, really. There was little need to add equity risk to a portfolio because cash comfortably beat inflation. This strategy worked for a while as equities didn’t consistently deliver and worse still, grabbed the headlines for the wrong reasons. But with rising inflation, low duration fixed income assets only protect savings in nominal terms. A consistent return of 7% sounds enticing but not when inflation is 7.4%. Inflation is the real threat: it is the single biggest risk to spending power. All too often this risk is an afterthought – despite the slow destruction it causes. Growing your capital steadily is attractive but not if you’re able to do less with it. This is especially true if you’re no longer earning an inflation-adjusted income.

Inflation felt by investors also tends to look very different from the official numbers provided by Statistics South Africa. If you are buying your groceries from Woolworths, you are experiencing significantly higher inflation than the reported figures in the headlines. It’s not just food (or petrol) that differs from the overall consumer price index. If you have medical bills, then your situation is worse given medical inflation typically runs at 3 to 4% above the official numbers.

To add to this dilemma, the local growth environment is impaired. You don’t need to look too closely to see that our economy is struggling. Outside of a very few resource companies that have benefited, until recently, from a sharp rise in commodity prices, our market is not rich with opportunity, despite the valuation argument that persists. Those companies likely to benefit derive their earnings outside of our borders or can take market share where there is no widespread economic growth.

Given the growth headwinds, the South African Reserve Bank may need to keep interest rates below inflation to stimulate growth (as is currently the situation). Allocating to cash will therefore erode capital in real terms.

So what can investors do?

Investors, with an appropriate time horizon, need to take on more risk to keep pace with inflation. It’s simply not good enough to just stand still in real terms, especially if you are drawing an income. Sadly, this is exactly the opposite of what we’re seeing – industry statistics indicate a renewed trend back into near cash alternatives, driven by the perception of safety.

In the long term, investors need to invest in assets that can beat inflation. That feels hard when the short term is dominated by fear. Investor focus tends to be on outperforming the market when it is rising and beating cash when it is falling. It is natural to want this return signature, but this would require an investor to be perfectly prescient. The problem is that humans are notoriously bad at forecasting. Absolute return investing attempts to remove this need for perfect foresight. Our strategy is to participate when there are upward market moves. But because of our strong focus on managing risk, we may underperform in a rising market. This sacrifice allows our investors to achieve capital preservation when there are downward moves. So, step one is to not lose capital. If your starting point is to preserve capital, you need to work a lot less hard to generate returns. The focus needs to be on absolute instead of relative returns. Outperforming competitors makes you feel good in the moment, but it doesn’t necessarily help you preserve your standard of living.

Some investment options to consider

Investors need to think hard about cash given the drag on real returns. That said, it is a critical lever for capital preservation that needs to be balanced against the drag on returns. Keeping some money in cash may be appropriate, but generally speaking, it should not be your only allocation. Assuming investments are to provide an income for the rest of your life, you need to base the investment decision with that time frame in mind and try to ignore the short-term noise.

The most direct solution is to buy inflation-linked bonds (ILBs), which provide a real yield in excess of inflation. At present, they offer an exceptional real yield of 3 to 4%. Nominal bonds are offering an even better real return – higher inflation is raising the cost of capital. Concerns about South Africa have also resulted in our government bonds having one of the highest real yields in the world. Short-term bonds provide a real, albeit lower, return with lower risk than longer-dated bonds. In our view, the belly of the curve, bonds with maturities of around 7 years, provides extremely attractive risk-adjusted returns. While RSA retail savings bonds may seem to capture this opportunity, consider the lock-in restrictions, opportunity cost of not investing in growth assets and tax implications.

What about listed property? Real estate is a real asset that should surely keep up with inflation? But excess supply is still a risk, particularly in an environment where economic growth is impaired. What new or growing businesses are filling all the offices and regional malls that have been built? Negative earnings revisions are reducing post Covid, but long-term headwinds persist.

While we’re on real assets, let’s not forget about gold. This precious metal may not provide an immediate hedge against inflation. It tends to work better over decades than months or even years. There’s also a lot of sentiment attached to it rather than a real valuation underpin, so we don’t believe it should make up a significant component of a portfolio.

What about offshore bonds or cash? As yields continue to rise, bonds appear increasingly attractive, but at this stage we find better risk-adjusted opportunities elsewhere. Overall, we continue to believe global bonds provide limited real return prospects for domestic investors and add significant currency risk.

Can equities bridge the gap?

Over the short term, there is no relationship between inflation and equity markets. Short-term market moves tend to be driven by new information, fear and greed. Over the long term, there is a relationship between equities and inflation, because companies need to pass on escalating costs to their customers to preserve their profit margin. Earnings over time should rise with inflation. Naturally, investors are concerned about investing in equities right now, given fears about further market weakness and the need to protect their capital. This is understandable. But there are opportunities available.

We believe that quality businesses that have pricing power are best placed to face these challenges. The most attractive of these can be found outside of our borders. They can raise their prices without losing revenue. The essential nature of their goods and services and their lower capital intensity mean they can pass input costs on to consumers. You want companies that produce products or services that are in demand – even when companies raise their prices. For example, in the last reporting period, Nestlé was able to increase prices globally without impacting volumes. Businesses that have cash on their balance sheets are even more attractive in the current environment. These businesses will start earning interest for the first time in more than a decade, whereas highly leveraged companies are going to start incurring higher and higher interest payments.

In our view, investors need to focus on the horizon and not become too despondent based on short-term fears. There are compelling alternatives on the table for investors despite what has felt like a difficult few years. If you put your savings in cash to avoid volatility, you might as well be putting it under your mattress. The investment options we are able to find for our portfolios will reward those with patience, and, more importantly, should compound comfortably ahead of inflation. Figure 1 shows the return expectations for the underlying assets in our SA Quality portfolios.

Figure 1: Range of expected 5-year returns
August 2022

Source: Ninety One. For illustrative purposes only; this is not the return of the Fund.

The Ninety One Cautious Managed Fund benefits from having the flexibility to allocate across asset classes. While the Fund has a bias to fixed income assets, it also invests in growth assets in the form of equities. The Ninety One Cautious Managed Fund has been able to deliver annualised returns well in excess of inflation since inception, over 16 years ago.¹ This period spans three significant global equity market corrections, including the Global Financial Crisis, highlighting the ability of the Fund to grow wealth in real terms while providing downside protection.

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¹ Source: Morningstar, as at 30.06.22. Performance figures are calculated NAV-NAV, net of fees, in rands, A class.