Asset Management

Manty Seligmann
Director – Asset Management

 

 

 

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Is inflation the real threat?

Inflation is the sustained increase in the general price of goods and services over a specified period.  The period is typically measured is 12 months though can be viewed over alternate time increments as required.

Inflation is usually calculated for a specific region, such as a country or even a demographic group – for instance, pensioners.  It is an important measurement tool as it affects individuals in multiple ways, depending on their financial situation and personal spending or saving habits, as well as their life stage.

A country’s central bank has the responsibility of controlling – and usually containing – inflation.  A common practice in the world currently, including South Africa, is to use an ‘inflation targeting’ strategy whereby the central bank sets an upper and lower range of inflation rates between which it tries to maintain the rate of inflation.  

The difference between interest rates and the rate of inflation is referred to as the ‘real rate’.  The South African Reserve Bank (SARB) – South Africa’s central bank – adjusts interest rates with the intention of either stimulating or slowing the rate of inflation.  When the rate of inflation surges, a central bank will conventionally respond by hiking interest rates (and thereby pushing up borrowing rates) in line with the inflation trajectory.  To contain inflation, it is generally accepted that the central bank needs to keep interest rates above the rate of inflation. 

Some of the reasons central banks influence inflation include trying to contain consumer spending, encourage saving, protecting the value of a currency, and ensuring that real rates do not become negative for lengthy periods.

Inflation can however be erratic and is caused by various circumstances.  This broad range of contributors to inflation often leaves a central bank on the back foot as they attempt to control inflation using all the tools at its disposal. 

 

This scenario is currently playing out in South Africa, and indeed globally, where we are all witnessing international inflation surging – erratically – to levels not seen in many years.  Some western economies have not seen inflation of this nature for decades. 

Some of these primary causes of inflationary spikes have been ‘anything but traditional’ in nature and have proved difficult for central banks to combat.  Circumstances contributing to this are varied.  Increased government spending and grant funding (both of which increase savings as well as spending) during and post-Covid, as well as the hike in fuel prices sparked by the Russia-Ukraine crisis, are two influential factors.  Another is the strong increase in asset values globally through a period of sustained ‘cheap money’.  

The recent jump in rates of inflation – from historical lows, to above 8% in the US and 10% in Europe – has seen central banks react swiftly (criticised by some pundits as being too harsh) to counteract the effect of inflation. 

The problem may arise however that central banks make incorrect projections based on incorrect assumptions when trying to predict future inflation levels, leading to inappropriate interest rates being implemented.  Were this to happen, economies would be artificially slowed, leading to a lack of growth and potentially a recession.  Who would choose to be a central banker in today’s world?

Inflation not only affects the cost of living, but also the return-on-investment portfolios.  Consumers and investors are affected.  It is common knowledge that people on fixed incomes come under pressure and get poorer over time in an inflationary cycle as they dip into their reserves to make ends meet.  This happens the moment the inflation rate exceeds the return achieved on investments.

The overall purchasing power of consumers becomes progressively less over time if they cannot grow their asset base or income at an appropriate rate in an inflationary environment.  The poorer members of society are disproportionally affected.  

Increased inflation influences future returns across asset classes and thus investors must consider the potential impact on their investment strategies.  Assets with fixed long-term cash flows will not fare as well in high inflation environments as assets with adjustable cash flows (for example if one can increase a rental on a property that one owns and has a fixed rate mortgage).

Elevated inflation above the real rate discourages short-term saving.  Consumers and businesses are instead encouraged to spend and invest.  This results in short-term gains in employment levels and can lead to lower inflation-adjusted labour costs. 

Eventually though, (if persistent inflation is not brought under control) a downturn usually occurs with a resultant reset in growth and spending expectations.  This in turn causes cutbacks and rationalisation.

Certain asset classes fare better in inflationary environments and their returns are expected to outpace inflation.  Based upon long-term data, as well as in GTC’s own experience, shares have held up well against inflation over the long run.  Over the past 30 years, shares have tended to rise in price when inflation accelerated.  

In theory, a company’s revenue and earnings should rise alongside the upward-trending cost of goods and services.  If one believes (as the asset managers tell us) that markets are ultimately rational, then this will translate into long-term gains for companies that are well-structured and can benefit from increasing prices.

The returns achieved from the share market – when compared with inflation – should not be measured in weeks and months, as inflation creates heightened volatility, in turn creating short-term market aberrations.  Returns should be considered over longer periods. Investors must ensure that their adopted investment strategy is well thought out and diversified into appropriate asset class allocations.  This is the basis of attaining long-term investment goals, and a strategy adopted by GTC within our inflation-targeted portfolios.

Some businesses do better in inflationary situations than others.  A company that has low capital needs and/or is holding strong cash reserves, is well positioned in these circumstances, as too is a company that can quickly raise the prices of its products.  Corporations with lower debt levels and stronger balance sheets tend to be more adaptable under duress and tend to perform better in high-cost environments than those with more significant gearing (gearing being a financial term describing the use of borrowed money).  Banking shares – in particular – have fared well in this environment, tending to increase the spreads between the deposit rates and the interest rates at which they receive and lend money.

Though inflation may be beyond the control of individuals, investors can still take action to preserve and even grow wealth over these specific (and often difficult) conditions.  The diversification within one’s investment portfolio into assets that are flexible, which can take advantage of higher prices whilst holding their cost base, is beneficial.  Over the long run, those that stay invested in portfolios where the stock selection is rational tend to outperform the rate of inflation.

Please discuss these and other investment-related strategies with your GTC Adviser.