In­fla­tion – how should you hedge?

Finweek English Edition - - INVESTMENT - Prof Evan Gil­bert, Mi­tonOp­ti­mal Multi-As­set Man­age­ment

One of the great­est threats to the ef­fec­tive­ness of any sav­ings ef­fort is in­fla­tion. Un­less your in­vest­ments are earn­ing con­sis­tent real re­turns over time, they will not pro­vide the nec­es­sary re­tire­ment ben­e­fits you need.

Given the sus­tained de­clines in in­fla­tion in South Africa over the past two decades, and his­tor­i­cally low lev­els glob­ally, this is prob­a­bly not the most im­por­tant con­cern for in­vestors right now. But there are many rea­sons to be wor­ried about in­fla­tion go­ing for­ward.

Not only have in­ter­na­tional cen­tral banks em­barked on an un­prece­dented ex­pan­sion of the amount of money fol­low­ing the global fi­nan­cial cri­sis of 2008, do­mes­ti­cally there has been a con­tin­ued in­crease in cost pres­sures that are likely to con­tinue. On top of the con­tin­ued in­crease in elec­tric­ity prices, the re­cent waves of wild­cat strikes have led to sig­nif­i­cantly higher wage set­tle­ments. The fact that th­ese strikes are un­pro­tected and yet have led to sig­nif­i­cantly higher wage set­tle­ments sug­gests that the cur­rent col­lec­tive bar­gain­ing sys­tem has bro­ken down. Un­til it’s fixed, we are likely to see con­tin­ued high wage cost pres­sures.

Sec­ond, the con­tin­ued very large deficit on our cur­rent ac­count means that there is sig­nif­i­cant pres­sure on the ex­change rate to de­value. Cur­rently it’s be­ing sup­ported by cap­i­tal in­flows, but th­ese are fickle, and our cur­rent at­trac­tive­ness to for­eign in­vestors will only ever be tem­po­rary. The rel­a­tive yield pre­mium of our bonds can dis­ap­pear ei­ther due to changes in our risk rat­ing (as hap­pened re­cently) and/or if the sit­u­a­tion in the devel­oped economies’ bond mar­ket nor­malises. On eq­ui­ties, a de­cline in com­mod­ity prices and/or a fail­ure of the African growth story to de­liver on its growth po­ten­tial can also lead to a loss of in­vestor ap­petite. The loss of one or both of th­ese sup­ports for the cur­rency will lead to po­ten­tially sig­nif­i­cant de­val­u­a­tions, which will be in­fla­tion­ary in the short to medium term.

What can you do about this? We an­a­lysed var­i­ous as­set class re­turns in real terms on a rolling one-year ba­sis since 1961 (with the ex­cep­tion of in­fla­tion-linked Bonds (ILBs), for which we only have in­dex data since De­cem­ber 2003). The ta­ble be­low sum­marises the per­cent­age of the time that the as­set class out­per­formed in­fla­tion on a rolling one-year ba­sis as well as the an­nu­alised av­er­age real re­turn and stan­dard de­vi­a­tions.

This anal­y­sis high­lights the role for eq­ui­ties as a long-run in­fla­tion hedge – it’s got the high­est long-run prob­a­bil­ity of beat­ing in­fla­tion as well as the high­est av­er­age real re­turn. Un­for­tu­nately this comes at the price of high­est volatil­ity.

Com­modi­ties also of­fer unique in­fla­tion­hedge prop­er­ties that are not com­monly recog­nised. First, the di­ver­sity of price be­hav­iour within this as­set class high­lights the folly of it be­ing treated as a ho­moge­nous as­set class. Gold, for ex­am­ple, has its own inf la­tion-hedge char­ac­ter­is­tics that are driven by fac­tors com­pletely un­re­lated to other com­modi­ties – prin­ci­pally re­lated to the ex­pected de­bas­ing of lo­cal cur­ren­cies.

Sec­ond, con­sumers are di­rectly ex­posed to the in­fla­tion­ary ef­fects of se­lected in­di­vid­ual com­mod­ity prices, ei­ther through their di­rect in­clu­sion in the con­sump­tion bun­dle eg food (maize, wheat, soya); or their di­rect im­pact on the price of ma­jor com­po­nents of the bas­ket eg en­ergy – trans­port and elec­tric­ity (oil, coal). It’s pos­si­ble to de­con­struct com­modi­ties in­dices and cre­ate port­fo­lios con­tain­ing only th­ese con­stituents. A tar­geted com­modi­ties port­fo­lio, com­bined with ILBs, of­fers very in­ter­est­ing in­fla­tion-hedge char­ac­ter­is­tics in this short to medium term. This com­bined port­fo­lio will cer­tainly dom­i­nate cash, the broad com­modi­ties in­dex or ILBs on their own.

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