Inflation – how should you hedge?
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.