Resetting expected returns
Prudential Portfolio Managers has revised its expectations about long-term returns from the major asset classes based on its view that higher inflation will be the “new normal” for the next few years in South Africa, Prudential Unit Trusts managing director John Kinsley says in the company’s latest “Consider This” publication for investors.
Kinsley says Prudential has increased its long-term inflation expectation from 4.5 percent to 5.5 percent, and is therefore expecting lower real (after-inflation) returns from cash, bonds and inflation-linked bonds. The long-term yield (investment return) required from equities should be higher than in the past, he says.
The October consumer price index, released this week, is 5.9 percent – the first time it has been within the Reserve Bank’s targeted three-to-six-percent band since February 2007. The expected long-term real return Prudential expects you will earn from cash is 2.5 percent, instead of three percent expected previously. Inflation-linked bonds are likely to deliver 2.75 percent instead of 3.5 percent, and government bonds are likely to deliver 3.5 percent instead of four percent.
From corporate bonds, Prudential expects a real return of five percent instead of 5.2 percent.
Expected long-term returns that are likely to increase due to the expected higher inflation, Kinsley says, are those from property (up to 6.75 percent from 6.7 percent) and equities (up to eight percent from 7.5 percent).
Kinsley says the consequences of these changes in long-term return expectations are that if you are exposed to the asset classes that are likely to earn lower real returns, you will either have to increase your exposure to classes that are likely to earn higher returns and therefore take on more risk, or you will have to lower your expectations.
Rather than taking on more risk, Prudential has reduced the target of its absolute and real return Inflation Plus Fund from inflation plus six percent to inflation plus five percent.
Explaining why Prudential expects higher inflation, Kinsley says the government’s increased focus on job creation may result in the South African Reserve Bank moving its inflation target higher than the mid-point of the inflation band. This is supported by the current debate about the implicit trade-off between jobs and inflation, Kinsley says.
He notes too the influence of the labour unions and their intention to influence government.
Inflation remains sticky, “Consider This” notes, because much of our inflation basket – electricity, rates and wage costs – is under public sector control and thus “administered” or “pseudo administered” in the case of education and medical costs.
These factors are sticky – a fall in demand will not necessarily lead to a commensurate fall in their price.
Another significant contributor to inflation is food. This is affected by the risk of a weakening rand exchange rate, Kinsley says.