Re­set­ting ex­pected re­turns

Weekend Argus (Saturday Edition) - - GOODPASTIMES -

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.

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