Paying the price for years of cheap capital

Years of easy monetary policy and bloated central bank balance sheets are catching up with us. Central bankers are realising that their balance sheets can’t expand endlessly. While this problem brewed, supply chain disruptions and the Russia-Ukraine war really lit the inflation fuse.

There is a price to pay for years of cheap capital and rising wealth, and that’s higher inflation. Unfortunately, South Africans are now suffering from inflation without having benefited from a significantly stronger economy. We have gone from low growth and low inflation to almost no growth and high inflation, as global economies pass on rising costs and our currency weakens. This combination has serious consequences for long-term savings.

The single biggest risk to spending power

When inflation was low and cash was generating real returns, conservative investors sought out money market funds and fixed income assets. There was little need for equity risk in portfolios because cash comfortably beat inflation. This strategy worked as equities didn’t consistently deliver.

But with rising inflation, low duration fixed income assets only protect savings in nominal terms. A consistent return of seven percent sounds enticing, but not when inflation is higher than that. Inflation is the real threat, as the single biggest risk to spending power.

To add to this dilemma, local growth is impaired. Outside of a few resource companies that benefited until recently from sharply rising commodity prices, our market is not rich with opportunity, despite the persistent valuation argument. Those companies likely to benefit derive their earnings outside of SA or can take market share in the absence of economic growth.

The South African Reserve Bank may need to keep interest rates below inflation to stimulate growth, which means allocating to cash will erode capital in real terms.

So what can investors do?

Investors with an appropriate time horizon need to assume risk to keep pace with inflation. You simply can’t stand still in real terms, especially if you are drawing an income.

In the long term, investors need to invest in assets that can beat inflation – which feels hard when the short term is dominated by fear. Investors focus on outperforming the market when it is rising and beating cash when it is falling. It is natural to want this return signature, but this would require an investor to be perfectly prescient. The problem is that humans are notoriously bad at forecasting.

Absolute return investing attempts to remove this need for perfect foresight. Our strategy within the Quality team is to participate when there are upward market moves. But because of our strong focus on managing risk, we may underperform in a rising market. This sacrifice allows our investors to achieve capital preservation when there are downward moves.

So, step one is to not lose capital. If your starting point is to preserve capital, you need to work a lot less hard to generate returns. The focus needs to be on absolute instead of relative returns.

Some investment options to consider

Investors need to think hard about cash given the drag on real returns. Keeping some money in cash may be appropriate, but it shouldn’t be your only allocation. Assuming investments are to provide an income for life, your decision needs to be based on that timeframe, while ignoring short-term noise.

The most direct solution is to buy inflation-linked bonds (ILBs), which provide a real yield higher than inflation. At present, they offer an exceptional real yield of three to four percent, while nominal bonds offer an even better real return because higher inflation is raising the cost of capital. While RSA retail savings bonds may seem to capture this opportunity, consider the lock-in restrictions, tax implications and opportunity costs of not investing in growth assets.

What about listed property? While real estate is a real asset, excess supply is still a risk, particularly in a low growth environment. What new or growing businesses are filling the offices and regional malls being built?

While we’re on real assets, let’s not forget gold. It doesn’t provide an immediate hedge against inflation and tends to work better over decades than months or even years. It can also be sentiment driven, rather than by real valuation, so we don’t believe it should be a significant component of a portfolio.

What about offshore bonds or cash? As yields continue to rise, bonds appear increasingly attractive, but at this stage we find better risk-adjusted opportunities elsewhere. Overall, we believe global bonds provide limited real return prospects for domestic investors and add significant currency risk.

Can equities bridge the gap?

Short term, there is no relationship between inflation and equity markets, as they are driven by new information, fear and greed. In the long term, there is a relationship between equities and inflation, as companies pass on escalating costs to customers to preserve profit margins. Naturally, investors are concerned about equity investment right now, given fears about market weakness and the need to protect their capital. This is understandable, but there are opportunities available.

We believe that quality businesses with pricing power are best placed to face these challenges, the most attractive of which can be found outside of our borders. You want companies that produce products or services that are in demand, even when companies raise their prices. Businesses with cash on their balance sheets are currently even more attractive. These businesses will start earning interest for the first time in more than a decade, whereas highly leveraged companies are going to start incurring higher interest payments.

Investors need to focus on the horizon and not become too despondent at short-term fears. There are compelling alternatives available despite what a difficult few years. If your savings are in cash to avoid volatility, you might as well put it under your mattress. The investment options we identify will reward patient investors and, more importantly, should compound comfortably ahead of inflation. DM