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WEALTH OF INSIGHT OLD MUTUAL WEALTH INTELLIGENCE Is inflation the greatest ENEMY OF long-term investors? Dave Mohr, chief investment strategist, old mutual wealth This might seem like a strange question, since we know that inflation is Deflation Deflation has historically occurred under two sets of circumstances. The first is when rapid technological changes cause prices to fall persistently, as was the case during the late 1900s. This type of deflation is associated with rising prosperity. The other, more dangerous set of conditions, is when the economy is so weak that falling incomes lead to falling prices in a downward spiral. This is what accrued during the Great Depression of the 1930s. an enemy of consumers. Why? Because as the prices of goods and services rise over time, the effective purchasing power of each Rand falls. However, the impact of inflation on investments depends on the inflation dynamics. Let’s consider four different inflation environments, and how asset classes behave under these circumstances: 1. Deflation – general price levels falling persistently. When an economy is saddled with a high debt level, deflation becomes particularly painful as debt rises in real terms. Put differently, as incomes fall, debt remains unchanged in nominal terms. Even persistently low inflation is dangerous when debt levels are high. The most recent significant instance was Japan’s experience. When a huge property and equity bubble burst in the early 1990s, a strengthening Yen, a fall in household wealth and a sharp reduction in bank lending put downward pressure on prices. The ageing of the Japanese population also contributed to prices persistently 2. Hyperinflation – prices accelerating rapidly (daily, or even hourly). The standard definition of hyperinflation is when prices rise by more than 50% per month. But obviously, inflation of 20% or even 10% per month is very disruptive. 3. Rising inflation – prices rising at an increasing rate. If it coincides with slow economic growth, the result is stagflation (stagnation plus inflation). 4. Disinflation – inflation rates falling from high levels. In other words, falling or rising only very slowly for the following two decades. prices still rise, but at a slower pace than before. Old Mutual Wealth is brought to you through several authorised financial services providers who make up the elite service offering. 6 WEALTH OF INSIGHT OLD MUTUAL WEALTH INTELLIGENCE Chart 1: Japanese prices, bonds and equities When hyperinflation occurs, investors in most asset classes suffer but borrowers benefit. The real value of debt quickly becomes zero, bonds Falling prices... 106 become worthless and no one wants to hold cash. The economy becomes Japan consumer price index 104 completely destabilised and economic activity becomes short-term orientated. 102 In Brazil’s case, equities failed to keep up with the first bout of hyperinflation 100 in 1990, possibly due to businesses being caught unaware. During the Index 98 second bout, equities kept up and outpaced inflation as businesses adapted 96 more successfully to the rapid price changes. As Chart 2 indicates, real 94 equity prices ended the second hyperinflationary period in positive territory, 92 but with stomach-churning volatility. 90 Chart 2: Brazil’s experience with Hyperinflation 88 86 1989 1992 1994 1996 1998 2000 2002 2005 2007 2009 2011 7 000 2013 Brazilian CPI y/y% Good for bonds... 350 300 6 000 Japan 10-year govt bond total return index Japan equities total return 5 000 4 000 Index % 250 3 000 200 2 000 150 100 1 000 Bad for equities... 0 1987 50 0 1989 1992 1994 1996 1998 2000 2002 2005 2007 2009 2011 1988 1989 1991 1992 1993 600 2013 Brazilian equity index in real terms Source: Datastream 500 Chart 1 shows the Japanese price levels at the top, and bond and equity returns over the same period on the bottom. When prices fall, consumers delay purchases, businesses delay investments and turnover in the economy generally falls. Similarly, company profits stagnate, which is bad for equities. Bonds, on the other hand, become a sought-after investment under deflationary conditions, as the purchasing power of regular coupon payments rises. Index 400 300 200 100 Deflation is an extreme and a rare outcome, but yet, at the time of writing, several smaller Eurozone economies have experienced deflation and the Eurozone as a whole seems to be dangerously close to it. 0 1987 1988 1990 1991 1993 Source: Datastream Hyperinflation Hyperinflation is rare but does happen. Carmen Reinart and Ken Rogoff’s book “This Time is Different” lists 14 recorded instances of hyperinflation since 1800. The highest hyperinflation rates on record occurred in Hungary in 1946 peaking at 9.6E+26% (that is 9 with 26 zeroes behind it!). Zimbabwe’s experience with hyperinflation is a more recent and very “close to home” example, but Brazil is an economy that is arguably closer in structure to our own. Rising inflation Throughout the 1980s, Brazil’s government turned to the central bank to fund its spending plans (by printing money). There were also frequent currency devaluations and the practice of indexation (automatic adjustment of prices and wages according to inflation in the previous period) was widespread. By the end of the decade, these factors led to hyperinflation. Several attempts to slow hyperinflation were unsuccessful, until a new currency, the Real, was introduced along with other reforms in July 1994. in US Dollars rose tenfold between 1970 and 1980. The 1970s was a period of global stagflation – rising inflation and stagnating growth — throughout the developed world. Two oil price shocks (real oil prices rose nine-fold during the decade), combined with falling productivity and widespread wage indexation, led to high and rising rates of inflation and stagnant growth. During this period, bonds and equities did poorly as interest rates rose despite a weak economy. It was during this period that gold established its reputation as an inflation hedge. The real price of gold The period of stagflation ended in the developed world when the US Federal Reserve (the Fed) hiked rates sharply to cause a massive recession in the early 1980s. But the Fed successfully brought inflation expectations under control and the rest of the 1980s were boom years (and a two-decade long bear market for gold ensued). Old Mutual Wealth is brought to you through several authorised financial services providers who make up the elite service offering. 7 WEALTH OF INSIGHT OLD MUTUAL WEALTH INTELLIGENCE South Africa, due to its economic isolation and the collapse of the gold price, experienced stagflation throughout the 1980s as well. As Chart 3 (bottom) shows, local equities managed to end the 1970s flat in real terms. In the 1980s, the local market benefited from the global boom, but the ride was extremely volatile and would have been extremely hard for many investors to hold on to. Throughout the 1970s and 1980s, local bond yields rose as inflation rates crept up, inflicting capital losses on bondholders (Chart 3 top). Chart 4: The Great US Inflation Moderation 16 12 % 10 18 16 4 Bonds lose value 2 SA govt 10-year bond yield 0 1980 SA CPI y/y% 1989 10 8 6 4 1972 1973 1975 1977 1979 1981 1983 1984 Bonds rally 18 8 000 Equities try to keep up SA govt 10-year bond yield SA CPI y/y% 16 SA equities in real terms 14 1980s - global boom and weak Rand helps 12 % 6 000 5 000 10 8 1970s - stagflation hurts equities 6 4 000 4 3 000 2 2 000 0 1988 1 000 1973 1974 1976 1978 1980 1982 1984 1985 1990 1992 1995 141 000 1987 Source: Datastream 121 000 Disinflation Since the early 1980s, inflation rates have fallen worldwide, led by the US. A number of factors contributed to this fall. Firstly, central banks, especially the Fed, established inflation-fighting credentials. Secondly, technological innovation reduced costs throughout the economy. Thirdly, the global pool of labour increased massively as several major economies (most notably China and India) abandoned isolationist socialist policies and joined the global economy. This placed downward pressure on wages throughout the world. Fourth, bloated companies reorganised to cut costs and improve efficiencies in order to compete in a globalised world. 1997 1999 2002 2004 2006 2009 2011 2013 Equities too SA equity index in real terms 101 000 81 000 Index Index 1998 Chart 5: Disinflation in SA since late 1980s 1986 20 7 000 1993 The period of disinflation has been extremely good for equities and bonds. In South Africa, it arrived later than the rest of the world, but inflation rates have trended downwards since the late 1980s as our economy opened up to global competition and the South African Reserve Bank (SARB) followed a restrictive monetary policy. Therefore, even though local inflation cycles have been very volatile over the past three decades, inflation rates have declined over this period. 12 1970 1984 Source: Datastream 14 % 8 6 Chart 3: Rising inflation in South Africa in the 1970s and 1980s 20 US CPI y/y% 14 61 000 41 000 21 000 1 000 1988 1990 1993 1995 1998 2000 2002 2005 2007 2010 2012 Source: Datastream Old Mutual Wealth is brought to you through several authorised financial services providers who make up the elite service offering. 8 WEALTH OF INSIGHT OLD MUTUAL WEALTH INTELLIGENCE Conclusion Old Mutual Wealth’s Strategy Funds are ideally positioned to beat inflation Inflation dynamics are key for investment strategies. Inflation itself is not over time. In fact, they are principally designed to beat inflation over recommended holding periods. These funds are actively managed, the enemy of investors, but the different inflation scenarios matter. This diversified portfolios that map directly to your client’s Investment Strategy, argues for investing in an actively managed and diversified portfolio eliminating the guess work for financial planners. In managing the Strategy where the fund manager can shift between asset classes based on their Funds, we will continue to monitor how inflation dynamics play out to ability to beat inflation over the targeted period. ensure your client’s funds are correctly positioned. How different asset classes relate to inflation It matters greatly whether inflation is accelerating or falling: • Equities: Company revenues are closely linked with inflation. Revenue = Price x Quantity. As long as firms can keep input costs under control and defend their margins – which the good ones with strong management teams, brand recognition and (sometimes) dominant competitive positions are able to do – earnings should rise with inflation. • Bonds: Bondholders typically receive a fixed semi-annual coupon (interest payment) and their capital is returned when the bond matures. Thus rising inflation erodes the purchasing power of coupons and the capital. Inflation-linked bonds have become increasingly popular as they pay coupons linked to inflation. • Property: Theoretically, rental fees should rise in line with inflation and household and business incomes. Over time, house prices rise by about 1% per year in real terms (excluding rental income, maintenance and running costs). Property prices can lag inflation for long periods of time. • Gold: Gold has a reputation as an inflation hedge that is perhaps undeserved. Gold prices surged in real terms in the 1970s, but fell again between the early 1980s and 2000s. Over the longer term (going back centuries), the price of gold has been volatile in real terms. Significantly, gold does not generate income and has no relation to price changes or economic growth (unlike equities and property). Recently, the fear of inflation and negative real interest rates gave gold a major boost. But as it became apparent that inflation was unlikely to explode, the gold price fell significantly. • Cash: The real returns on cash will largely depend on how tough or “hawkish” the central bank is on inflation. During the 1990s and 2000s, the SARB kept the repo rate positive in real terms to combat inflation. Since the global financial crisis in 2008, real interest rates have been negative locally and in most major economies, as deflationary forces outweighed inflationary forces. INVESTING TO BEAT INFLATION OLD MUTUAL WEALTH RANGE OF INFLATION TARGETED STRATEGY FUNDS OLD MUTUAL INVESTMENT GROUP OLD MUTUAL MULTI MANAGERS RECOMMENDED INVESTMENT PERIOD StrategY Suited to clients who require: Inflation plus 2%-3% A growing income stream over time, and/or inflation protection with moderate volatility only. Old Mutual Real Income Old Mutual SYm|mETRY Cautious 2 to 3 years Inflation plus 3%-4% Medium-term inflation-beating returns without excessive risk. Old Mutual Stable Growth Old Mutual SYm|mETRY Defensive 3 to 5 years Inflation plus 4%-5% Significant inflation-beating returns, accepting the associated volatility. Old Mutual Balanced Old Mutual SYm|mETRY Balanced 5 to 7 years Inflation plus 5%-7% High real capital growth rates from mostly local assets, or Regulation 28 compliance for retirement investments. Old Mutual Flexible Old Mutual Edge 28 SIS Inflation Plus 5-7 7 to 10 years Maximum Return The highest possible return available from local and global assets over the long term. Old Mutual Maximum Return SIS Inflation Plus 7-9 10 years OTHER STRATEGY FUNDS IN OUR RANGE INCLUDE: Money Market:Old Mutual Money Market Fund Enhanced Income:Old Mutual Enhanced income Old Mutual SYm|mETRY Money Market FundOld Mutual SYm|mETRY Enhanced Income Fund of Funds Old Mutual Wealth is brought to you through several authorised financial services providers who make up the elite service offering. 9