Download LONGzTERM INVESTORS?

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