Luigi Marinus and Prieur du Plessis
GLOBALLY, inflation has soared in recent months, as evidenced by the latest print of 8.5 percent in the US. Whether this is due to years of quantitative easing and low interest rates or base effects post-lockdown (which may have an impact on the longevity of high inflation) is currently of little interest to consumers.
South Africa (SA) has not been immune to rising global inflation, with domestic inflation edging higher. The South African Reserve Bank has increased short-term interest rates by 1.25 percent off the lows, with the latest increase of 50 basis points announced in the most recent Monetary Policy Committee meeting.
From an investor perspective, the questions are: do certain asset classes perform better in inflationary conditions, and if so, can reasonable investment returns still be achieved?
For certain asset classes, like inflation-linked bonds and cash, the answer appears to be straightforward. Inflation-linked bonds have an inflation hedge, which serves as a buffer against inflation, as the coupon and principal adjust as inflation changes. Cash tends to benefit from increasing short-term rates, as monetary policy acts to control the inflation level.
The obvious asset class to which inflation is detrimental is nominal bonds. The expectation of inflation and subsequent interest rate increases tends to increase bond yields, which results in a negative capital appreciation of nominal bonds. For other asset classes, the outcome may be less clear.
Consider the one-year period from August 2007 to August 2008 where, during the global recession, South African inflation increased from 6.8 percent to peak at 13.7 percent. In the accompanying table, we can see the returns of the various asset classes for this period.
As expected over this period, SA nominal bonds underperformed, while SA inflation-linked bonds and SA cash delivered strong returns. The remaining local and global asset classes delivered negative returns. What is less clear, however, is whether these asset classes delivered a negative return because inflation increased or whether the concern about a global recession was the overriding factor.
While inflation may have an effect on companies, costs are likely to be transferred to consumers in the case of manufacturing companies or rent payers in the case of property companies. Valuation levels and macroeconomic conditions have historically had a larger influence on these higher-risk asset classes.
Therefore, it appears that interest-sensitive asset classes can provide an investment strategy that combats high inflation. What is less apparent, however, is how well expectations forecast the future path of inflation and whether there may be an overemphasis on inflation when other market forces may be more influential.
Undoubtedly, current global inflation levels are concerning, but the action of the US Federal Reserve (Fed) to control inflation may have a greater impact on markets. The Fed needs to balance the risk of high inflation and the influence increasing interest rates may have on reducing gross domestic product growth.
Increasing interest rates may also bring inflation under control quickly but may result in the US heading into a recession. If this manifests, it is likely to have a larger negative impact on financial markets than what high inflation may have. However, if the Fed is successful, it could result in positive markets. The probability of a US recession may still be low but is not an immaterial concern, and this needs to be taken into account when managing assets.
A diversified portfolio, even in the face of high and rising inflation, should not be constructed with only one outcome in mind. Increasing the inflation-linked bond and cash allocations in portfolios could provide some inflation protection, but significant overweights would result in missing out on positive opportunities should the expected path of inflation not materialise.
Luigi Marinus and Professor Prieur du Plessis are portfolio manager and non-executive director of PPS Investments respectively; email: lmarinus@pps.co.za
BUSINESS REPORT ONLINE