The search for a real return

THE SEARCH FOR A REAL RETURN

We saw a surprise interest rate hike during the month when the South African Reserve Bank hiked the Repo rate more than the anticipated 0.25 % resulting in an unexpected 0.50%pa rise in the Repo rate.  We have written numerous articles on how the Reserve Bank’s mandate is to control inflation and they do this through adjustments to the Repo rate.  When inflation is entrenched in the South African economy, they raise interest rates to tighten cashflow in the economy, this has the effect of reducing spending resulting in a knock-on effect on inflation.  In this month’s Financial View, we want to look at a slightly different concept – and that is how inflation impacts your investments.

The recent rate hike was surprising because of the quantum of the adjustment and the fact that our economy is not running hot at all.  The current inflation is largely due to imported pressures such as a weak Rand, high oil prices and high grain prices, as opposed to rampant spending.  To that end the only apparent reason for such a large rate hike was to try to protect the currency.  South Africa is seen as a risky investment destination and thus we need to reward investors by offering a higher return.  If we don’t have this return premium the rationale for a foreign investor falls flat.  Central banks around the world have hiked their interest rates so we had no choice but to follow their lead.  A plummeting Rand would have a far worse impact on our economy. 

All the recent rate hikes mean that the Repo rate is above inflation rate as represented by CPI for the first time in a couple of years.  If one looks at the below graph, you’ll see that the recent past two years inflation (in blue) has been above the interest rate (in red). 

It is critical for an investor that the interest rate exceeds or is above rate of inflation.  When you put money away you would like it to deliver a return in order to increase your wealth.  The increase in wealth is not just about your investment / savings increasing in value.  To really increase your wealth, you need to at least maintain the spending power of that investment.  

Returns are often defined as either being a nominal return or a real return.  The nominal return is the actual return.  The Repo rate (which can be used as a proxy for cash investment returns) is currently 7.75% so your nominal return for investing in cash would be 7.75%.  The real return is far more important though.  The real return is by how much your return has exceeded inflation.  With inflation at 7% it would mean that a cash investment currently would be delivering a real return of just 0.75%.  So, in the same graph above, when the red line is above the blue one the cash investment would deliver a positive real return.  Conversely if the blue line is higher than the real return is negative.

Real returns are so important because if you are not keeping pace with inflation, you are getting poorer each year.  Inflation erodes the value of money over time as anyone who follows the bread price can attest to.  We have all seen the images of old menus where hamburgers cost less than R1 etc.  If you still use R1 coins you will find now you need a whole stack of them just to buy the simplest burger.

Even though cash investments have been providing negative real returns over the last couple of years the financial industry has seen large flows into cash and money market investments during this period.  Human nature means that we try avoid volatility and short term losses and the natural instinct is to invest in something that will provide protection in the short term as opposed to what will deliver the best result over the long term.  We have constantly reminded readers that they need an appropriate level of exposure to equities.

The above graph shows the cumulative performance of three of the largest investment sectors within South Africa.  The South African EQ General is all the equity funds that will have exposure to companies listed on the stock market.  The South African MA High Equity sector is where we find all the “balanced” funds that people use to save for retirement.  The South African MA Income sector are those funds that are trying to outperform cash through an allocation to bonds and cash.  Each line represents the average performance of the sector. 

The graph above covers the past three years and reflects the period from the lows of the Covid crash to date.  One can see that the Income sector offers steady growth and almost no volatility.  For every R100 an investor had invested in that sector after the crash they would now have R122.  With the balance fund or High Equity fund the investor has more exposure to equities and would have experienced more volatility and achieved a higher end value of approximately R154. 

If they had however invested in the Equity sector, they would have a significantly larger R181.  Despite the up and down nature of the returns, the investor in equities almost doubled their money over the last 3 years. 

Although the graph above may be tracking an extreme period which included the covid lows, it is a good example as it shows that over the long-term investments with a good amount of exposure to equities will usually outperform cash.  The most important decisions an investor can make when investing is to determine the investment objective and the investment time frame.  Where the intention is to get wealthier over the long term, then it is critical to try maximise the real return, and more times than not that would involve investing in bonds, property and equities.  This should be done according to the investors risk profile.