A Deeper Look Into Inflation

Taking A Deeper Look Into Inflation

As the new year gathers pace and we take some time to reflect on investment returns over the last number of years, it is extremely important to put into consideration what truly affects the long-term creation of wealth.
Without a doubt, the single biggest detractor of wealth creation is inflation. The latest monthly inflation figure was released during the last few weeks. It currently stands at 4%.

What does 4% mean?… how is it calculated?…
… why does it affect my ability to grow my hard-earned money?…

We might also be asking why it feels as if our medical aid bills, groceries, favourite bottle of red wine and the petrol price went up significantly more than 4%?

Inflation is a sustained and significant increase in the general price level. Simply put we are asking, if a basket of goods and services cost so much this time last year, what does that same basket of goods and services cost now? This definition implies that increases in the prices of a few individual goods and services do not necessarily amount to inflation. It is only when price recorded for a wide range of goods and services increases that inflation occurs.

Taking this into account, we will begin to realise that different goods and services in this basket have different prices and are of different value. Bananas are priced differently to say milk, a trip to the doctor or filling up a car and we spend a different proportion of our income on certain things that we want and need in our daily lives.

However, every person is slightly different and spends a different portion of their hard-earned money on different things, which is where things become tricky. Statistics South Africa (StatsSA) has compiled a ‘representative basket’ of goods and services bought by us and our fellow consumers. This representative basket is also known as the Consumer Price Index (CPI).

Before we continue, it might be interesting to look at the weights attributed to some of the major components in the CPI. Space in the article doesn’t allow us to share a detailed breakdown of all the components, it’ll probably be super boring, but the following section is enough to illustrate the relative importance of the broad categories.

Weights used for Calculating the CPI (% of Monthly Spending)

(South African Reserve Bank data)

As you might have expected, the two most important items in the budget of the ‘average’ South African household are food and housing. Although the word ‘average’ is an interesting discussion point and detracts from our individuality, we will leave the point on average for another time. However, it might be worthwhile to ask: Am I a member of the ‘average’ household in South Africa. Do I spend 17.24% of my monthly income on food and non-alcoholic beverages and 2.63% on communication?

Now that we have a basic idea of what inflation is, how it is computed and the different elements in a representative basket of goods and services? We will now try and tackle why it is so important for our investments. If the general price of good and services rise, i.e. inflation goes up, it means that our ability to buy a basket of goods decreases. Put slightly differently, the purchasing power of our money decreases. It is here where the importance of growth assets within an investment becomes ever so important. Although there are different drivers of inflation, namely demand pull or supply push inflation, rising prices are detrimental to our standards of living. When investing, we are rewarded for the amount for risk we are willing to take. Because of inflation, we are forced to take risks, in order to generate a higher level of return, to combat the negative effects of rising prices.

For us to understand the effect of inflation and without having to understand the subject matter in too much detail, we can make use of the Rule of 72. Inflation, as we have discussed is a measurement of the value of your money over time. The higher the consumer price index (CPI) the less your rand will be worth. That is the main reason why the Reserve Bank is mandated to keep the rate below 6%.

Let’s get an idea of how damaging a high inflation rate can be by using the rule of 72. If inflation is 6% then simply divide 6 into 72, and the answer 12 is the number of years your money will take to halve in value. So inflation at 6% will halve the value of the rand in 12 years. If inflation was allowed to reach 12% then 12 divided into 72 results in 6 years. It will only take 6 years for your money to halve in value. A scary thought indeed.

It is only once we understand the dire implication of inflation on the value of the rand that we will start thinking differently about our investments. As investors, we need to have growth assets in our portfolios, to negate the effect of inflation. Put differently, to ensure a hard earned R100 keeps its purchasing power.

What are these growth assets

Growth assets are assets that may be more volatile, like shares or property. These asset classes have proven over the long term that they can grow one’s wealth. While money in a bank account might feel safe, if we are lucky, we might get 3%-5% in interest. If inflation is 6%, it means that in real terms, we are going backwards. What we need to understand is that growth assets might under-perform or do nothing for several years as is the current reality in the South African stock market. But do not lose hope or sell out of these growth assets. Remain diligent and invested, as the effects of inflation will be negated by the ability to be patient with these growth assets.

In closing, our focus, when building solutions for clients, is twofold. On the one hand, we are focused to ensure the purchasing power of our investors remains intact. Secondly, we also understand that it can be emotionally taxing for clients to be invested in these growth assets. We therefore combine them with less volatile, lower return assets, to improve the client experience and keep them invested for as long as possible. As investors, we need to always try and conceptualize the implication of inflation on your hard-earned money when making investment decisions.

– Sybrand Engelbrecht

Article Credit:  https://www.investopedia.com/ask/answers/what-is-the-rule-72/ , Everyone’s Guide to the South African Economy, 12th edition, Andre Roux.

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