Lower inflation and investment returns

The steady decline in the international oil price in recent months is starting to filter through to the South African economy environment in the form of lower fuel costs and, in all likelihood, a period of significantly lower inflation. While this has the majority of consumers breathing a sigh of relief, for investors a declining or low inflation environment can be something of a double-edged sword.

That’s according to Dave Mohr, Chief Investment Strategist at Old Mutual Wealth, who explains that investors with portfolios that include performance benchmarks that target inflation-linked growth should not be overly concerned about the possibility that their returns will be reduced significantly if SA inflation follows the downward trend most analysts anticipate in the coming months.

“While it is possible that returns on an investment with an inflation-linked benchmark may decline slightly, to assume that dropping inflation will automatically translate to an equivalent decline in returns demonstrates a lack of understanding of the somewhat tenuous link between inflation and investment performance,” Mohr explains.”

“Historically, global equities and REITs, in particular, have performed relatively well in low inflation environments,” he points out, “which means that such an inflationary drop should not impact significantly on the ability of investment managers to still add value to their clients through appropriate stock selection in the coming months.”

Mohr also points to the potential for lower inflation to underpin the SA economy as a whole as a strong potential positive for investors. “We expect headline inflation to fall sharply from the 5.5% at the end of 2014 to around 3% by April this year,” he says, “and this will deliver a major boost to real consumer income growth and spending, not to mention having the potential to shrink the country’s current account deficit.”

According to Mohr, investor fears around lower returns in 2015 should also be allayed by the fact that, since any low inflation environment in South Africa in the coming months is primarily linked to the lower oil price, it is unlikely to shape the investment backdrop in this country for any significant length of time.

“What’s more, in the South African context, lower inflation effectively increases the possibility of lower interest rates,” he contends, “both of which ultimately deliver higher levels of disposable income and enhanced consumer purchasing power, which are likely to more than offset any marginal short-term reductions in investment returns.”

Mohr goes on to explain that, while the likely short-term reduction in South African inflation should have little to no impact on long-term investment returns, a protracted period of low, or falling, inflation, such as that seen in many developed regions at the moment, would be more of a concern.

“A strong economy has an ability to produce its’ own inflation without having to resort to artificial means, such as the quantitative easing seen in the USA and Europe at present,” he explains, “so sustained declining inflation has the potential to actually stunt a country’s economic growth, primarily by hindering corporate profitability, and steadily eroding investor confidence.”

He is quick to point out, however, that such a long-term low inflation environment is highly unlikely for South Africa in the foreseeable future, particularly given the likely inflationary pressures of the country’s ongoing energy challenges and the IMF’s recent conclusion that the rand is still overvalued as a currency by between 5% and 20%.

“While a further severe decline in our currency value would have obvious economic implications, we actually expect the rand to be a little more stable in the coming year,” he explains, “particularly as slowing US policy normalisation helps to clip the wings of the US dollar to a degree.

“This combination of a more stable currency with stronger economic growth as a result of lower inflation could, in fact, create a very positive 2015 for SA investors,” Mohr concludes.