Safeguarding your savings against inflation and deflation

Armien Tyer, Managing Director of Sanlam Investment Managers writes that the debate over whether the world is headed for inflation or deflation has flared up again, with the jury still out on which scenario is likely to unfold.

No matter which, valuations that are at best reasonable – and in many cases expensive - and lower growth and corporate earnings going forward mean average nominal investment returns are likely to be lower than those returns, specifically on equity, achieved during the Goldilocks era (1992 to 2007).

With this challenging investment environment likely to prevail for a while, it is going to be vital for investors to avoid falling prey to the so-called ‘money illusion’, namely, focusing on nominal returns rather than real returns in which the impact of inflation is taken into account. For instance a 15% nominal return when inflation is 6% translates into a real return of 9% compared with a much better 12% if inflation is 3%. Thus it is ultimately the returns in excess of inflation that matter most – and these will be determined by whether the world is going to experience high or mild inflation, or deflation.

Given the significant impact each of these scenarios would have on real investment returns, we conducted research into the possible consequences of protracted inflation or deflation on retirement savings.

For illustrative purposes we investigated the impact these three outcomes would have on an investor, who, at 35 years old, begins saving 10% of his R200 000 salary for the 25 years to retirement.

We quantified intractable inflation at an average annual inflation rate of 11.7% and deflation of 1.3%, both of which reflect actual periods of high inflation and deflation since 1924. These were compared with a ‘normal’ investment environment during which long-term inflation averaged 3.5%. Our findings are based on different real annual salary increases depending on the scenario, with increases in an inflation environment at the lower end of the scale (2.9%) and at the upper end (5.6%) in a deflationary environment, given the fact that companies still need to offer reasonable nominal increases  notwithstanding inflation rates of less than zero.

We then saw the impact these three different inflationary scenarios would have on a professionally-managed balanced fund, such as the SIM Balanced Fund, as different assets provide specific security and/or opportunity in the event of inflation/deflation. It is common knowledge that equities offer the best protection against inflation because of the higher returns they have historically achieved. Within a deflationary period, however, bonds tend to protect the investor best against falling prices – but there’s no guarantee this will be the case, particularly when government has unsustainable debt burdens and investors are not natural savers.

However, in Japan, where deflation has been around for 20 years, bonds have yielded better returns than equities because there is such avid internal demand for bonds.

Impact of inflation/deflation on a balanced portfolio

In our case study, we assumed the following asset allocation across the different scenarios:

Based on the past 86 years, we established the historic returns achieved by the three key asset classes during the three scenarios: deflation (annual price increases of less than 1%); inflation (1% to 7%); and high inflation (more than 7%). These returns are:

The result of our research into the impact of inflation/deflation on a balanced portfolio at retirement after 25 years of saving is captured in the graph:

These results show that high inflation is the biggest threat to returns at retirement, eroding the value of an investment portfolio most significantly after 25 years of investing. In a high-inflation environment, the investor has R1.28m at retirement, R1.4m or 52.9% less than in a normal environment (R2.7m) and R1.2m less than in a deflationary one (R2.47m).

Deflation has a more limited impact; costing the investor R242 000 or 8.9% less than the R2.7m  accumulated over 25 years in a normal inflation environment. The main reason for this result is that a professional investor would have tipped the portfolio towards bonds, which tend to offer relatively better returns in a deflationary environment.

Investors do have ways of catching up on the lost ground, such as investing for longer. In a protracted deflationary environment, an investor could stay invested for another year, which would put him in the same position as he would have been in a ‘normal’ investment environment. In a high inflation  environment, the investor would have to continue investing for another seven years to reach the same end point in a ‘normal’ environment.

These results generated by a fairly simple case study highlight the potential negative impact ‘extreme’ inflation outcomes could have on your retirement nest egg. These are worth considering because periods of protracted inflation and deflation are more ‘normal’ in national and global economies than investors often realise. For instance, developed economies were dogged by high double-digit inflation for much of the 1970s and early 1980s before inflation was again brought back into single-digit territory. Meanwhile, Japan hasn’t been able to shake off deflation for two decades.

The results of our analysis also highlight the importance of diversifying your investment exposure across all available assets, as well as the benefits of relying on a professional investor to best position the portfolio for future possible events and significant structural economic changes.

Conclusion

It’s difficult, if not impossible, to predict the future; particularly when the global economy and financial markets are undergoing seismic change. We navigate the inevitable market volatility and uncertainty – and emotions stirred up by them – by sticking to our pragmatic value investment philosophy. This enables us to invest based on the underlying value of an asset rather than on market prices, which are often determined by greed or fear.

Invest in a balanced fund, particularly during periods of significant structural economic change, because a professional fund manager is best placed to position your investment portfolio appropriately.