Have you thought about the risk of inflation?

With the current extreme levels of monetary and fiscal stimulus, inflation risk is escalating

Have you thought about the risk of inflation?
For many investors, the risk – rather than just the return – of their investments has been top of mind during this uncertain time. While pandemic-induced factors such as currency volatility, recessions and sluggish growth can leave investors nervous, there are bigger risks that investors often fail to consider. These include allowing your emotions to influence your decisions, the failure to save adequately, and perhaps most detrimental, underestimating the impact of inflation over time.

However, no drastic increases in inflation have been recorded yet
In South Africa, inflation rose to 3.20% in January 2021 compared to 4.50% in the same month last year. The US inflation rate was recorded at 1.40% in January 2021 compared to 2.50% in January 2020. Britain’s inflation declined to 0.70% in January 2021 compared to 1.80% in the same month last year. And in China, inflation fell by 0.30% in the first month of this year compared to an increase to 5.40% in the same period over the previous year.

Recent Inflation Rates Compared to January 2020

In the US, inflation has remained depressed despite the unprecedented levels of stimulus (indicated in Graph 1 as ‘US Money Supply’), largely because of reduced money velocity, i.e. the pace at which money is circulated, and recirculated in the economy.

The practical challenge is that although stimulus has been provided, it is not reaching the broader economy. Consumers have more money, but it is not being spent. We can see evidence of this in the US savings rate that has catapulted from 7.5% before the Covid-19 pandemic to 20% currently (see graph 2). At the height of the initial lockdowns and coinciding stimulus package, the savings rate ballooned to 35%. Currently there is a lot of pent-up spending in the form of savings. As this capital starts to find its way into the US economy, velocity will pick-up and so too should inflation.

Graph 1: The velocity of money – US money supply

Source: Federal Reserve Bank of St. Louis
*Data as at 11 February 2021

Graph 2: US personal savings rate over 10 years

Source: Trading Economics

The impact on investments and income levels
Rising inflation reduces your spending power, and the real value of your investment (i.e. net of inflation). If prices go up, affordability declines, meaning your returns need to be higher for your capital to maintain the same purchasing power. If you fail to consider price inflation in your investment strategy and your returns don’t outperform inflation, your chances of achieving your wealth creation goals become very slim.

While it is understandable that investors are avoiding equity markets due to the current environment and pressure experienced in markets over the past year, we believe it is essential that investors avoid excessive cash allocations. This is especially true right now, when interest rates are at 50-year lows. Although cash is generally perceived as the safest investment because of its inherent stable nature due to generated returns through interest income, we believe that cash is actually the asset class that comes with the highest inflation risk and highest probability of not exceeding inflation.

So where to from here?
We believe, now more than ever, that medium- to longer-term investments should be tilted towards non-cash and growth assets. Our recommendation remains for investors to use multi-asset funds that actively allocate assets across the asset class spectrum, both locally and abroad, in line with the fund managers’ views of prevailing market conditions in each area.