Inflation Can Destroy Your Savings
Over the past few years, it seemed that inflation had been tamed throughout the world. Now it is back in the news and back in our lives. Experts are divided on whether the recent surge in prices is a temporary phenomenon or the start of a longer-term trend of structurally higher inflation.
We have a look at these arguments because understanding the effects of inflation on your investments is vital to preserving and growing your wealth in real terms. The South African inflation rate is now 4,9%, in line with long-term trends, while in the United States inflation surged to 6,2% last month – the highest in 30 years.
The developed world’s enormous monetary stimulus packages in response to the pandemic more than made up for the incomes lost to widespread shutdowns, without making up for the supply that those incomes had been producing. The result is higher inflation.
Initially, it was expected that the rise in inflation was the result of strong growth in the global economy recovering from the Covid shocks of the past 18 months, and would be short-lived. Now the US Federal Reserve believes that inflation will be transitory and should start to fall in the New Year, but it will remain higher than it has been in the recent past.
Energy prices have surged over the past 6 months, partly due to the global recovery, but also due to other factors including problems in transitioning to greener alternatives. Oil, coal, and natural gas still provide the base-load power essential for electricity grid stability and their prices have more than doubled in 2021, further increasing inflationary pressures.
Savers and investors feel the effects of inflation in several ways, but primarily through the erosion of spending power – if your lifestyle costs R100 today and costs R150 in 10 years’ time, you want your investments to keep up so that you can still afford the lifestyle you desire.
Nowadays, nearly everywhere in the world, government debt is enormous. The interest on this debt needs to be paid, and naturally the lower the interest rate, the lower the cost of repayment. We can understand then, why governments want ultra-low interest rates and are even happier if those rates are below inflation – negative real rates.
Low-interest rates with high inflation are known as financial repression and destroy savings.
Investors on the other hand want interest rates above inflation otherwise their investments cannot keep up with the rising cost of living.
Most developed countries now have negative real interest rates of 3% pa, which means that for every year you leave your money in the bank you would lose 3% of your spending power. Here in South Africa interest rates for a bank deposit are around 4% and inflation is now 5%, which locks in a loss of spending power of 1% every year, before taxes. So, the lesson is that cash in the bank alone is not a viable long-term solution for most investors.
Investing a portion of your portfolio in equities is an inflation-beating strategy over the long term.
While the stock market is volatile, the JSE has returned more than 12% pa for the past 120 years, which is on average 7% higher than the inflation rate. Having a portion of equities in your portfolio is an essential strategy to maintaining the purchasing power of your portfolio over time.
Speak to your financial advisor about how to balance your risk profile and the realities of long-term investing.