With inflation expected to rise and interest rates likely to follow suit, investors must be wondering what to look to next — particularly as consumers will be under pressure and asset prices are expected to undergo a downward adjustment.
There’s no doubt that the inflation outlook has deteriorated this year. Inflows of foreign funds during 2010 contributed to an 11% appreciation of the annual rand/dollar exchange rate, which helped to keep inflation at historical lows. But foreign inflows have been drying up and an appreciation of the rand against current levels seems unlikely.
We no longer have a decent buffer against the inflationary impact of excessive wage increases, electricity price hikes and food and energy prices.
Inflation influences the income yield and income growth prospects of asset classes and it is also the benchmark for real returns. The South African equity market has performed strongly but local equities with forward yields in the region of 3.4% (based on dividend growth forecasts for 2011, which may prove to be overly optimistic) are below their historical averages.
This, together with the expectation that earnings growth (and dividend growth) from local companies may be subdued because consumers will struggle financially, suggests that the equity bull-run may be coming to an end.
Of course, 2010 saw dividend growth of some 16% generated by South African companies. In part this reflects a resumption of certain dividends that were waived during the financial crisis, while consumer spending also served to boost company profits. But we should be cautious about further growth in consumption. Although historically low interest rates have allowed consumption to revert back to near pre-recession levels, the South African consumer is overly indebted, with few savings.
Any increase in interest rates is likely to rein in consumption and the consumer’s spending power will lessen with rising inflation and higher interest rates. This could in turn hamper the dividend growth of South African companies.
With expensive local equity income streams, offshore opportunities are appealing. Dividend yields of first-world mega-cap stocks are unusually high, especially considering local alternatives. It could be that equity valuations in these markets will give investors the opportunity to generate inflation-beating returns over the next five years.
Higher South African inflation is expected to translate into a depreciating rand. Investing in offshore markets would offer investors a hedge against a weaker currency while also diversifying risk.
If you don’t want to invest offshore, defensive local sectors might be for you: say, pharmaceuticals, food and telecommunications. Such companies can protect their turnover and pass on rising costs to consumers, which will allow them to hold steady in the current market conditions.
The South African bond market has benefited from increased foreign demand and the impact of a strong rand on inflation. These dynamics probably won’t continue due to rising inflation and an anticipated decline in foreign demand. Inflation-linked bonds might be the ones to follow because of their attractive real yields and inflation-hedged income.
Property fundamentals remain weak and, given the longer-term inflation outlook in South Africa, property could be an expensive source of income. It has strong bond-like characteristics, resulting in the yields of both asset classes being highly correlated.
Both Marriott Asset Management and Absa Multi Management have nailed their colours to the offshore mast, coming out strongly in favour of maximising offshore exposure. The offshore allocation for retirement fund assets was previously capped at 20% but the new ceiling of 25% of total assets is perhaps one that should take advantage of now.
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