A primary objective for investors is to preserve their capital and wealth over their investment lifetime. To do this, the investment returns they achieve need to at least outpace inflation so that they achieve a real return, thereby increasing the actual value of their investments over time. In the normal course of events, investors and financial planners base their assumptions on annual increases on the consumer price index (CPI) aka headline inflation – the figure that dominates newspaper headlines every month and represents average price increases for all South Africans. But this measure may well underestimate to what extent purchasing power is being eroded year after year, because in many instances headline consumer inflation doesn’t reflect the underlying reality for a vast majority of investors, who experience different inflation rates according to their income group, location or age. In fact, often the inflation rate that best reflects their reality is higher than the headline rate and it’s this figure that investors should be striving to outpace.
Income group Inflation Differentials
The annual price increases you experience depend very much on the income group. Higher income groups experience relatively lower inflation compared to those in lower income groups. This is mainly because low-income households spend more of their income on volatile commodity items, namely food and transport. In contrast, high-income expenditure groups tend to spend more on relatively stable services items.
Location Matters
Another key determinant of your personal inflation rate is where you live. Different provinces have different inflation rates too – and the differential can be quite material. For instance, in the Northern Cape inflation rose to 7.8% year on year, while Limpopo’s annual average price increases were 140 basis points lower at 6.4% year on year in December 2011. Investors in the bigger economic hubs of Gauteng and the Western
Cape were better off than those far-flung provinces, with inflation falling within the target band of between 3% and 6%. Gauteng recorded inflation of 5.8% and the Western Cape 5.9% in December 2011.
Counting the cost of Age
The older you are, the more inflation you have to contend with, it seems. Pensioners’ consumer inflation averaged 6.5% during the year to end-December 2011 versus a headline inflation rate of 5.8% during the same period. Research shows that pensioners spend most of their investment income on medical costs – and medical expenses increase at a considerably faster rate every year than headline inflation. However, based on the information at hand, it’s clear that anyone investing for retirement will probably need to factor in a higher inflation rate at retirement if they want their money to keep up with inflation.
All these different underlying inflation rates pose a dilemma for investors, namely which inflation measure is most appropriate to them, given their current and future circumstances and resultant investment goal.
What makes up the CPI Basket?
The official measure of headline inflation is the CPI for all urban areas, which is based on a weighted basket of goods and services, as determined by Stats SA at a particular point in time. The weights explain how much income was allocated to the goods and services items in the basket. The basket and weights are based on the 2005/06 income and expenditure survey. The figure details the contents of the basket and their weights. As you can see, on-average, households channel more financial resources into housing and utilities and the least to health items. At the same time, the biggest weightings in a low-income earner’s basket are food and non-alcoholic beverages.
The goods and services reflected in the inflation basket are surveyed on a monthly, quarterly, bi-annual and annual basis to monitor any changes in an average South African’s standard of living. To capture any structural spending changes, Stats SA reviews the basket every five years and adjusts the contents of the basket and their weightings to reflect changing consumer tastes and preferences. That means weights
are fixed for five-year periods, with the last re-weighting and rebasing exercise conducted in 2008 and based on the 2005/06 income and expenditure survey.
Headline inflation trends
Ultimately, the headline CPI represents the average of all consumers in SA and, as with any average, may differ widely for many individuals, as discussed above. But headline inflation does serve an important purpose – it gives investors a general sense of where inflation has been and where it may be going.
Fortunately, headline inflation slowed significantly from persistent high double-digit figures in the Eighties until the early Nineties. In fact, inflation averaged 11.5% year on year from January 1986 to December 1999 compared to 5.8% year on year from January 2000 to December 2011. This can be attributed to a host of policy reforms, which included SA opening up its trade with the rest of the world and reducing tariff barriers. That in turn forced competition into the economy and ultimately improved efficiency and lifted productivity.
This was supported by fiscal policy and the introduction of an inflation-targeting framework. The SA Reserve Bank was mandated to keep headline inflation within the target band of between 3% and 6%. This framework provides a guide of the inflation rate investors can expect as long as the Central Bank doesn’t change monetary policy. Although, the inflation-targeting framework remains the anchor for long-term inflation expectations, exogenous shocks – such as food and petrol prices, remain key risks to inflation.
Further, the exchange rate has a significant role in price formation because SA is a small open economy. Recently, inflation jumped above the upper target band to 6.1% year on year in November 2011 and steadied in December 2011. This was in large part due to climbing food and petrol prices. At the same time, core CPI as measured by CPI excluding food, non-alcoholic and beverages, petrol and energy remained stable over the same period.
The bottom line is that notwithstanding the certainty provided by the inflation-targeting framework, investors should acknowledge there are different inflation realities for different individual circumstances and each person needs to act accordingly to counter the adverse effect of inflation on their particular lifestyle.
To help them plan appropriately, investors should seek professional financial advice on where and how to invest, based on their financial needs and risk preference. In addition, while it’s worthwhile to keep an eye on what’s happening at a headline inflation level, investors need to identify the inflation rate that’s most relevant to their personal circumstances – and adjust their regular contributions and investment strategy to overcome the actual inflation hurdle they will face during their lives.
Collective Insight Autumn 2012 Page 8
