A ‘great’ interest rate of 6%?

JOHANNESBURG – In November 2015, the South African Reserve Bank (Sarb) hiked interest rates by 25 basis points, increasing the prime rate to 9.75%.

Against the background of the rand’s recent slide against major currencies, inflation is likely to accelerate even further during 2016 and the Sarb will be under renewed pressure to hike rates next year.

For consumers, who have already been feeling the pinch of economic pressures, 2016 will probably be another tough year.

In a rising interest rate environment, cash investments may seem more attractive than they did a year or two ago. In this article, Jeanette Marais, director of distribution and client service at Allan Gray, answers four questions about investing in a rising interest rate cycle.

Why should the impact of inflation also be taken into account when evaluating the interest rate offered on your investment?

In the long run, inflation remains an investor’s biggest enemy, but its impact is fairly simple to determine. Don’t consider the interest rate offered on your investment in isolation, but also take inflation into account. In other words, deduct inflation from the rate of return on offer – what’s left will give you an indication of the real growth on your investment, if any.

Banks regularly run ad campaigns offering an “attractive” interest rate of 5% or 6% on cash investments – either a money market or fixed deposit. Are these offers really attractive?

Each investor needs to consider his or her own circumstances and risk appetite to determine if the investment on offer is attractive. Let’s assume the interest rate offered is 6%. Currently, the official inflation number is 4.8%, which means the growth on your investment would be 1.2% per annum.

But consider these two complications.

Most people’s effective inflation rate is much higher than 4.8% – just consider medical inflation, the rate of increases in food prices and inflation on your imported vehicle. This suggests that your personal inflation number is likely to be much higher than the official inflation figure and it is important to keep that in mind.

Secondly, if you are drawing an income from your investment you can be sure of one thing: your capital will be eroded.

Assuming the official inflation number is 5% and you draw an income of 5% per year, the required rate of return on your investment has to be at least 10% to protect the buying power of your capital. Thus, to grow your investment in real terms, you would need a return of more than 10%, which means a 5% or 6% return only guarantees you of one thing: you will struggle to outperform inflation.

In the short-term, a cash investment may outperform inflation by a percentage point or two, but this will not be enough to grow your capital significantly in the long run. How do investors overcome the risk of investing too conservatively?

To earn a real return, investors need equity exposure in their portfolio, even if it is a small percentage. In the long run equities is the only asset class that can sustainably outperform inflation.

Clients often argue that they don’t have a long-term investment horizon at the age of 60 or 65, but this is not true. People live much longer today than they used to. If you retire at 60, there is a relatively high probability that you still have 30 or 35 years ahead of you. In other words, time is on your side.

But if you are concerned about your investment time horizon and want to stick to a more conservative investment strategy, choose a Balanced Fund, where the asset manager will make decisions about the relative attractiveness of various asset classes on your behalf. In other words, the manager will take more conservative portfolio positions when he is concerned about market levels and will increase exposure to shares when opportunities present themselves.

The stock market can be volatile and there is always a risk that a market correction could scare investors into changing course. When should you change your investment strategy?

You need to adopt a long-term approach. You should only change your investment strategy if your personal circumstances change, for example when you reach retirement age and have to plan for the next 30 or 35 years.

But your investment strategy should not be adopted due to changes in external factors, such as an interest rate hike or market volatility.

Markets, interest rates and inflation numbers change on an on-going basis. They are driven by sentiment and cycles, but shouldn’t trigger a change in your long-term investment strategy.