Money Marketing Newsletter – Inflation – how to interpret it……

Inflation – how to interpret it – how to measure it – how to combat it – how to relate to it in our own financial plans?  These are questions we often ask.  This week’s Money Marketing offers an easy-to-relate-to view on Inflation/CPI worth reading.  In my own office I have an interesting visual aid that has been up on my wall for many years illustrating the effect of inflation. When you visit my office, make sure you take a look at it. The basic story: In 1972, for example, the following mode of transport could be purchased (new) for only one thousand rand (R1 000): a Motor Car. Today it is not uncommon to pay R1 000 or more for a pair of shoes or for your child’s roller skates.  We know the story!  But what are we doing about it? 

In today’s newsletter we take a look at inflation. If an investment priority is to beat inflation then we need to know more about inflation and what a reasonable inflation number is going to be. Investing is general and specific – it is general in that we want an investment to grow and beat inflation and for this we require growth assets. Achieving this becomes specific when we bring our own needs and circumstances into the picture. Inflation is a very big topic and the thoughts we provide below are intended to start a discussion.

A story behind inflation
 
The Wimpy Menu
The dangers of some fast foods aside – a look at a Wimpy menu provides a real and usable insight into inflation that we actually face and experience.

Marriott Asset Management often use the Wimpy menu to illustrate inflation. At their latest Johannesburg roadshow they compared the 1983 menu with the current menu:

In 1983 a Farmhouse breakfast cost R2.70 – today it is R35.95.

In 20 years will you be able to afford your breakfast if you retire today?
 
Beating inflation
The answer we would love is yes and to get there we need to beat inflation. But are we looking at real inflation when we value our investments and future liabilities?

In Franco Busetti’s book The Effective Investor Andre Traverso writes in a chapter titled ‘The only economics you really need to know’ that inflation increases the cost of the household’s consumption basket and therefore diminishes the purchasing power of each rand earned. “A smaller quantity of goods and services can be bought with the rewards of a household’s labour and the household has thus become poorer.”

“This is the cost of inflation and explains why it is the most important macroeconomic variable that investors should follow.”

Is CPI your true measure?
Inflation is defined in the South African Dictionary of Finance as a persistent rise in the general level of prices or a persistent decrease in the quantity and quality of goods and services that can be purchased with a single currency unit.

If I ask the question what is inflation in SA the most likely answer is CPI – 3.7%. This is inflation as measured by Stats SA according to their basket of goods. Have you experienced inflation of 3.7%?

Marriott calculate that the inflation seen in the Wimpy menu is 10% – and that is also the historic long term average (from 1969) of South Africa’s inflation.

Since 2001, CPI has averaged 5.9% – but this has been the decade in which we experienced the worst recession since the second World War.

Two important points need to be noted:
1. The rand has an impact on our inflation – if you take out the effect of a strong local currency in 2010 Marriott calculate inflation to be around 6%.
2. CPI is typical for a general ‘average’ consumer. It is in real experience very different from individual to individual and business to business.
 
What’s measured in CPI?
The inflation basket of goods that makes up CPI stats was changed from February 2009 and includes the following at their respective weightings in the basket:
Food and non-alcoholic beverages – 18.28% of the basket
Alcoholic beverages and tobacco – 5.56%
Clothing and footwear – 4.42%
Housing and utilities – 21.04% (electricity and other fuels make up 2.18% and water 0.98%)
Household contents, equipment and maintenance – 6.14%
Health – 1.48% (this does not include medical aid)
Transport – 17.79%
Communication – 3.13%
Recreation and culture – 3.93%
Education – 2.15%
Restaurants and hotels – 2.78%
Miscellaneous goods and services – 13.30% (includes insurance- health, long and short term)

If you take your monthly expenditure does it look like this – and how will it change in retirement?

This is a critical question and one that is central to the inflation assumptions we make.

For example – as a retiree you may not spend only 1.48% on healthcare and 3.37% on medical insurance. The figure could be much higher – and there are estimates that show that the vast majority of medical expenditure occurs in the last few years of our lives. Couple this with recent experience of increases in all costs related to healthcare (not 3.7%) and the guide you need for retirement funding becomes clearer and most often greater.

CPI is a measure for the individual
Kevin Phillips, MD of idu Software has eloquently pointed out that a business (from which we all purchase goods and services) faces a very different set of costs and increases that is not adequately explained or measured by CPI.

A business will have its major expenses as salaries, rent, utilities like electricity.

The average increase for wages was between 10 – 11% in 2010, electricity around 10 times inflation and likely to go down to 15% in 2012, and rent based on lease agreements often has an inbuilt escalation that is a lot higher than the current 3.7% and the last ten year average of just under 6%.

So a business faces a higher cost base than measured CPI and many struggle to not pass on these increased costs to buyers of their goods and services. These are the cost-push factors Reserve Bank Governor Gill Marcus often refers to.

The base effect
Another critical CPI point to note is that CPI measures are based on year to year changes – inflation this year compared to last year. In some cases these numbers are higher or lower due to a base effect – so 2008 inflation was very high – that was the comparative measure so 2009 numbers were always likely to be better.

CPI may be your starting point but is it your end point?
In noting all the inflation variables – and the re-emergence of inflation worldwide, Marriott puts a reasonable inflation expectation going forward of at least 7%.

At the end of last year we asked Stanlib economist Kevin Lings about forecasting inflation – which has been a difficult task. In 2008 when it skyrocketed it was unexpected, and when it fell rapidly it also took many by surprise. Forecasting inflation Lings noted – requires getting the currency right.

Marriott ask the same question – Is the rand likely to continue to appreciate from current levels?

We won’t ask for any bets on this one – far too easy to get wrong. Marriott refrain from making any short term bets (where the currency has been driven by foreign inflows and outflows into SA capital markets ) – but favour a look at the long term where the driver of exchange rates is purchasing power parity (what you would pay for your Wimpy Farmhouse breakfast in another currency). According to their calculations purchasing power for the rand is USD/R8.80. That means a weaker rand and in the long term the inflation benefits a stronger rand has provided may not continue.

Inflation remains the thing to beat for a true investment that will provide future wealth and income. What that inflation is – is a far more difficult discussion. CPI is a guideline – but it only measures what it measures and that may not be applicable to your life and expenses.
 
It provides a useful starting point and guide – but you cannot exclude your circumstances and future consumption when using it as that guide. It is a stat we often talk about and use but to gain more use and value from it we need to understand it better and relate it to our own financial plans.
 
The opinion and comment in this newsletter is opinion and comment only and does not in any way constitute financial advice. Please seek expert advice from a qualified financial planner for all investment decisions.