The Debilitating effect of Inflation on Investments

This article was published in The May 2014 issue of the Global Analyst

       ·      Rs. 1 lakh invested in Equities 25 years ago will now be worth Rs.47 lakhs before inflation and Rs. 7.6 lakhs after inflation!
·         Rs. 1 Lakh invested in Gold 15 years ago will now be worth Rs. 6.7 lakhs before inflation and Rs. 2.7 lakhs after inflation!
·         Rs. 1 Lakh invested in Fixed Deposits 10 years ago will now be worth Rs. 2 lakhs before inflation and Rs. 1 lakh after inflation!
·         What Rs. 6,700 could buy in 1980, you will now need Rs.1 lakh for the same!

    Almost always we make investment decisions based on absolute performance rather than inflation adjusted performance. In my humble opinion, this approach can have very costly consequences in terms of our wealth and overall financial well-being.

     Without considering the effect of inflation, the investment performance can look really dramatic. For eg., Rs. 1 lakh invested in 1979 in equities can now be worth Rs. 1.88 crores!. But when adjusted for inflation it is worth only Rs. 12.6 lakhs, still better than other investments like gold and fixed deposits. Also, inflation creates more havoc in the long run than in the short run as it is a steady and silent killer. For eg., if you have invested Rs. 1 lakh in a fixed deposit in 1979, it is now worth Rs. 15.5 lakhs. But when adjusted for inflation, it is worth only Rs. 1 lakh! In other words, for 34 long years your investment worth has remained unchanged.

Source: RBI, BSE, and other sources. All data for period ending 31^st March 2013. 

     The table above reflects the complete picture across time and investment category. Let us analyse by investment category. At this stage, it may be worthwhile to explain what is nominal and real. Nominal rate of return is the absolute rate before adjusting it for inflation. Real rate of return is the performance after adjusting for inflation. For eg., during the last five years fixed deposits have returned an annualized return of 8% while inflation was also running at more or less same speed causing the real rate of return to be nil.

      

      Fixed Deposits

     If you are a fan of fixed deposits, think again. Most of us, deal with bank fixed deposits without realizing the meagre return (after inflation) that it offers. It has failed to produce any reasonable real rate of return in any time period. While banks have benefitted by the fixed deposits as they make nice spreads (the difference between lending rates and deposit rates), the investors have not made any returns since inflation eats away all the returns leaving nothing on the table. Whenever inflation increases in the economy, the RBI uses interest rates as a tool to contain the inflation (though I am not sure how effective that strategy is so far). In other words, when inflation increases, interest rates also increase thereby technically protecting the real rate of return. However, as data shows, inflation seems to have had the upper hand resulting in the dismal performance of fixed deposit. Over the long-run, a 0% real rate of return can hurt seriously. 

     

      Gold

    Your wife’s obsession with gold after all is not a bad idea! Gold has always produced good real rate of return across all time periods unlike fixed deposits. Gold seems to be having a gala time of late (during the last 5 years) compared to say last 25 years or 34 years. Gold has generated nearly 25% nominal returns annualized (before inflation) and 15% real return (after inflation) during the last five years making it as the best performing investment. It also had a nice run when seen from a ten year context with inflation adjusted annualized returns at nearly 11%. However, in the long run (25 years and 34 years), its real return (inflation adjusted) seems to be moderate but still better than fixed deposits.

    The recent good performance of gold in the last five years could be more due to global financial crisis and its aftermath all across the world. So long as global uncertainty persists, we can expect gold run to continue.

      Equities

      Indian Equities by far has the best story to narrate, especially in the medium to the long-term. In the short-term, (last 5 years), the equity performance is negative after adjusting for inflation but this is only expected given the volatility with which this asset class evolves in the short term. As said before, the global financial crisis has a direct bearing on the performance of equities and hence it is no surprise that its performance has been lack lustre. However, if you can muster some patience, it is by far the best hedge against inflation. It produced a real return of 8.5% annualized in the last 25 years compared to 1.7% for gold and 0.9% for fixed deposits. The same trend can be observed for the last 34 years where it produced a real return of 7.7% compared to 2.7% for gold and 0.1% for fixed deposits.

     It is thus clear that if we can have a time frame of 10 years+ then we can expect equities to protect us from the inflation beast. In the absence of treasury inflation protected securities (TIPS) as it exists in US, the only place to hide against inflation seems to be equities. Though there is no statistic to back the claim, I also feel Real estate doing a good job of protecting value against inflation.

      Welcome to the world of Finance!

     On a side note, while inflation is certainly not benefitting investors, it is benefiting insurance companies in terms of launching products. Recently Aviva launched “Family Income Builder” scheme which states as under:

    “You would be surprised to know that the cost of living has doubled in the last 12 years, and this trend is expected to continue. Are you sure that your savings are also growing at a similar pace? Presenting Aviva Family Income Builder - a life insurance plan that doubles your money. Pay an annual Premium for 12 years and get double of what you have paid every year, for the next 12 years, guaranteed”

    Simply put, what they are saying is that they will double your money in 12 years! A back of the envelop calculation says that the annualized return of such a proposition is just 6%, far lower than the fixed deposit returns that you get in banks! The catch is not in doubling, it’s how soon you double. Welcome to the world of finance!

   

     Trends and Challenges:

     There are 3 trends that are worth noting from a lifestyle point of view:

     ·        You will live longer than you think-more importantly your wife will live longer than you (based on life expectancy)
·         Your investment will produce lower returns as you age yielding lower income &
·         Your cost of living will increase more than what you estimate

      The power of inflation probably comes in directly in the last trend i.e., cost of living and to an extent in the second trend where after inflation the net returns will be lower. The final outcome of these 3 important trends is that you will experience a lower standard of living in retirement.

     

      How to beat it?

        ·         Focus on health-don’t just be content with maintenance. Spend money on building a healthier body.
·         Develop an investment strategy that is inflation proof (and fixed deposit is certainly not one of them)
·         Work longer-move your retirement age from 65 to say 70 or even 75

      The author thanks Karthik Ramesh and Rajesh Dheenathayalan for assistance. 

Gold prices set to hit $2,500/oz as buying season kicks in

Beginning with Eid, gold buying to heat up with Indian wedding season, Diwali, Christmas and Chinese New Year

The price of gold, the ‘safe haven’ commodity, is expected to continue its new rally in the forthcoming months as the gold buying season kicked in on Tuesday with the first day of Eid – a traditionally strong period of gold sale in the Middle East.
Closing at $1,791 per ounce on Monday, the first day of Eid saw gold price jumping more than 2 per cent, or $38, to $1,827on Tuesday, followed by another rise on Wdnesday, and was trading at $1,837/oz at 12 noon UAE time. Spot gold held steady on Thursday with little change at $1,824.39 an ounce.

This rise is despite a massive increase in margin requirements to trade gold announced last week by the CME Group Inc., the parent company of the main metals and energy exchanges in the US. It raised the amount of money needed to trade gold contracts by 27 per cent to $9,450 per100-ounce contract.

Experts believe that this latest rally will defy the hike in margin requirements and propel gold prices beyond the$2,000-mark in the coming months. In fact, some experts are calling for double of that level.

According to Steen Jakobsen, Chief Economist from Saxo Bank, gold still has a long run ahead. “Looking at how precious metals will react to a new QE (quantitative easing), the answer is simple. I think we will see $3,000 if not $4,000 for gold, and other metals should follow suit.”

Gold’s latest upward journey has already begun with Eid, and gold buffs maintain that it will continue until the Chinese New Year with significant gold buying happening during Diwali, Christmas, and the Indian wedding season.

However, downward risks remain, say experts. “As with the dollar, if this is the ‘end game’ then the spike will be followed by risk-aversion which could overall curtail the highs. At all times, one has to realise this is close to the end of the trend, and for every $100gold rises, the risk increases disproportionately as there is more and more speculative hangover involved,” added Jakobsen.

M.R. Raghu, Senior Vice-President-Research at Kuwait Financial Centre (Markaz), believes that some moderation is likely. “Gold has performed 33 per cent for the year out of which 13 per cent was post the US downgrade (August 5). Obviously, the run up is too fast and hence some moderation is bound to happen at this level,” he told Emirates 24/7.

“For investors that entered the party early on, it may be a good idea to cash out partly at these levels. From here, the price may correct, say 5 to 10 per cent, before resuming another go. Hence, I would not advise investors a total exit from gold since the macro picture is negative, which is kind of positive for gold at least for some time to come. It may find it difficult to hit $2,000 [per ounce], but once it does, you can see more buying coming in,” he said.

Advocates of gold affirm that gold remains the world’s go-to currency. Commodities analysts at Standard Bank said recently that after touching record levels, gold came off its highs a few days back, as risk aversion subsided. “Equities across the globe rebounded as investors shrugged off the pessimism of the past few days and moved into riskier assets, amid growing concern that the bullion rally was overdone and hopes of further Fed monetary stimulus. However, this was short-lived, as risk aversion was soon apparent, as Asian markets opened. Moody’s downgrade of Japan’s sovereign credit rating reignited concerns over the developed world’s fiscal problems, sending Asian equities into the red, to the benefit of safe-haven precious metals,” said a recent report released by the bank.

“[A] drop in prices has attracted an element of bargain hunting, which should provide support across the precious metals complex in today’s trade. However, with European stocks currently trading up it appears as if risk appetite is not completely absent, which could limit the upside for precious metals,” it added.
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Gold price to reach $1700/oz

Published Wednesday, June 29, 2011 in Emirates 24|7. click here to read

With gold prices hovering around the $1500-per-ounce-mark, experts believe that a surge in prices in the next six months is likely, with prices reckoned to increase by about 15 per cent to reach $1700/oz by the end of the year.

Despite the fact that the price of the yellow metal has gone up by just 5.5 per cent since the beginning of this year, M.R. Raghu, Senior Vice-President-Research at Kuwait Financial Centre (Markaz), believes that “gold will have another good year in 2011.”

“In my assessment, it is likely to end at $1700 per ounce levels, implying a 20 per cent increase for 2011. It did about 30 per cent for 2010,” he told Emirates 24|7.

With a lacklustre economic recovery in the US and concerns over uncertainty in the European debt markets giving support, gold prices are likely to break previous records, say analysts. The precious metal has immensely gained in popularity as a safe haven investment, and is expected to continue its upward trajectory.

Experts at Standard Bank too are believers in the gold story, and see prices moving up. “We believe gold will continue to push higher in 2011. Our core view on gold is driven not only by our observations in the physical market but also by continued growth in global liquidity, driven not so much by the Fed anymore, but increasingly by government borrowing,” said Walter de Wet, a commodity analyst at the bank.

Experts maintain that the performance of the yellow metal is less volatile as compared to other commodities, giving it more scope to appreciate.

“Unlike silver or oil, gold has a risk-controlled performance so far with low volatility as it has a wider audience (retail, institutional, hedge funds and government treasury). As articulated before, gold will continue its march so long as US economic recovery is hazy, Europe is in doldrums and the inflation monster in Asia is uncontained,” explains Ragu.

In its first quarter report of 2011, The World Gold Council said that gold demand grew 11 per cent compared with the first quarter of 2010, as the average gold price for the quarter rose 25 per cent year-on-year. It’s an as-expected quarter, said the council.