Luigi Marinus, Portfolio Manager at PPS Investments

The sleeping giant is a group of flat-topped hills in Ontario, Canada that looks like a giant lying on its back. Local legend says that the giant was turned into stone when the silver mine it was protecting was discovered. Sleeping giants, which can be likened to inflation, though have an unrealised potential that can awaken at any time.

Inflation on the rise

Globally, inflation has started to increase for the first time in many years. The conservative argument about inflation is that it is transitory, which is what the US Federal Reserve has alluded to. This effectively implies that current inflation is not permanent as it is coming off a low base caused by the slowdown during COVID-19 related lockdowns. In South Africa, the most recent inflation print was 5% and it was only the second time that inflation reached this level since November 2018. Like the US, South African inflation is also coming off a low base. The less benign argument is that years of low short-term interest rates and increased money supply is finally having an inflationary effect. In addition, the cheques handed out in the US during lockdown have been used by consumers on goods and not invested as was the case previously when excess capital was mainly held by corporates.

The South African Reserve Bank (SARB) has an inflation target of 3% to 6%, so the latest inflation print of 5% is within the band and should normally not trigger any concerns. However, the SARB has made it clear on several occasions that a point estimate at the mid-point of the target band is where long-term inflation will be aimed. Recently, the SARB governor mentioned the possibility of officially reducing the inflation target to 3% to reduce the long-term effect of a structurally high inflationary economy. While this may be commended as a noble aim, it was widely seen as too far of a stretch in expectations to be seriously considered. 

Investors, including money managers must weigh up these arguments and consider which asset classes would perform well under these possible scenarios. In an inflationary environment, it is likely that asset classes backed by tangible assets, like commodities and property, will perform well. In addition, inflation-linked bonds have a built-in inflation hedge. 

Asset classes that are likely to perform poorly are nominal bonds, as yields are expected to increase, and equities, as companies’ above-inflation profit potential will decline. Cash becomes an important consideration as fixed cash investments real yield reduces, while floating-rate note investments will increase in tandem with any interest rate adjustments. 

The key though is not to be in a position where one is forced to choose between the two scenarios. There is a fair amount of uncertainty as to how inflation could play out, particularly over the short term and the penalty for choosing the wrong direction may be material. At PPS Investments, we aim to make asset allocation calls and construct portfolios that are adequately diversified to remain competitive regardless of the inflation (and corresponding short-term interest rate) outcome. Our portfolios hold a combination of inflation-linked bonds and nominal bonds, as well as meaningful exposure to general equities, resources, and property counters. 

While we lean on the side of inflation being more transitory with lower inflation, particularly over the short to medium term, coupled with low short-term interest rates, we’re not making a one-sided call that this is how the scenario will play out. Experience has also taught us that sleeping giants should not be underestimated and should inflation awake, the PPS fund range will be suitably invested to manage that outcome.