PORTFOLIO POINT: Cash is definitely no longer king when it comes to deposit returns. Inflation is set to rise, and you’re better off looking at other higher-yielding options.
Readers may remember some weeks ago I wrote about the medium-term prospects for the retail sector and how a likely end, or at least easing, in price deflation in some areas would aid margin expansion and help underpin earnings growth.
The stats show that volumes growth has been there for some time. The bigger lament for some of our retailers has been the dampening impact of price deflation on revenue and earnings.
Last week’s consumer price index was important for a number of reasons, and one of them is that we are indeed seeing price disinflation end in some areas and ease in others.
For instance, the latest figures show price gains in both clothing and furniture-related items were their largest in about one year and follow decent price falls over recent quarters. Of course, where we are not seeing any let-up in disinflation is in audio visual products and computing. But, in general, the point remains that so far my view is on track and, as I discussed at the time, some of our retailing consumer discretionary stocks are very cheap. Increasingly, private equity agree as we can see from the recent action of TPG.
The flip-side to this, and the other dynamic that investors may want to consider, is that it is looking highly likely that we have seen the trough in the inflation cycle. Why is that important? Because, in this environment, cash is going to become very unattractive and I think the pressure to seek alternatives, while by no means urgent yet, is growing.
Already, Reserve Bank of Australia data suggests that the attractiveness of cash has been whittled away quite sharply as chart 1 shows.
Chart 1: Australian term deposit rates (average all terms)
The chart shows nominal returns to cash, as represented by terms deposits (average of all maturities) and special rate deposits. As the RBA cuts rates and funding pressures for the commercial banks ease, these rates have come down quite sharply. It was only a year ago that you could get deposit rates paying 6% and probably over that – these are averages. That is now down to 4.8% on special rates and a paltry 3.8% just on your generic term deposit rates (again I know there are better rates than that, but these are averages).
Chart2: Term deposit rates (real and nominal)
When you look at things in real terms (which adjusts for inflation), the returns are even worse. Why is it important to look at things in real terms? Because inflation destroys the value of your cash. As things become more expensive (inflation), each dollar you hold buys less. Over a year or two you won’t notice, but over five to 10 years, if you don’t adjust for inflation, all of a sudden each dollar you hold is worth 10-30% less than it was.
So in real terms, your ‘special rate’ return is approximating 2.6% right now. The best-case scenario is maybe 3.6%. Generic term deposit rates are averaging 1.6%. To see how bad this is, look at chart 2 above. It shows that, with the exclusion of the GFC when rates were slashed, you’ve got to go back to 2005 to see a rate as low.
To add insult to injury, look at what returns on you cash you could get. Chart 3 shows dividend yields compared to cash. They are all in real terms – remember that by definition, dividend yields are real returns (dividend /price). Cash comes in just ahead of health and below energy stocks, but well and truly behind telecoms, financials, consumer discretionary and utilities – which all offer real inflation-adjusted returns of close to 6%.
Chart 3: ASX sector dividend yields and cash
Unfortunately this situation or divergence is only going to become more pronounced over the next 12-24 months given that inflation has probably troughed. There are two reasons for this.
Firstly, the carbon tax is obviously going to be a key component in lifting inflation, and even the Commonwealth Treasury is forecasting a 0.7% lift in inflation just from that. I suspect it will be a little higher, but either way this alone will see headline inflation tend towards the upper bound of the (2%-3%) target by the middle of next year. That’s assuming no pick-up in underlying inflation.
Which brings me to my second and more important point that it is more likely than not, which is that underlying inflation will also pick up. Remember that up until mid- year 2011, it had looked as through core inflation, that is excluding the impact of the floods, had been rising sharply. Then, just as quickly, the CPI dropped off a cliff in the ensuing three-quarters. The question for us is, why? And are those factors that dampened inflation a permanent feature?
Chart 4 below shows us where the disinflation came from – tradeable goods. Inflation in non-tradeable goods, which are about 60% of the CPI basket at ( 3.3%y/y), is still quite elevated and hasn’t really changed much over the last few years. Tradable inflation by way of contrast has the lowest inflation rate (-2%y/y) in at least 15 years (that’s as far back as records go).
Chart 4: Tradable and non-tradable inflation
What specifically within the 40% of the tradable drove the CPI down? The vast bulk of it comes down to two components. Fruit and vegetables, and audio visual. The decline in fruit and vegetables alone was half of it, and we know this is a correction from price hikes due to the floods and the subsequent jump in yields following great soil saturation. We know it’s not a permanent feature. Food price declines have been more than just fruit and vegetables, mind you – the price of meat and cereals has declined given high rainfall, stock rebuilding and slaughter rates. The point is, history suggests it is all temporary. Consider that in 2012, food prices are down about (-3.2%y/y) so far. This is the lowest in decades and compares to an average increase over the last few decades of 4.5%.
Chart 5: Domestic food price inflation
Similarly, we know that the Australian dollar simply cannot continue giving support to price deflation on an ongoing basis. At some point the impact wanes, as the $A doesn’t and can’t rise in perpetuity. As I noted previously, we are already seeing the turn in some items like furniture and clothes. This is why tradable inflation, import prices and the like all picked up in the June quarter.
That leaves the persistent underlying trends in inflation – or true core inflation – which I estimate at 2.5%. Why is that important? Because headline inflation tends to core inflation, and it can happen quickly once temporary factors dampening the headline measures disappear. That’s still within the band, sure, but then consider the backdrop. Private domestic demand has been well above trend for over a year now for a start. The unemployment rate is historically very low, and even if it rises to 6% as some suggest, is still very low. If food price inflation tends toward its trend growth rate over the coming year, that alone, would leave headline CPI back above 3% by early 2013, and that’s not taking into account the carbon tax. Together we could have, on modest inflation assumptions, CPI closer to 4% with the carbon tax by the middle of next year.
Unfortunately, as we saw last year and are witnessing right now in Europe, the US and Britain, it is highly unlikely that the RBA will respond to this growing inflationary pressure.
At the very least the bar to action, amid never-ending European concerns, is very high and the RBA will act with a long lag. If inflation hits 4% next year and with rates if anything only going lower, that leaves your real return to cash close to zero – and that’s starting early next year.
One of the first and most important implications of this is that investors and self-managed superannuants might want to start thinking about alternatives to cash investments. It’s not urgent, by any means. But it is important to start the research process now, and be alert to the fact that inflation is rising, so that as it does and your returns to cash fall to zero, you can protect yourself before it becomes too expensive.
Elizabeth Moran wrote a great note recently about how you can protect yourself with inflation-linked bonds, and this strategy is certainly worth checking out for the long-term investor. At the very least they are a must for any diversified portfolio.
Another strategy worth considering is to buy into some of the high dividend yielding stocks, like the banks or telecoms and then neutralise your capital risk with the use of put options (which would give you the right but not the obligation to sell a stock at an agreed price).
So in that instance you would simply buy a put option on whichever bank, or on Telstra (TLS). With real returns on cash at around 2.6% and as long as the cost of insuring your holding is less than 3% or 4% of your holding ( the difference between the dividend yield and cash) then it makes perfect sense to do it. Strategies like these may not be perfect but they are certainly worth exploring now – and doing if they are cost effective.