Protect your portfolio from inflation and depreciation
STATIN recently released point-to-point inflation data ending in January. Over the last 12 months, the Jamaican economy registered an inflation rate of 5.3 per cent. This compares with 9.3 per cent recorded over the 12 months ending in January 2014.
In contrast, the value of the Jamaican dollar declined against the US dollar by approximately eight per cent over the same period. Inflation and devaluation for 2014 were both below their historical averages.
Jamaica’s inflation has averaged over 10 per cent per annum for the last 12 years peaking at 26.5 per cent over that period. Similarly, the average rate of devaluation for the last 40 years is 13 per cent per annum. Let us quantify the impact of these forces. For example, $1,000,000 in 1974 was worth US$1,098,901.10. However, 40 years later (the average working life of an individual), $1,000,000 is worth roughly US$8,809.22.
Similarly, a 10 per cent rate of inflation quickly turns J$1,000,000 into J$385,543.29 over a 10 year period.
It is therefore important for your retirement portfolio to at least keep pace with the trend in inflation or better. In the US, for example, the inflation target is two per cent, while in Jamaica the target is now approximately six per cent. What is true is that US dollar assets provide a good hedge against inflation and protect your long-term investment portfolio.
Benchmark interest rates have declined by over one percentage point to 7.14 per cent in the past 12 months ending in December 2014. Local interest rates over this 12-month period are now just slightly higher than inflation for the same period; a somewhat rare occurrence in the local economy.
Ironically, equities and real estate, which have been accepted by most fund managers as the best hedge against inflation have had mixed fortunes. The main index of the Jamaica Stock Exchange, saw a decline of 5.3 per cent for calendar year 2014, while the Junior Market Index saw a decrease of 9.2 per cent over the same period. Unfortunately, there is no recognisable benchmark for real estate to gauge performance.
Inflation is a very critical component in assessing the performance of any medium- to long-term portfolio. The ability to provide a rate of return above inflation is the only way to preserve pension or retirement portfolios.
Consumer Price Index (CPI) inflation plus a minimum of 2.5 per cent has been the standard hurdle rate, with some fund managers using a premium of as high as four per cent above inflation as a benchmark.
But what about devaluation? you may ask. The role of devaluation in setting a hurdle rate is debatable. However, it must be taken into account when assessing overall performance of pension portfolios.
To put this into context, a Jamaican dollar bond with a term of over three years, yielding nine per cent per annum would still be below the average rate of inflation for the last 10 years and could be viewed as a relatively poor investment. However, if a similar bond was issued in US dollars at the same rate or even as low as five per cent per annum, in local currency terms, the investor would be better off than purchasing the previous bond in Jamaican dollars.
Lower yields on US dollar investments can put investors far ahead of the returns on higher-yielding Jamaican dollar assets. Similarly, taking lower yields on US dollar assets, allows pension funds to take a more conservative approach to risk management.
In lieu of purchasing US dollar assets outright, there are several options in the local environment that provide this hedge. For example, there are several companies that have a significant percentage of their earnings in foreign currency which work as a hedge against inflation and devaluation and may be considered to preserve your medium to long term portfolio.
Kevin Richards is Vice President, Sales and Marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm