Written by Tom Stanley, Investment Adviser, 30th April 2023
Ever since Netflix launched their Drive to Survive series in 2019, I have tuned into Formula 1 on the regular. As a kid with a diecast model Testarossa, I was a Ferrari fan – Naturally, Drive to Survive rekindled that Ferrari spark.
Last weekend’s Azerbaijan GP was shaping up as an exciting one as Ferrari qualified in first place. Qualifying first, meant Charles Leclerc of Ferrari was in the box seat with a chance to win their first race of the 2023 Formula 1 season.
As you can probably tell from the photo above, the win did not materialise. Leclerc (and my team Ferrari) finished a respectable third. What happened? Let’s dig in…
Despite a strong start, by lap 3 (of the 51) Leclerc could only watch as Max Verstappen of Red Bull Formula 1 zipped past in what was clearly a faster car, especially on the straights.
A couple laps passed, and it appeared only a matter of time before Sergio Perez (also Red Bull Formula 1) would also pass Leclerc – By lap 5 the writing was on the wall – another straight and Red Bull was 1st and 2nd, Ferrari 3rd.
The next 46 laps of the race were interesting viewing, but most of the interest wasn’t at the front of the pack – the Result? Red Bull 1st & 2nd with Ferrari 3rd – BUT, what piqued my interest was the monster lead the Red Bull drivers built throughout the race.
Sergio Perez finished 1st, Max Verstappen was 2.137 seconds behind, and finally Charles Leclerc crossed the line 21.217 seconds later in 3rd.
21.217 seconds may not seem like a lot, but when the cars are travelling at average speeds more than 200km/h, that 21 second lead corresponds to around 1.2km of distance!
So, on average how much faster were the Red Bull drivers compared to Leclerc in the Ferrari?
- Red Bull (Perez) Average Speed: 205 km/h
- Ferrari (Leclerc) Average Speed: 203.5km/h
A 1.5km/h speed differential! The difference between a walk and a brisk walk. A tiny margin when considering the top speeds of these cars are often greater than 300km/h.
Now, you may be asking how the relative speed of Formula 1 cars relates to your investments? It doesn’t directly, but it does offer a good analogy for cash and term deposit investors in the current inflationary environment.
Over the past 10 years, returns on cash have been measly at best (especially after tax). Per the below, AMP’s KiwiSaver Cash Fund has returned 1.26% per year on average over the past 10 years. But with the OCR at 5.25%, cash funds are now returning upward of 5%!
It finally feels like those holding cash are getting a good deal – But are they?
Before I dig in, please do not take this note as some blasé statement of ‘cash is trash’, or as me saying you shouldn’t hold cash – At Amicus we see cash as a core defensive asset class when building portfolios, a good deliberate choice if you’re about to buy a house, and a critical buffer when managing any retirement plan.
Holding cash in the short to medium term can be a smart move as it gives you options.
The point of my note this month (like most previous notes) is to challenge the mental shortcuts we often take, and hopefully offer a fresh perspective.
To kick things off, I want to share a quote from Twitter’s @PauloMarcro:
“Inflationary recessions create monetary illusions.”
This statement may come across as a little cryptic, but the point being made is:
“7% nominal growth (or return) with 9% inflation feels much different than 0% nominal growth (or return) with 2% inflation” – but they are essentially the same when it comes to an investor maintaining purchasing power.
The 7% return feels great as we see interest payments landing into our accounts, but when we are losing purchasing power faster than the dollars are coming in, we are prone to falling victim to the Money Illusion – a term first coined by the great John Maynard Keynes. The money illusion states that the average person tends to view their wealth and income in nominal terms instead of real terms.
A little like me watching the Baku Formula 1 race on the weekend – An NZ based investor focusing on 5% cash returns when your purchasing power is eroding at near 7% (due to inflation), is like rooting for Ferrari while Redbull are driving faster cars – Leclerc may have been driving at 203.5km/h throughout the race, but in relative terms he was going backwards at 1.5km/h from the starting gun!
Without context, the 1.5km/h speed difference of cars in F1, or the 2% difference in return between cash and inflation may seem easy to shrug off – Especially with the level of pessimism and volatility in other asset classes. But a 2% negative REAL return can really bite over the long term. Research Affiliates did a great job in quantifying the impact of negative real returns and history of inflation in this paper from Nov 2022 – One of their key takeaways:
“We think the central bank consensus, that 2% inflation is ideal, is arbitrary. True price stability—zero inflation on average over time —is easy to achieve. The Byzantine Empire managed it for over 600 years. That said, 2% inflation is reasonably benign, with the currency losing “only” 75% of its purchasing power in an average human lifetime.”
Let the last part of that statement sink in while you think back to how many lollies you could buy at your local dairy with 5 cents or even 50 cents when you were a kid!
But inflation and the negative REAL returns are only transitory right?
Many would have heard or seen headlines to the effect of “Adrian Orr admits Reserve Bank is ‘deliberately engineering recession’”, so inflation should be out for the count soon right? The reserve bank believes that is the case:
“Annual CPI inflation is assumed to return to within the 1 to 3 percent target band in the second half of 2024, and to 2 percent by the end of 2025” (RBNZ Monetary Statement, Feb 2023).
The Reserve Bank’s crystal ball may be less cloudy than mine, but if we respect history, and look to the conclusions of the Research Affiliates paper I mentioned above – What are their findings based on historical inflationary periods?
“It should come as no surprise that the median time to bring 4% inflation down—ever so modestly—to 3% is brief, about 18 months (still perhaps longer than many might expect). But after inflation hits a less benign 6%, the median number of years to cut inflation to below 3% soars to 7½ years”.
So, the powers that be in New Zealand are trying to engineer a recession, and expect to bring inflation back to target within a year. But history would say that on average it takes 7.5 years to get the inflation genie back in the bottle.
Only time will tell where inflation goes, but as investors it is good to be aware of the how wide the range of outcomes may be.
What to do with this information?
- Be deliberate – Holding cash or term deposits can be a good idea and a valuable ‘ballast’ for a portfolio in the shorter term – Cash gives you options, but it is critical to understand how much cash you are holding, how you are investing the cash, and why.
- Do the numbers – If you are committed to holding cash for more than 1-3 years, be aware of the REAL return you are getting. Are you going backwards like Ferrari or making gains lap-by-lap like Red Bull? – The math is simple: ‘REAL return = RETURN after tax – INFLATION’.
- Know we are here to help – Inflation, interest rates and purchasing power matter, but they can be complicated and noisy to understand. We don’t have a crystal ball, but we are here to help you unpack the ‘now’, and help you make informed decisions around your savings, investments, and plans.
If you’ve made it this far, nice work. Thank you as always for your time and attention. Hopefully my F1 analogy is not lost and puts the current environment in context.
As always, know that we are here to help – Please feel free to reach out, book a time for a call (links below), or share this note with others.