The ‘muddle through’ policy response of the European Union will continue to maintain pressure on the periphery to reform, whilst stumbling toward fiscal union, states Royal Bank of Scotland’s London based Head of European Rates Strategy in a new report assessing the outlook for inflation in the Euro zone.
Austerity measures have created deterioration in the cyclical budget components, pushed up debt and deficits in the adjustment period and with low interest rates and a delicate return/risk ratio persisting, the pressure is on. European asset owners must adapt their allocation strategies to protect against an uncertain inflation outlook for those all- important real-returns.
The Inflation Hedging & Real Return 2012’ report, produced by Clear Path Analysis, in collaboration with Royal Bank of Scotland and Insight Investment, examines how to create out performance in both a high or recessionary inflation environment and debates the potential implications of the current quantitative easing. In this insightful report pension plan owners come together with the wider investment community to unpick the latest inflation hedging strategies and analyse the tools and processes needed to ensure assets can outperform inflation which threatens to increase future liabilities.
Assessing the European inflation environment, Andrew Roberts, Head of European Rates Strategy, Royal Bank of Scotland, comments; “The architects of the ‘muddle through’ policy response will continue to maintain pressure on the periphery to reform, whilst stumbling toward fiscal union. This approach has a chance of working, so long as creditor nations are willing to finance it, but remains at risk from deepening growth recessions.”
Smarter asset allocation is at the top of agenda and in debating the merits of real assets vs synthetic inflation instruments Sinead Leahy, Head of UK Pension Solutions Group, Royal Bank of Scotland, states; “The linker market in the UK is about £350 billion, and our estimate is that 50% is currently owned by UK pension schemes.”
Leahy goes onto to say that, “Recently the trend has been for funds to isolate the inflation level that you can get from linkers by buying the physical bonds or synthetically on total return swaps, then paying fixed interest rates to remove the interest rate element.”
Alan Higgins, Head of Investment Strategy, UK Coutts, makes the following statement; “High quality government bonds are still negatively correlated, so even though yields are low, you still get a favourable diversification effect from having gilts and U.S treasuries” Thus gilts remain a more favourable inflation hedging tactic for UK asset owners.
Reza Vishkai, Head of Specialists Investments, Insight Investment, provides a compelling exploration into farmland as an alternative asset class in today’s uncertain economic environment. “Demand for arable production is also being driven by the increasing requirement to produce biofuels as an alternative form of energy. Around 30-35 countries now have targets or mandates in place for ethanol or biodiesel production, creating a competing source of demand for cereals, oilseed and sugar, all of which are key inputs into the biofuel production process.”
Certainly arable demand is there and according to Vishkai “For pension schemes, the asset class can provide a mechanism to address the need for stable returns, inflation hedging, income generation and diversification.”
Protecting investments from risks, remains the ultimate goal, as Rudyard Ekindi, Director of Investment Research, NEST Corporation, concludes; “The hedging discussion is always a difficult one as we don't believe that we can hedge in order to eliminate risk. We can hedge if we feel that there is an opportunity to earn an extra risk premium and to eliminate risk.”
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