A report by leading pension managers, trustees, corporate sponsors and asset managers in the UK, Europe and the US examines how institutional investors should position asset allocation strategies for a high inflation scenario plus the investment strategy that will best protect against growing inflationary pressures.
The emerging markets and commodities boom along with the effects of the economic stimulus packages mean pension schemes and the wider institutional investment sector have found themselves struggling to make sense of inflation expectations.
In a fascinating roundtable Emmanuel van der Mensbrugghe, European Director at the International Monetary Fund; Trevor Williams, Chief Economist at Lloyds TSB Corporate Markets andMember of Shadow Monetary Policy Committee;as well asThomas Mayer, Chief Economist at Deutsche Bank debated the real trend for inflation in Europe.
Commenting on the macroeconomic environment and inflation outlook over the next 12 months,Thomas Mayer estimates that levels will reach around 3% on food and oil price pressures.“But there’s a more important underlying development which is taking place and that is a long term upward trend in inflation caused by lax monetary policies globally, which will significantly erode the value of low return assets and cash.”
On the subject of ahigh profile case of lax monetary policy,Emmanuel van der Mensbrugghe,referring to the “massive” fiscal adjustment of 5% that Greece has already made, implies thatthere may be room to make use of high performing assets in an inflationary environment: “We tend to focus on the liability side but there are also assets in these countries and we take the view that there is scope to utilise some of these assets to enhance their creditworthiness”.
Markus Heider, Global Head of Inflation Researchat Deutsche Bank adds: “Among central banks, the ECB believes that inflation risks warrant higher policy rates, while the US Fed remains concerned about high unemployment weighing on inflation and is still completing QE2. But the best example of the divergence in views may be the BoE, with one MPC member arguing for further QE, while three others are advocating an immediate policy tightening.”
Stephen Jones, Co-Head of Fixed Income at Aegon Asset Managementexplains: “These price pressures look set to continue despite only modest economic recovery and an assumption of a significant amount of spare capacity in the UK economy. Raw material costs, food, energy and tax changes have driven recent inflation events, and while the tax change effects will fall away in 2012, we believe that other price pressures will persist.”
Published today, the Clear Path Analysisreport‘Inflation Hedging for Institutional Investors’ highlights what a heightened inflation environment means and what can be done about it.
Stephen Jones believes that countering this threat (the emergence and persistence of inflation) requires a specific and dedicated investment response. “Our Inflation Linked Fund seeks to deploy a multi asset approach to firstly offset some of the expense seen in the core index-linked asset, and secondly capture price moves at all stages of the price pressure pipeline. Therefore the fund can and does invest in commodities, equities, credit, foreign exchange and interest rates around a core holding of index linked bonds sourced from the UK and overseas government markets. In so doing, we are taking exposure to the causes of inflation as well as assets that benefit from the end result.”
Nicolas Tabardel, Global Head of Inflation Volatility at Deutsche Bankconsiders whether there will be substantial amounts of volatility in the future: “We’ve become used to low and stable inflation in the last twenty years. If you take a long term historical perspective, that’s an exception. Over the next five to ten years inflation volatility will be much higher, which makes it more important to develop investment strategies to hedge that risk.”
In terms of how the inflation options market has developed and what is driving the demand, he notes:“The growth in volumes has been phenomenal. Last year we had a growth spurt in the market, combined interbank volumes for Europe and the US trebled from $13bn in 2009 to $50bn in 2010. If you look back, in 2004 this market didn’t exist and in 2005 the market traded $1bn. Volumes have been roughly doubling every year on average, so it’s very fast growth.”
On the main trading themes in this marketNicolas Tabardel suggests: “In the UK we havedemand for floors from pension schemes but wealso have supply of caps, so that’s the onlymarket where caps are available in large size andare cheap. It seems that everybodywants to buy inflation caps, the only place wherecaps are cheap is the UK but nobody wants tobuy them here.”
Explaining the rationale of using inflation options he concludes: “Many of our clients are exposed to inflation risk and inflation volatility risk in one form or another. We see pension funds that have LPI (liability driven investment) liabilities; we see real estate investors receive LPI linked rent and we see bond investors buy TIPS (treasury inflation protected securities) and therefore hold inflation flows. Both of these are good reasons to use inflation options.”
Looking to other protection options, David Donora, Head of Commodities at Threadneedle Investments, remarks that commodities remain an effective strategy: “They have long been recognised as a credible hedge against inflation, especially unexpected inflation. Commodities continue to provide protection against inflation and its destructive effects, particularly as long as emerging markets growth remains robust and developed market governments continue to deploy unorthodox economic policies.
David Donoraidentifies two drivers behind this trend. “Emerging markets growth is highly commodity-intensive owing to the need to build infrastructure and improve the living standards for nearly half the world’s population, so this demand for commodities appears well entrenched. On the current path, the best case scenario is that there will be a slow, sustained decline in the value of the dollar. With commodity prices denominated in dollars, this means that the price of commodities will continue to climb.
He continues:“Looking forward, while the risk is that we have to contend with a more volatile world, commodities continue to provide a safe haven for capital preservation and remain an effective hedge against inflation.”
William Nicoll, Head of Alternative Structures at M&G Investmentsbelieves: “We approach inflation and real estate from a different angle and have for many years sought the closest inflation linkages – one of them is in long-term inflation-linked leases. These are a very attractive way for us to try and get some type of inflation hedging into a portfolio that is linked back to property risk. If you’ve got an underlying tenant who is very high quality then you can start seeing that almost as an inflation-linked bond, rather than property, a type of inflation linked bond with an extra bit of property or credit risk.”
“Another clear opportunity here is in social housing, where you have an explicit RPI linkage to the rents being paid into the housing associations. A bond backed by a housing association and secured on residential property therefore has a direct inflation linkage. You can go from a very low risk idea of social housing bonds to a higher risk idea of inflation linked leases and then on through to the direct property investment itself. It’s simply a question of how long is your time horizon – if it is long enough then libor-linked investments, inflation and property would all tend to work together at some point.”
Jon Masters, Head of Property Derivatives at BGC Partnersgoes further: “With the uncertain investment environment, high inflation and potential regulatory change it makes sense for pension funds to consider ways to protect investment returns using the latest risk management tools. In the case of property this entails utilising derivatives.”
He continues: “By using a blended RPI / Property Linked Note a pension fund can protect its portfolio against the erosive nature of inflation with no basis risk whilst giving property returns and capital guarantees in a quicker and more effectual way than buying or selling various sector specific assets within that property portfolio.”
From analysis undertaken by BGC he states: “In the case of commercial property investment, rental income vastly improves the performance of commercial real estate returns relative to RPI. Therefore, it is sensible to protect the income element from the erosive nature of inflation… Secondly, the residential sector is a good inflationary hedge and diversifier within a portfolio. Using property derivatives, pension funds can now gain synthetic exposure to the returns of the residential market without any of the traditional tenant / ethical dilemma risk or management burden, associated with ownership of the physical asset.”
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