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Inflation at the crossroads: What should pension schemes consider?

22 Sep 2020

After more than a decade of historically low prices across advanced economies, are investors about to face rising inflation levels again?

If gold prices are anything to go by, investors are certainly lacking confidence that current price levels can be sustained. Prices for the precious metal have risen by more than 35% year-todate and demand for index-linked gilts has also surged.

At the same time, rising prices of options for inflation swaps suggest that some investors have also not completely written off the possibility of a deflationary scenario.

While questions had already been asked prior to the Covid-19 crisis as to what extent record low levels of inflation could be sustained, the forced economic shut-down as a result of the pandemic has made changes in price levels more likely, with potentially dramatic consequences for fixed-income heavy investment portfolios.

An early indication that price levels might be rising were inflation figures for July from the Office for National Statistics, which suddenly jumped to 1%, rather than the 0.6% predicted.

While this is still some way off the Bank of England’s 2% target, the crisis has fundamentally altered consumption patterns making it much harder to predict how prices for the traditional consumer price inflation (CPI) consumption basket might pan out.

“The inflation outlook for the next 12 to 18 months is probably the most uncertain it’s been in my 15-year career of trading inflation-linked products,” argues Evan Guppy, head of liability driven investing at the Pension Protection Fund.

Textbook theories questioned

The problems of predicting price levels precede the pandemic. In the aftermath of 2008’s global financial crisis, while inflation targeting has been defined as the cornerstone of central bank policy making, macro-economists have struggled to come up with a coherent framework to understand what drives inflation. The experience of the past decades appears to have invalidated the two dominant textbook theories, the Phillips Curve and the monetarist theory of inflation.

The inflation outlook is probably the most uncertain it’s been in my 15-year career of trading inflation-linked products.

Evan Guppy, Pension Protection Fund

The theory of the Phillips Curve suggests that low unemployment would lead to a rise in wages and hence drive up price levels. But the past decade or so has been characterised by relatively low levels of unemployment combined with stagnant wages and persistently low inflation across Western economies and Japan.

Similarly, the monetarist theory of inflation, as popularised by Milton Friedman, suggests that an increase in money supply could drive up price levels. But the period following the 2008 crisis has seen record levels of money being pumped into the economy while price levels sank more or less continuously. Nevertheless, the 25% increase in money supply in the US alone is one reason why investors continue to remain wary about price levels.

Elina Ribakova, deputy chief economist at the Institute for International Finance, stresses that investors should be careful not to conflate the monetary base with money in circulation.

“This is similar to what we saw post the global financial crisis,” she says. “The money multiplier changes and the financial system is more complex than just central banks printing money, banks transmitting it to corporates and individuals and those spending more.

“On the one hand everyone is more cautious during any shock, more money is saved rather than spent,” she adds. “In, addition, it is not only banks that intermediate interest rate changes/or base money supply changes by central bank.”

Stuart Trow, credit strategist at the European Bank for Reconstruction and Development and trustee of the bank’s pension scheme, adds that broader structural trends have dampened price levels. “Inflation is supposed to be the indicator that the economy is getting out of whack, but, for whatever reason, I happen to believe it’s globalisation and technological advances. We have actually had quite a lot of supply side dampening on inflation since the mid-80s and that’s why it has been so difficult for central banks to get price levels up again,” he says.

Could the tide be turning?

Nevertheless, there is now a growing concern that a new trend could be emerging. While it is unclear whether the growth in money supply could feed through to higher inflation, the slowdown in global trade as a combination of Sino-US trade wars and the effects of the Covid lockdown could also push up price levels.

Trow argues that while it is hard to deduct longer-term trends from a one-off figure, the July inflation data could be a sign that the tide is turning. “It does show that there are pressures feeding through, particularly for the services sector where there isn’t any international competition. They might have no choice but to feed through rising costs because otherwise they’re gonna go out of business,” he warns.

Ribakova adds that a pick-up in commodity prices, those for oil in particular, could also affect headline inflation in the medium term, particularly given the extremely low oil price at the beginning of the year. However, she believes that this effect would only be temporary. “Central banks are likely to look through the first round effects of commodity prices as long as they don’t
spill over into other sectors and affect core inflation.”

Ribakova is also sceptical that a surge in demand due to faster than anticipated economic recovery could lead to a rise in price levels. “We see a surge in demand as an unlikely scenario as we are still seeing second waves of infections in many countries and no vaccine yet,” she says.

Trow is more wary about a long-term shift and argues that we may have reached peak globalisation. “The effects of international trade are not as readily available now and added to which we have a huge amount more cost in the system as well. I’m not expecting inflation to jump up straight away but the predisposition for prices to rise when growth resumes will be greater
now than it has ever been up until Trump came in and started slowing down global trade.”

Another reason why many investors have started fearing inflation is that a rise in price levels could be seen as politically desirable for central bankers, as states are having to tackle growing debt levels. While central bankers are yet to admit that the 2% inflation target pursued in the US, UK, Europe and Japan has become increasingly redundant, a rise in price levels would help states tackle their growing debt level as a result of the Covid crisis. Indeed, Fed chairman Jay Powell acknowledged in his latest Jackson Hole speech that inflation moderately exceeding the 2% threshold would be seen as a desirable trend.

RPI reform

But securing a portfolio against inflation risks is far from straight-faced. While the price of traditional inflation hedges such as gold has surged globally, for the UK in particular, index-linked gilts have traditionally been a weapon of choice for institutional investors in order to tackle changes in price levels.

But with only a quarter of gilts issued offering inflation hedges, 80% of whom are already owned by pension schemes, the market is heavily oversubscribed. And as defined benefit (DB) schemes are maturing and in turn increasing their fixed income exposure, demand for index-linked gilts is likely to increase. Indeed, the Pension Insurance Corporation estimated in 2014 that it could lead to a cumulative net shortage of index-linked gilts amounting to more than £500bn.

Enter the retail price inflation (RPI) reform, which is likely to complicate things further. By the end of last year, the then chancellor, Sajid Javid, announced plans to align the way RPI is measured with the more commonly used consumer price inflation plus housing (CPIH). This could have significant
effects for returns on index-linked gilts, which are so far linked to RPI. Because the current RPI formula slightly overstates inflation by about 1% compared to CPIH, the revised RPI formula would lead to lower investment returns from index linked gilts.

By changing the inflation measure, the government could save a tidy sum of money. The questions to be confirmed now is how it could affect outstanding government commitments and whether the reform should enter effect in five or 10 years’ time. If the reform is established in 2030, the value of outstanding linkers could drop by £90bn, introducing the reform in 2025, it could drop by up to £120bn, Insight Investment predicts.

While the initial announcement has led to a slowdown of demand for linkers, the delay of the consultation due to Covid and falling prices for index-linked gilts at the beginning of the year meant that demand increased, Evan Guppy explains.

“Over the past six months, quite a few investors have given up on waiting for the outcome of the consultation and quite a lot of pent up demand has been released into the market,” he says.

But Kevin Wesbroom, a professional trustee at Capital Cranfield, argues that the outcome of the consultation is too uncertain to drive demand. “Whether it makes sense to buy linkers now is slightly subtle. It depends on if the price you are paying today fully allows for the fact that the RPI will change.

If every scheme decided to go for index-linked bonds, there would simply not be enough out there to satisfy demand.

Kevin Wesbroom, Capital Cranfield

“So the interesting question is how the market is coming up with a view on what the government will get away with,” he adds. “My understanding from speaking to investment advisers is that about half of the change has been reflected.”

Opportunity costs

With the outlook on inflation remaining as uncertain as ever, Trow argues that opportunity costs of index linkers are a key factor to consider. His scheme pursues a barbell strategy, where a relatively higher equity exposure is offset with index linked gilts to match liabilities. But he is also acutely aware that an over-exposure to linkers could come at a price.

“If nothing happens the returns are extraordinarily low and the opportunity costs are worth considering,” he adds. “Lots of people tried to fight the equity market rebound after 2009 and it got to the point where the market recovered by so much that people who had been in cash or safe assets like linkers felt that it was too late in the game to chase the market. Yet the market did keep going on for another decade.”

Guppy highlights that while alternative inflation hedges, commodities in particular, might offer higher returns, make it much harder to tie them to the movement of inflation risks and liabilities. “If commodity prices fell sharply as a result of structural changes in demand but prices of other parts of the inflation basked might rise so a commodity strategy might not be perfectly matched to liabilities,” he says.

Wesbroom also cautions that the lack of supply in linkers means that it would be impossible to fully hedge inflation risks through linkers alone. “If every scheme decided to go for index-linked bonds, there would simply not be enough out there to satisfy demand. There are a few overseas funds that
you might be able to use but the inflation rate would obviously not be as closely tied to UK levels.”

While a precise match of liabilities through inflation-linked products was always a purely theoretical promise, the uncertainty of the inflation outlook and the returns on index-linked gilts are likely to make it a lot harder to achieve.

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