The wrong type of inflation?

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4 Jan 2017

Rising inflation looks to be a dead cert, but what form will it take and do schemes need to start thinking about hedging? Emma Cusworth investigates.

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Rising inflation looks to be a dead cert, but what form will it take and do schemes need to start thinking about hedging? Emma Cusworth investigates.

However, although Europe is the UK’s main trading partner today, the region is not likely to see much growth itself in the coming years.

“It may be better [ for the UK] to tilt towards faster growing economies,” OMAM’s Lebleu says. He believes the question of a hard or soft Brexit is irrelevant. “There is only one kind of Brexit,” he adds. “That is to leave the EU institution and become an external trading partner. That is not necessarily a bad thing in the long term, but I’m not sure the economy is up for the transaction costs [of changing the trade regime] in the short term. The transaction costs will be higher than people currently think.”

He points to rent-seeking segments of the economy – car manufacturers, farmers and finance to name a few – where the costs of moving to a new trading regime will be higher than the aggregate cost of EU membership today.

“This weighs on growth and will likely lead to the wrong kind of inflation,” Lebleu says. There is currently no clear view on how Britain will navigate its exit from the EU, or what that will mean for the future of the British Union. It may be some time yet before we know exactly what kind of inflation UK investors are going to be dealing with. This isn’t likely to be clear until the back end of 2017 at least.

TO HEDGE OR NOT TO HEDGE?

The prospect of a sustained period of inflation and the pressure that places on cashflows if rates stay low creates a dilemma for institutions. On the other hand, what if inflation does indeed settle back to lower levels further down the road? Global structural trends – demographics, automation, globalisation – all point further towards lower inflation in the longer term.

Aon Hewitt’s Datta says the prices of direct inflation hedging in the UK look “too high to put on hedges”. “They have already risen by quite an amount and there is arguably more to come,” he says. “Investors are faced with a difficult choice of whether or not to hold out for better prices.”

However, there is still significant concern that inflation risk could be higher in the future. Given that risk, schemes may still be happy to pay for hedging despite it being more expensive in order to take some risk off the table.

JLT’s Sheth says funds should take a “phased approach” and look for opportunities to hedge that are not just limited to direct sources of inflation hedging such as gilts. “The probability of a period of sustained high inflation has increased,” he says. “That has driven up the cost of inflation protection, but it may still be worth protecting against.”

He points to alternative inflation protection options including infrastructure, property and even equities for those who can stomach the volatility. “These asset classes have a looser link to inflation, but offer better prospects for growth than government bonds,” he argues.

Pension schemes can also look to their sponsors to share the spoils of the weaker currency to reduce deficits. “If companies are enjoying the windfall effects of a weaker pound, then their capacity to pay more in is higher,” Datta says.

“It is reasonable for pension schemes to look for that, but companies may feel they have already done so,” he continues. “It comes back to hedging – if there is adequate hedging in place, then the sponsor doesn’t have to worry as much.”

Aviva’s Dewey believes investors should seek to hedge inflation risk in the most cost efficient way possible and in the battle to do so, being nimble is key. “Over the last year there have been a couple of instances where investors could have put hedges on at around half a percent less,” he says. “Those opportunities do exist, but you have to have a plan and be ready to exploit them when they arise.”

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