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Inflation: Look who’s back

9 Sep 2021

Inflation is set to be the dominant issue for investors, but also a complex and uncertain one. Andrew Holt investigates.

The scourge of many a modern economy is back. It had been assumed that inflation was out of fashion and had gone the same way as flares, but, like flares, inflation will never truly go away. Indeed, it looks set to be the main investment issue in the remainder of the year with its impact shaping the investment outlook for 2022, and possibly even for 2023.

High energy prices and a semiconductor shortage point to the cost of goods and services continuing to rise from their current multi-year highs. Indeed, US inflation measured by the Consumer Price Index (CPI) has climbed to 5.4%, its highest rate since the financial crisis of 2007/08, spooking many stocks in the process. This was followed by a 2.5% rise in the cost of goods and services sold in the UK, a three-year peak.

However, this dropped to 2% in July partly caused by prices rising sharply when the first lockdown ended around a year ago. This has left economists, who expect inflation to end the year at 4%, to dismiss the news as “the calm before the storm”.

Arguments about the severity of any inflationary impact centre on whether the rise is transitory or a long-term trend. The former suggests less to worry about, with the latter pointing to something more serious. The numbers point more to a temporary outlook as three months of rising inflation does not conclusively mean we have entered a new regime. At least, not yet.

This naturally poses problems for institutional investors. Transitory or trend? This is a question that many professionals struggle to answer. “We just don’t know, so we like to be prepared for a range of outcomes,” says James Brooke Turner, investment director at The Nuffield Foundation.

“For us,” he adds, “this means holding a portfolio of largely foreign assets without hedging and thinking about our equity and bond portfolios in terms of duration. We aim for a portfolio that is neither long, short nor value, but an orthogonal mix of styles.”

Ultimately, inflation presents a real danger for Brooke Turner. “For a closed fund like a charitable endowment, inflation represents a permanent loss of real capital, making it one of our key risks, probably the key risk,” he says. “In addition, since most of our spending is on salaries, our measure of inflation is not retail price index (RPI) or CPI, but earnings, which usually represents an additional cost. It is for this reason that only 10% of our fund is in bonds, all of which are in small, directly managed short-dated gilts.”

Inflationary outlook

In trying to unpick the inflationary maze further, Evan Guppy, head of liability driven investment (LDI) at the Pension Protection Fund (PPF), expects to see the UK and Eurozone follow the same inflationary pattern witnessed in the US. “The US has seen inflationary pressures sooner, largely because of their earlier path out of lockdown. Much of this can be attributed to sharp increases in the price of re-opening sensitive goods and services like hotels and airlines,” he says.

However, Guppy points to signs that price increases have reached the labour market and so it is fair to assume that the rise in inflation is not purely due to markets re-opening.

“We expect inflation to remain somewhat elevated throughout 2022 and 2023 as the impact of the very accommodative monetary and fiscal policy that we see across developed economies meets relatively constrained aggregate supply,” he adds. “While we expect inflation to remain elevated, the rate of increase will be less than what we expect to see this year.”

This has implications for the PPF. A significant proportion of the pensions lifeboat’s assets are sitting in its LDI portfolio. “The benefits we pay our members are linked to inflation, so when inflation goes up, the amount we need to pay our members increases,” Guppy says. And this is where the LDI strategy comes in. “It protects us against these outcomes by allowing us to invest in a mixture of inflation-linked government bonds and derivatives.”

Without the LDI strategy, a sustained increase in inflation would have a material detrimental impact on the PPF’s reserves. “The linkages between the remainder of our investments and inflation are less explicit but still important, nonetheless,” Guppy says.

“The impact of inflation on our portfolio might also depend on the type of inflation we are experiencing at the time,” he adds. “If it coincides with a period of above-trend growth, then this is more likely to be a ‘good’ outcome for a typical portfolio allocation because the stronger nominal growth should be sufficient to offset higher inflation and deliver positive real returns.”

However, in a stagflation scenario, where inflation is elevated but growth is likely to be more painful, invested assets may be impacted by squeezed profit margins and a higher rate of insolvencies.

While we expect inflation to remain elevated, the rate of increase will be less than what we expect to see this year.

Evan Guppy, Pension Protection Fund

The big three

Guppy, therefore, sets out a three-pronged approach beneficial to pension funds in the inflationary environment. “While approaches to addressing changes in inflation vary between funds, there are key steps which will likely be similar across the board,” he says.

Firstly, it’s critical for pension funds to understand what sensitivity they might have to a sustained period of elevated inflation in the good inflation and stagflation scenarios.

It’s also important for funds to recognise that these sensitivities will come across different asset classes where they might not immediately be expected. “For example, schemes might allocate assets to different equity sectors and locales which might result in a bias towards higher inflation and/or higher interest rates,” Guppy says.

Secondly, funds should decide whether this sensitivity is a bet that they want to have in their portfolio. They also need to decide on how big they want that bet to be. For example, what is a fund’s appetite for its portfolio to be protected or even benefit from a period of elevated inflation? How will the fund position its portfolio to improve its outcome if investors believe that inflation is transitory?

Finally, schemes need to decide how they want to position their portfolio and which scenarios they will mitigate against. “However, these decisions, whether they are buying inflation-linked government bonds, increasing allocations to commodities or rotating equities to inflation-sensitive sectors, will become clear. The right answer will depend on your views and the start- ing point for your portfolio,” Guppy says.

Key risk

For Henrietta Gourlay, investment manager at the Grosvenor Estate Family Office, inflation is a real concern. “Over long periods of history, inflation has always been a key risk to people’s wealth, and so yes, this is something that has concerned me for a while,” she says.

And she has an interesting perspective on the history that led us to the current environment. “The fact is that the West has been importing deflation since 2001 when China was admitted into the World Trade Organisation, and suddenly the world had access to Chinese labour – and hence goods – at a fraction of the ‘Western’ price.”

As a result, Gourlay says, the prices of manufactured goods compress and these have then stayed lower than they might have in the wake of the global financial crisis. “Despite plenty of global quantitative easing post crisis, we have not seen much sign of inflation globally. What we have seen is inflation in fixed assets – property prices, for example – but not in the bas- ket of goods by which RPI is assessed, and so central banks have had no incentive to raise rates.”

Currently global interest rates are at an historic low, so there has never been a better time to borrow money. “Concern over an increase in rates from next year onwards means that companies should, in theory, be scrabbling to lock in financing for future projects now, and if they do, they will be flush with cash,” Gourlay says.

“We are though,” she adds, “seeing signs of shortages of supply of some materials, creating supply-induced inflation which was always going to be inevitable when parts of the global economy have been shut down since late January 2020. There are bottlenecks in production which have resulted in a mushroom- ing in demand created by all this monetary and fiscal support and consumers getting out and spending.”

This phenomenon may be short lived though, as the imbalance will be corrected once prices reach a point where they are too high to be sustainable, and when the capital raised under this ultra-low rate environment has been spent.

“Access to capital is important here though,” Gourlay says, “as it is important that the global markets continue to allow capital to flow into areas of demand. For example, there is super-high demand for materials needed to electrify the world: copper and lithium – but the mining industry is under scrutiny from an environmental perspective. This makes it harder for them to access the capital markets.”

Despite plenty of global quantitative easing post crisis, we have not seen much sign of inflation globally.

Henrietta Gourlay, Grosvenor Estate Family Office

Ironic infrastructure

Gourlay see a certain irony in investors seeing infrastructure as a good inflation hedge. “Obviously, infrastructure is important, but it is feeding the fire in the short term,” she says. “We are seeing signs of that in timber and concrete shortages, which will ultimately lead to price increases in these products.”

Addressing what this means for Grosvenor Estate’s portfolio, Gourlay says: “Our portfolio is already well diversified across asset classes. The biggest risk is that inflation exceeds the over- all return on our portfolio, creating a negative real rate of return.”

Looking at the inflationary scenario impact on his portfolio, Brooke Turner says: “The impact on the portfolio is less of a consideration than the impact on our grant-making budgets if we want to maintain them in real terms. Of course, we can just give away less money, but in the present climate we are trying to spend more because the issues are now so pressing.”

In the short term, the portfolio has held-up well, says Brooke Turner, with previously under-performing value managers compensating for any gains conceded by growth managers. “As the pound has begun to weaken, US dollar holdings have offset any declines,” he adds.

Hedging investments

Should investors look to hedge their portfolio to deal with the inflationary threat? Not surprisingly, given their name, hedge fund investments are something asset owners are turning to in dealing with inflation.

A third of investors are planning to increase their investments in hedge funds over the latter half of the year, according to a report from HFM in partnership with the Alternative Investment Managers Association (AIMA).

Leading the investor pack in making this move are family offices. They are the most proactive in increasing their alloca- tions to hedge funds, favouring them over other alternative assets, apart from private equity, notes AIMA. “They have greater appetite than some of the institutional investors,” says Tom Kehoe, AIMA’s managing director and global head of research.

“Private wealth can be a little nimbler than their larger institutional investor peers – the state pension plan for example – and they have been best positioned to take advantage of various dislocations in the market via hedge fund and other alternative investments enjoying shorter lead times for investing,” he adds.

Global macro funds are expected to be the biggest beneficiaries, with the largest predicted inflows for the latter half of the year. Long-short and multi-strategy funds were also shown to benefit due to their versatility in a post-pandemic environment.

“Investors recognise the appeal of hedge funds to help protect their portfolio against inflation,” Kehoe adds. “The hedge fund universe is populated by many different investment styles and strategies each with their own risk and return characteristics.”

And these strategies, according to Kehoe, are generally not confined to any one side of the market, which means they are often able to outperform in various market conditions. “Hedge funds and other alternative investment strategies – like private credit – have historically performed well in low interest-inflationary environments.” Hence the applicability to today’s environment.

In reference to this, Kehoe adds: “Taking today’s situation regarding inflation concerns, investors can allocate to global macro, multi-strategy or fixed income strategies to name just a few hedge fund strategies which investors can call on to help navigate the situation.”

Long and shirt of it

A macro hedge fund manager can hold long and short positions in various equity, fixed income, currency, interest rate and commodity derivatives. As such they can be long commodities, gold and other precious metals – all of which have been proved to be a good inflation hedge.

“Staying with more illiquid markets, if and when inflation levels increase, private credit, with its combination of higher start- ing yields and shorter maturities, will likely fare better than many traditional fixed income instruments,” Kehoe says.

As someone who uses hedge funds, Gourlay, adds: “We already have an allocation to hedge funds, but not specifically to mitigate the risk of inflation. We divide our allocation into growth hedge funds and diversifiers: the idea being that growth funds should produce more directional returns, and diversifiers should protect on the downside while still giving upside exposure.

“Obviously with interest rates so low, real returns in fixed income will be under threat unless the fund manager is doing something clever with derivatives or investing in riskier bonds,” she adds. “Presumably, this is why some family offices are looking at hedge funds as a diversifier in place of bonds.”

She does, however, issue a warning. “Many hedge funds performed well, protecting on the downside, during the Covid sell off, but the performance of hedge funds as an asset class has been somewhat disappointing over the last few years after fees. “There are some superstars, but these funds are mostly closed now, and plenty of others have had very mediocre performance coupled with high investor fees,” she adds.

Ultimately, the inflationary environment, whichever way it evolves, will present institutional investors with challenges. And, it should also be noted, the current environment is also part of a wider, on-going trend. “In the longer term, it is important to recognise that we are going through a digital revolution and when people have full transparency on pricing – which is what technology enables – you may end up with perfect competition,” Gourlay says. “As a result, companies will be incentivised to increase productivity and efficiency to drive down their marginal cost of production, and this means that consumers will ultimately benefit from lower prices.”

Tackling the inflation threat: Inflation-indexed fixed income and TIPS

Due to the uncertain inflationary environment and in an attempt to prevent losses in their assets, a chunk of institutional investors are adding inflation-indexed bonds into their portfolios. Global investors steered $2.6bn (£1.8bn) into global inflation-indexed fixed-income strategies in the first half of 2021, reversing the outflow trend which saw $13.8bn (£10bn) leave the asset class in 2020, according to eVestment.

The institutional assets under management for global inflation indexed fixed income now stand at $51bn (£37bn) compared to $1.1bn (£800m) in inflation indexed Europe fixed income. According to one survey, institutional investors have less than 30% of their fixed income portfolio allocated to index strategies, but this could change as the survey found that 66% of global investors intend to prioritise the use of indexing.

Although the picture is not clear cut. Not all investors see adding inflation-indexed bonds as the most efficient way to shield against longer-term inflation risk. Sovereign wealth funds took $6.7bn (£4.8bn) out of global inflation-indexed fixed-income in 2019 and 2020 with public funds reducing their exposure by $9.6bn (£6.9bn).

One of the worries could be that out-of-control inflation may lead central banks to increase interest rates, which in turn could cause yields to increase and bond prices to fall.

But it is in Treasury Inflation Protected Securities (TIPS) – US government paper that are indexed to inflation – that steps are being taken by institutional investors to tackle inflation the most.

Corporates are enamoured with Passive TIPS/inflation fixed income, putting $7.5bn (£5.4bn) into the universe through 2019, 2020 and the first half of 2021 bringing the value of this universe to $107bn (£77.7bn).

Although for overall assets under management, US TIPS/inflation fixed income trumps it, totaling $133bn (£96.6bn), creating a substantial and important investment universe to address the inflationary threat.

Tom Kehoe, managing director and global head of research at the Alternative Investment Management Association, says, “Investing in TIPS is a good strategy for protecting an investment portfolio against inflation.”

Institutional investors faith in TIPS has proven to be well placed. They have generated returns, including interest payments, of 3.9% thus far in 2021, according to a Barclays index which tracks the TIPS market.

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