Investment Adviser - Managing and profiting from inflation risk
26 February 2010
The extraordinary economic and market events of the last few years have called into serious question many accepted truths. The developed economies have emerged from a prolonged period of remarkable stability and growth, with low inflation and interest rates. Following on from the deepest recession since the 1930s, central bankers started to believe that the inflation dragon was slain for good. Now however, the outlook is far less certain. The sharpest economic downturn since the Great Depression has been met with the biggest package of global economic stimulus ever. The effects of this are still unclear, and will be so for a long time yet. The outlook for economies and markets is thus far less certain than we have been used to. Where we had been accustomed to debates over moves of a quarter percent in interest rates, we now discuss in which direction policy should head as a whole, and there is much disagreement over it. Policy is now very broad brush, not fine tuned.
There is reasonable consensus that cyclical inflation pressures are very muted at present, with high unemployment and spare capacity in the economy to absorb the growth impulse. In the UK though, unemployment has risen a good deal less than many expected, and inflation has continually surprised on the up side, which might suggest that more capacity has actually been lost, rather than being spare.
The current UK inflation spike is, as Bank of England Governor, Mervyn King frequently insists, largely down to base effects and the return of 17.5% VAT. But UK inflation has beaten market consensus in 16 of the last 22 months, and consistently been higher than the Bank of England’s forecasts. In particular the effects of the fall in sterling were particularly poorly estimated. While most expect the year on year inflation rate to fall sharply through this year, its “stickiness” makes some nervous.
So how should investors manage the uncertainty over the economic outlook and inflation in particular? We have to consider the cost of risk insurance of various types, and one of these is clearly inflation risk. In times of uncertainty such as this we should expect it to be more expensive to protect ourselves against inflation risk than when the outlook is clear, just like someone who living in an insalubrious area would have to pay more to insure their car than someone from a more exclusive area.
Unfortunately the inflation risk premium is an elusive beast which many an academic has tried, and failed, to isolate. We therefore have to use a proxy. One of these is the slope of the inflation swap curve, and if we look at both US and European markets, one has to pay barely more to protect against inflation for 20 years than to insure for 10 years, so the risk premium is at the low end of the range, which seems counter-intuitive.
Classically as an economy emerges from a recession, portfolios should be heavy in real assets - ones that offer protection against inflation eating into the returns - such as commodities, equities, property and inflation linked bonds, as opposed to financial assets like nominal bonds.
Our chart shows the total return histories for the last decade for all of these asset classes, using gold for commodities (a traditional inflation “hedge”), the FTSE 100, the UK IPD property index, global inflation linked bonds (sterling hedged) and the UK Retail Prices Index (RPI) as our inflation reference. We have used global inflation linked bonds because the UK market has for many years been an expensive market, distorted by an imbalance of government supply and demand from pension funds.
We can see that over this period gold has produced the best real returns, with inflation linked bonds and property some way behind, and equities lagging inflation, delivering negative real returns. Plainly one can argue over the period used, and some will argue that we should look at an even longer term for returns, but for many, the long term may just be too long.
What is important here though is not the overall total returns, but the volatility of returns. Many investors talk of gold as an inflation, “hedge”, but we would argue that a hedge should be of similar volatility to the variable being hedged. Gold is far more volatile, and so a poor hedge.
If an investor simply wants to hedge inflation, then he should use the asset specifically designed for the purpose, which is inflation-linked bonds. More risk hungry investors vary their mix of real assets which increases the risk level, but may mean these investors make low or negative real returns for long periods if their judgment, or luck, is poor.
It is therefore simple to argue that a portfolio of real assets, like any portfolio, should be as diverse as possible, and the level of risk in the portfolio should be in an equivalent place on the risk continuum to the risk tolerance of the investor. It can be shown that global inflation linked bonds reduce this risk level, increasing the diversification of the portfolio.
The chosen mix of real assets will also of course be affected by the type of inflation which is then experienced. If the economy grows well, and earnings rise and margins build, this generates “good” inflation, which will help riskier assets to perform well, while real yields on bonds rise. If however the inflation is generated by inefficiencies in the economy or by cost pressure such as commodity price rises, then equities and their ilk will suffer as margins are squeezed. In this environment inflation linked bonds will perform well along with commodities.
The current outlook is highly uncertain, and it is a fairly simple task to construct a view that encapsulates both of these scenarios. Growth and good inflation can be foreseen as the stimulus packages take full effect and slack in the economy is taken up. However the growth of the commodity-hungry developing economies could push up price pressures without growth in the developed world, leading to a much less palatable scenario. Of course, the outturn is likely to be somewhere between the two.
So we can see that investors need to take account of inflation risks in their portfolio construction, and set their risk levels in line with their tolerance. The chosen mix of real assets will be determined by this.
Jonathan Gibbs, Manager of Global Index-Linked Bond Fund, Standard Life Investments
This article was first published in Investment Adviser on Monday 8th March 2010.
