Recent spikes in inflation have led consultants to advise schemes against buying overpriced hedges and urging them to stay underhedged over the next three years, while looking elsewhere for inflation-linked returns.
US inflation jumped to 5 per cent for the 12 months ending May 2021, while UK inflation rose to 2.1 per cent, according to figures released by the Bureau of Labor Statistics, a unit of the US labour department, and the UK’s Office for National Statistics.
Investment consultants say the recent rise in inflation is a consequence of the global pandemic.
“Many global supply chains were mothballed in response to the pandemic,” says Tapan Datta, head of asset allocation at Aon.
As inflation hedging is so expensive, investing in real assets could help to hedge this risk even if it isn’t a direct match
Rupert Watson, Mercer
With rapid reopenings causing a sharp spike in demand, most supply chains have struggled to ramp up fast enough, he says.
Datta points out that while much of the spike in inflation has been driven by material and producer prices, shipping and freight costs have increased as much as three to four times because these services have also been constrained.
US economic policy has turbocharged this trend. “The $3tn (£2.2bn) Biden stimulus added fuel to the fire from March onwards, and is likely to continue to cause inflation to spike for the next few months,” Datta says.
Change in attitude
A more detailed analysis of the inflation data shows price hikes have been driven by specific factors such as a shortage of semiconductors, which caused a lack of supply of new cars. As a result, demand has driven the price of used cars higher as people avoid public transport.
But these mismatches between supply and demand are likely to reduce as manufacturing capacity increases. “This is not a generalised increase in prices,” Datta says.
Not all agree, however, that this is a temporary blip. Some say inflationary pressures are likely to persist over the longer term.
Rupert Watson, head of asset allocation at Mercer, says: “We’re already seeing the re-emergence of strong economic growth after the pandemic and that is likely to persist, pushing up demand.”
Global consumers are in a strong position with debt servicing costs at multi-decade lows, so interest rate costs will be lower and drive long-term demand for goods.
“In addition, investment is going to be strong both from businesses and government, which will drive longer-term supply and demand,” he notes.
That is partly being driven by the transition away from a carbon-based economy towards a greener one, which will require heavy expenditure, Watson adds.
Perhaps most important is the shift in government attitudes towards debt. Watson argues there has been “a complete change in attitude” and an acceptance that the best way out of an economic crisis is to invest.
Prepare for inflation scenarios
Even if pension schemes think these inflationary pressures are likely to persist, the action they need to take is not clear cut.
Datta explains that “UK inflation hedging costs are now very expensive, but that is driven by a deliberate Treasury policy to issue fewer inflation-linked bonds”.
The strength of equity markets has driven a boom in funding levels for pension schemes, with many trying to lock in those gains by reducing their interest and inflation risks, which has become harder to achieve.
The strength of this demand has pushed the cost of inflation hedging so high that for the next three years Datta recommends schemes consider staying slightly underhedged.
Pension schemes could compensate for the lack of hedging with returns from real assets. “In addition, we expect the cost of inflation hedging to reduce over this time as issuance of inflation-linked gilts starts to pick up,” he notes.
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Watson emphasises it is not clear that inflationary pressures will build over the longer term, but there is now a wider range of possible inflationary scenarios than there has been for many years.
Pension schemes need to ensure their portfolios can withstand different scenarios. “As inflation hedging is so expensive, investing in real assets could help to hedge this risk even if it isn’t a direct match,” Watson says.
“If inflation does increase over time, it will be important for trustees to assess the impact on the sponsoring companies [as] some firms are more susceptible to rises in inflation than others,” he adds.
This article originally appeared on MandateWire.com
