June 2011

INFLATION PROTECTION: ‘If you see clouds forming, you need to raise the umbrella’

Umbrella-stormsOverheating emerging market economies are exporting inflation to the rest of the world. But as investors’ inflation expectations rise, so does the cost of protection, finds George Mitton
Two years ago in Venezuela a can of condensed milk cost about four bolivars (€0.6). Today it costs 18. A pack of razor blade cartridges has almost quadrupled in price. According to Jesus Enrique, a sociologist and English teacher from Maracaibo in the country’s north-west corner, both the poor and the middle class “struggle to make ends meet and it’s even more difficult when you don’t have a job”. Venezuela has an acute case of a malady that afflicts nearly all emerging markets: inflation. At nearly 30% last year, Venezuela’s rate was the world’s highest in 2010, according to the International Monetary Fund (IMF). But this problem does not only affect Venezuelans. Inflation is contagious. Fast-rising prices in emerging markets are increasingly filtering through to the United States and Europe, and are a major threat to asset managers. As Jim Stride, director of Axa Investment Managers UK, puts it: “Inflation is the number one enemy of fixed-interest investors.” Institutional investors at least seem to recognise the problem. The consultancy, Mercer, says 80% of European pension funds are more concerned with inflation than they were last year. William De Vijlder, chief investment officer, strategy and partners, at BNP Paribas Investment Partners, has also noticed this trend: “When I’m speaking to clients and I ask them, ‘What keeps you awake at night?’ and a subject that always comes back is inflation.” The Mercer survey says a quarter of European funds are buying instruments to protect their portfolios. But De Vijlder stresses that the appropriate protection will depend on the kind of inflationary environment. If inflation is caused by demand outpacing supply, equities will tend to do well. Reallocating some fixed-income spending to equities would be advisable. But many commentators think factors beyond consumption are at play, for instance, the effects of quantitative easing policies in the UK and US. These are linked to the budget deficits, and some say it is these deficits that are driving inflation in developed countries. The worst-case scenario is that the current environment is one of stagflation, which occurs when inflation coincides with poor economic growth. “If it’s a stagflation shock, your equities will go down the drain,” explains De Vijlder. Worryingly, a report produced by the IMF in 2009 claims that since 1973 most inflation shocks have been stagflationary. To prepare for the worst scenarios investors ought to look beyond equities to instruments such as index-linked bonds. However, a lot has changed in the past few years. Inflation expectations have got priced into financial markets and the cost of many of these instruments has risen. “The days of cheap inflation insurance have passed,” says Thomas Becket, chief investment officer at PSigma Investment Management. “Real yields on index-linked bonds have fallen. Inflation break-even rates are not on the side of investors.” This is troubling because index-linked bonds have traditionally been a key tool for inflation-proofing, particularly bonds tied to a measure of inflation such as the consumer price index (CPI). Becket says real yields on these bonds – the return adjusted for the effect of inflation – are now “prohibitively low”. Having peaked at 4.5% in the last three years, inflation-linked bonds are currently offering returns of about 3.4% on a 20-year maturity. This is hardly reassuring to investors, particularly in the UK where inflation was at its highest point in two years in April and the Bank of England, in its inflation report, admits there is a “good chance” that the CPI inflation rate will hit 5% later this year. The retail price index (RPI), which includes housing and mortgage costs, is even higher. Inflation-linked bonds have also proved to be more volatile than other bonds since the financial crisis as they fluctuate in line with the market’s inflation expectations. Faced with these challenges, many investors are seeking alternative inflation-proofing strategies. One potential hedge is real estate. Long leases on commercial property and promising revenue patterns are appealing to investors. And in the UK market, for instance, commodity inflation is pushing up construction costs, driving up real estate values. As Marcus Sperber, head of BlackRock’s international real estate business, explains: “Real estate can provide something that other assets can’t at the moment.” Real estate is not a foolproof hedge, though. A 1991 study by Wurtzebach, Mueller and Machi claims that if more than about 10% of commercial properties are vacant, it becomes impossible to raise rents to combat inflation, and the assets no longer work as an inflation hedge. Another way to deal with inflation could be with tactical investing. Matthew J Eagan is portfolio manager at US firm Loomis Sayles, which recently launched an absolute return bond fund that employs long/short strategies. He says funds which employ short selling can deal with potentially costly inflationary environments in a way conventional long-only funds cannot. He believes tactics such as short selling will become increasingly important for coping with tough environments. “If you see clouds forming, you at least need to be able to raise the umbrella,” he says. Another strategy is selective equity investing determined by stock picking. Demand for essential services such as energy, food and healthcare is often resistant to rising prices. This is because consumers have no other choice but to buy these goods. Stock-picking strategies can become more powerful if investors identify those companies with pricing power; that is, firms with a dominant market position that can pass on increases in supply costs to their customers, and maintain profit levels. Investors interested in this strategy should investigate the Herfindahl-Hirschman Index, which is a measure of industry competition used by the US Department of Justice to enforce antitrust law. Of course, none of these tactics is as simple as transferring the inflation risk to another party through an inflation swap. This is a strategy employed by many pension funds as a quick and convenient way to inflation-proof their portfolios. The problem is swaps are so popular their rates are being kept low, often no better than inflation-linked bonds and, in some cases, worse. Finally, there is the traditional route of investing in commodities such as oil and gold. However, many worry whether this is appropriate given that these goods have increased greatly in price in recent years. The question of which strategy to choose will depend on individual investors and their risk appetite. For some, the stakes are very high. Pension funds are preoccupied with inflation because the amount they are expected to pay out is inflation-linked. Treeve Coomber, a senior investment consultant at US company Towers Watson, advises his pension fund clients to hedge some of their liabilities by buying inflation-linked bonds. Unlike some analysts, he does not consider them overpriced and notes that although the current inflation rate is above 3.4%, it could well come down again in the next 20 years. “Currently, we think the price of inflation-linked bonds is fair,” he says. “We’re suggesting to our clients that if they’ve got inflation risks and they’ve got the capital to buy these bonds, they should.” Within this asset class, investors may find value in subsets such as corporate-linked index bonds. Another related and promising asset class is floating-rate bonds. What is certain is that investors should prepare for continued rising prices, at least if the actions of the Bank of England (BoE) are anything to go by. Some say it is failing in its remit by not controlling inflation, but there may be tactical reasons for its soft approach: fear of deflation. Though the BoE does not like high inflation, it does at least have the tools to deal with it, namely raising interest rates. It does not have the tools to cope with falling prices. Paul Mueller, fund manager of Invesco’s Euro Inflation-Linked Bond Fund, says that for this reason “governments will always be more tolerant of inflation than they will be of deflation”. The European Central Bank has been more determined in its efforts to keep inflation to 2%. However, European inflation did climb to 2.8% in April. Much of Europe’s inflation is imported from the fast-growing economies of the developing world. Though the continent has mainly avoided spiralling food prices, which acted as a catalyst for this spring’s unrest in North Africa, it has faced rising energy costs. The effects of these price rises are less severe than in Venezuela, where shoppers find that everyday groceries can double in price in a year. However, the threat to investors’ portfolios is great, and unless managers put money into appropriate inflation protection, the costs will be all too real. ©2011 funds europe

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