Several leading banks and institutions have more pessimistic estimates than the OBR including Barclays Capital at just over -1%, the European Commission at just under -1%, Nomura at -0.5% and Fathom Consulting, who believe the UK economy is already running at 1.5%.
“While there probably is a bit of space capacity,” Hill says, “there is less than many anticipate. That creates a major threat of slower economic recovery and a higher inflation per rate of change of output.”
PAINFUL EXPECTATIONS
If inflation were to rise faster as a result of a lack of space capacity, market inflation expectations would revise upwards. This creates a problem for pension funds because even small changes in expected inflation are compounded for investors with long-term liabilities.
“The main thing any large institutional investor is concerned about is a jump in expected inflation as that erodes real return,” according to JPMAM’s Dryden.
“Yields are still stuck at record lows, but institutions can’t just switch out of fixed income due to their constrained mandates.”
Historically, pension funds have mainly relied on the natural balancing effect of higher interest rates to resolve the problems created for schemes funding by a rise in expected inflation.
“Yields may not rise,” Hill warns, “so the benefits to pension funds will not be very great.”
With the Bank of England doggedly determined to avoid deflationary risk at home and abroad, those interest rate rises could not only be slower to materialise, they could also prove less medicinal than many are expecting.
SLOW SOLUTIONS
JPMAM’s Dryden says: “We know interest rate rises are coming, but it is a mug’s game trying to predict when. When they do go up it will take time for the impact to trickle through. It won’t have an instant impact on inflation as it can take up to 18 months for a rise to be felt in the real economy.
There is a case for the Bank of England to get moving with rate rises to anticipate higher inflation 18 months down the line from now.”
The Bank of England (BoE) appears to be guiding markets towards the first rate rise at the end of this year, but the deal is far from done. The BoE has already lost some degree of market faith in its guidance after providing conflicting messages to the market.
Although it initially suggested unemployment hitting 7% would be a trigger point for rate rises, that has been met and surpassed. Unemployment was running at 6.5% in July. and Governor Mark Carney is already emphasising his concerns over the slow pace of wage inflation and the role that factor will play in future interest rate decisions.
Despite Carney’s recent guidance, the strong pound, risks of eurozone deflation and the dampening effect of the BoE’s warnings alone on households and companies should reign in borrowing, Spencer believes.
“Assuming that wage rises remain subdued, all these factors should help to keep interest rates on hold until the first quarter of 2015.”
INFLATION SOLUTIONS
The later the rise, the higher inflation will be once the effect has trickled through.
Furthermore, if future inflation is rooted in a capacity shortfall (rather than the quantitative easing many market participants believe), the problem is more endemic and harder to solve.
“The tools usually open to the Bank of England are virtually useless for solving inflation caused by supply-side constraints in the economy,” Hill argues. “The Government is left with structural reform, which is why they are putting a lot of emphasis on areas like transport and energy generation infrastructure investment, but they are not making as much progress as they had hoped.”
The average UK pension scheme is, however, under-hedged for inflation. As David Dyer, senior portfolio manager for the AXA Sterling Index Linked Bond fund says: “Pension funds are generally under-exposed to inflation because of the lack of supply of inflation linked assets leaving them exposed to the risk of increasing inflation.”
Furthermore, many institutions continue to lock-in to today’s low interest rates as the trend towards de-risking gathers pace. This potentially extends the period during which low real yields present a risk to funding ratios and investment returns.
Wouter Sturkenboom, EMEA investment strategist at Russell Investments, warns:
“Liability matching portfolios will be locking in low rates today. Over a five to 10 year horizon, we have got to expect rates to normalise to around 4%. Those that lock-in low rates today in liability-matching portfolios will see disappointing returns.”
Higher inflation and low interest rates will combine to keep real yields down for longer than many investors are expecting, especially if the inflation stems from capacity shortfall resulting from flatlined productivity growth. Continued low real yields could fail to offset rises in long-term inflation expectations, which would create a snowball effect on scheme liabilities and investment returns.
“Institutions are facing negative real returns for longer than they think,” JPMAM’s Dryden concludes.
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