Rising inflation looks to be a dead cert, but what form will it take and do schemes need to start thinking about hedging?
Inflation in the UK is all but guaranteed to go up in the short term, putting pressure on institutional investors trying to manage liabilities, especially where they are already cashflow negative. Over the longer term, the inflationary outlook is far from clear, however. The path to Brexit remains uncertain, but could prove decisive.
Institutions will face a tough decision on whether to hedge inflation risk despite significantly higher costs, or look through the short-term pain in the hope of lower inflation in the long term. Whichever way that goes, interest rates are unlikely to bring much relief in the short to medium term.
Inflation expectations appeared to take a sharp upward trajectory last summer as Britain surprisingly voted to leave the European Union. Recent months have seen a significant increase in the cost of inflation protection as implied by the differential between nominal and inflation-linked gilts. More demand for inflation-linked bonds means a greater premium on those assets, which has driven the differential out roughly 0.5% over the last few months. Investors choosing to hedge at today’s levels would be paying that extra differential annually for decades, which would have a massive compounding effect.
According to Jignesh Sheth, head of strategy, investment consulting at JLT Employee Benefits: “If inflation doesn’t go up, pension funds may be better off not paying that [additional cost].”
To a large degree, the price of inflation also gives a misleading projection of where long-term inflation expectations are.
Tapan Datta, head of asset allocation at Aon Hewitt, says: “Market inflation pricing has rocketed up in the last few months, which can be misleading as it suggests inflation expectations have done the same, but that’s not the case.” Datta and other experts point to a considerable supply/demand imbalance in the inflation-linked gilt market as well as differences in underlying liquidity and relatively low issuance that give rise to what Datta says is a “very distorted” picture of the way inflation expectations have risen. “They have gone up a bit,” he says, “but over 20 to 30 years it is unlikely a substantial rise will be sustained.”
SHORT-TERM INFLATION DRIVERS
In the short term, at least, inflation is “guaranteed to increase”, says Olivier Lebleu, head of international business at Old Mutual Asset Management (OMAM). “The question,” he says, “is what nature that inflation takes.”
The Consumer Prices Index (CPI) surprised on the upside by increasing to 2.3% in the 12 months to February, having hit a two-year high of 1.8% in January. This exceeded expectations in a quarterly survey by Barclays released in November which showed projections for inflation over the next year rose to 2.2%, up from 1.7% in the previous survey three months earlier. Looking out further, the survey showed inflation expectations one to two years ahead rose to 2.7%, up from 2% three months prior and the highest level since mid-2014. Five-year expectations rose 0.7 percentage points to 3.7%.
Much of the changing inflation outlook is based on relative currency moves. Over the last year, sterling has fallen 20%, fuelled mainly by the Brexit vote, after which the pound fell 15% against the dollar. That has given rise to the so-called ‘Marmite Effect’ of pushing up producer input prices given the translation effect of currency moves.
According to John Dewey, head of investment strategy at Aviva Investors Global Investment Solutions: “Producers are trying to raise prices as a result. While it’s not clear how much can be passed on, there will be some direct pass through which will push up consumer prices.”
