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Hedging Inflation Risks in 2022

4 Mins read

Although inflation expectations are falling, many investors are concerned about the high inflation and the interest rate hikes. Traditionally, pension funds are vulnerable to inflation, depending on the nature of their liabilities. Their long-term investment portfolios are also exposed. Moreover, in the USA and Europe, it is often still an ambition to adjust employee pension benefits for inflation, although in most cases this has not happened for many years. Yoram Lustig, head of multi-asset solutions, EMEA & Latam, and Michael Walsh, solutions strategist at T. Rowe Price, discuss the causes of inflation and ways to mitigate its impact: “Our preference – depending on investor circumstances – is a combination of various inflation-sensitive liquid assets in portfolios.”

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What is driving inflation, in the short and long term?

Lustig and Walsh believe that three major short-term cyclical forces are driving inflation to current high levels: one on the demand side, the second one on the supply side, and the third one on the financial side. In the short term, they can significantly affect the performance of the stock and bond markets.

In the long run, inflation is driven by the following factors:

·  Technology. Technological disruption and innovation have a deflationary effect.

·  Aging. The aging of the population is deflationary because it leads to a slowdown in growth and shifts in consumption and behaviour.

·  Globalization. While globalization has been a deflationary force in recent decades, adapting the proven vulnerability of global supply chains could reduce the deflationary impact and even turn it into inflationary.

·  Energy transition. A new inflationary force that is likely to accelerate soon is the energy transition that counteracts climate change.

While inflation is likely to remain high next year due to cyclical factors, it is likely to decline as they decline. The market seems to agree with this view. Yields on US 10-year Treasuries have risen slightly in response to inflation. However, it remains exceptionally low, suggesting that the bond market still believes the high inflation is temporary. In the longer term, investors should, among other things, keep an eye on the dynamics of structural forces.

Current events should remind investors to ensure their portfolios can withstand changing market conditions. Stock tends to become more correlated in a highly inflationary environment, so investors may want to consider expanding diversifiers to include safe-haven investments such as inflation-linked bonds and liquid alternatives.

How can a pension fund with euro liabilities cover itself against inflation?

Pension funds have a range of instruments that they can use to hedge inflation. These instruments are divided into three categories:

·  Explicit hedges of liquid assets. Such as liability-driven investments (LDI). LDI includes derivatives, such as inflation swaps, and fixed income instruments, such as inflation-linked bonds, which allow portfolios to be hedged against inflation.

·  Liquid inflation-prone assets. Assets that have a high correlation with inflation and so should keep track of it. These assets include value stocks, Japanese and emerging market equities, global high yield bonds, emerging market debt and commodities.

·  Illiquid real assets. Assets such as real estate and infrastructure must keep pace with inflation. The benefits are that these assets provide a good inflation hedge and add diversification benefits to portfolios.

How should investors balance strategic and tactical inflation hedging?

Lustig and Walsh believe that each investor’s goals and requirements strongly determine the choice between strategic and tactical inflation hedging. If investors are flexible in their approach, the three most important parameters when choosing inflation hedging are:

·  Correlation with inflation. How effectively can the inflation hedge do its job? That depends on the time horizon and whether inflation is expected or unexpected. For example, in the short term, the most effective hedges are short-term cash and inflation-linked securities. Its yield or price can move quickly with short-term key interest rates or inflation changes. Over the long term, stocks have often shown a high correlation with inflation. But on the other hand, stocks and bonds do poorly when inflation rises unexpectedly. Higher expected inflation may in turn be favourable for equities and disadvantageous for long-term bonds.

·  Cost. Investing in different assets comes with different costs. The charges include cash payments, such as fees, and management fees for the investor. Only if inflation is going to be persistent, higher costs may be justified, for example for investments in direct real estate with explicit inflation links.

·  Liquidity. Inflation remains an uncertain factor because cyclical and structural inflationary and deflationary forces are dynamic. It is difficult to predict whether inflation or deflation will prevail. Liquidity provides the flexibility to change the portfolio based on changing circumstances or if expectations turn out to be wrong.

What are the inflation expectations?

Lustig and Walsh expect inflation to likely remain high well into 2022, but to decline. Nevertheless, inflation could remain higher for longer if major central banks remain too cautious for too long. If that happens and consumers fear rising inflation, they may consume more or demand higher wages, leading to a vicious inflation spiral.

The bond markets still seem to rate the likelihood of the last low as interest rates remain close to their lowest level. Lustig and Walsh believe that this is becoming increasingly risky the longer the prices remain high. They, therefore, have negative expectations for government bonds in their multi-asset portfolios. In an environment where investors are raising inflation expectations, the value of these bonds is likely to be severely eroded.

They expect inflation to decline to normal levels in this century in the long term. Continuous technological innovation is likely to increase productivity, automation, and efficiency. Population aging is another deflationary force. While globalisation may turn around, there are currently few signs of deglobalization, and it could be decades before this happens. There are signs that the expected negative consequences of the pandemic are only slowly materialising. Therefore, Lustig and Walsh believe that deflationary factors will likely prevail over structural inflationary forces in the medium term.

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