Inflation has become a sticky problem. Pricing pressure has remained high in spite of a relatively weak UK economy. And this poses additional challenges for pension schemes and their liabilities. Stephen Jones assesses the outlook for inflation and proposes a novel solution for addressing the issue

Is inflation a problem?
In September, UK consumer price inflation rose again for a second month to an annual rate of 5.2 per cent. The RPI measure, meanwhile, increased to 5.6 per cent from five per cent. The large increase in the past year is usually attributed to three factors: the rise in VAT at the start of the year, higher commodity prices and higher utility bills.

So far, the Bank of England’s Monetary Policy Committee (MPC) has refrained from raising interest rates. They have remained at their historic low of 0.5 per cent for more than two and a half years. The MPC appears to have been considering lifting the base rate earlier in the year, but held back after realising the economy was not growing as fast as it would have liked.

The MPC now seems more worried about (low) growth than (high) inflation. Indeed, that the MPC re-opened its asset purchase programme of quantitative easing in October proves the Bank is prepared to tolerate higher inflation now. The extra £75 billion of cash that will enter the economy over the remainder of 2011 to buy government bonds and provide liquidity to the banking sector should lead to higher prices.

On the inflation front, the Bank expects CPI inflation to peak at around five per cent and then fall back in 2012 as some of the temporary effects – such as the VAT rise – fall out of the annual figures. Crucially for the MPC, wages are not rising at a pace to keep up with inflation. However, the effect of the VAT rise coming out of the inflation figures will happen only gradually. What’s more, inflation will be retreating from a very high base, and will most likely still be well above the Bank of England’s two per cent target. So this will continue to feed through into schemes’ liabilities at a higher rate for the next couple of years. Bear in mind the Bank of England’s own projections – they admit there is a fifty-fifty chance of inflation being above its two per cent target at the end of its two to three year forecast horizon.

Of course, inflation is not a phenom­enon confined to just the UK. In Europe, the ECB was being pressured to reverse some of its interest rates hikes from the summer, as the euro-zone economy is teetering on the brink of recession, but higher than expected inflation last month prevented the ECB from cutting rates. And further afield, inflation remains a serious worry to central banks across Asia and emerging markets.

So in this world of high inflation and low interest rates, how can UK institutional investors ‘mind the gap’ and find investment returns that stave off the erosive effect of inflation and maintain their funding requirements?

What can pension funds do?
Usually, pension funds think about inflation defensively and use inflation-linked assets as part of a de-risking strategy. Often, this portion of the portfolio is managed passively with index-linked gilts. Historically, there has been a good reason for this. The index-linked gilt market is the second largest index-linked market in the world and offers high liquidity.

In our view, however, excess demand over supply has distorted the pricing in this market. Prices are increasingly being moved by supply and demand factors, rather than inflation and valuation considerations. For example, short-dated real yields have been negative for almost as long as the base rate has been at 0.5 per cent, but few people believe that the UK will see deflation in the near term. So the index-linked gilt market has become an less efficient way of protecting against the very thing it sets out to do.

A better solution is needed. First, institutions need ways of matching their liabilities that actually achieve what they are supposed to. And second, with returns from equity portfolios struggling to deliver decent returns, trustees are looking for their entire portfolio to make a contribution in terms of alpha.

A more sophisticated approach
More advanced investment solutions are needed. At Kames Capital, we’ve come up with a novel approach, which has been successful in garnering interest in its first year – to the tune of more than £200 million in assets under management.

Our approach is to consider all the different drivers of inflation in their various guises. First of all, we start with a core of index-linked gilts, which provides some basic inflation protection. We scale up and down the size of our holding in this sector as valuations of these assets and others changes and as we find opportunities in other asset classes.

We complement this core with strategic allocations to other inflation-linked assets, such as currencies, commodities, dividend-paying equities and interest-rate sensitive products such as corporate bonds and conventional gilts.

Here are some examples of how to achieve this
In currency markets, if we take an underweight position in sterling relative to some stronger currencies, this would allow some offset to the strong influence that sterling’s depreciation has had in recent years. In commodities markets, we are able to execute trades that can capture better the recent drivers of inflation in the UK, such as commodity, energy and food prices.

In equity markets, we can identify companies whose asset bases and cashflows are linked to inflation – obvious examples are utilities and food retailers, but there are many others. We recognise that the main way that many companies accrue value to their shareholders is not through capital growth but through growing dividends over time and in real terms.

What does this strategy offer?
We think this approach is exciting. It is unusual in that it offers a truly actively managed approach to inflation protection – which is so often (and unnecessarily) treated in a defensive way. An active management strategy can protect assets and take advantage of changes in interest rates as they occur.
A multi-asset approach to inflation protection is flexible. It acknowledges the drivers of domestic inflation and seeks to address them by investing across multiple asset classes. Accessing these investments, alongside the protective qualities of inflation-linked bonds in a dynamic way can better offset inflation. And as a more comprehensive approach to inflation protection, an actively managed multi-asset strategy can access opportunities in different asset classes as they arise – rather than being stuck in index-linked gilts come rain or shine. Similarly, the other side of that coin is diversification – the multi-asset approach to inflation protection should be less risky than a single asset fund.

Time to act
As we’ve discussed already, we expect inflation to remain a significant factor for the rest of 2011 and into 2012. Some people are dismissing inflation as a concern for pension funds because they believe inflation will drop next year. But inflation is not just a recent problem. It has been higher than the Bank of England’s two per cent target for most of the past five years.

And pension funds’ inflation-linked liabilities have been increasing for some time too. Pension funds are on the whole underweight inflation-linked assets relative to their liabilities.

While inflation-linked liabilities have reduced slightly in some cases with the change from RPI to CPI as the measure used for increasing pension benefits, this is still an issue that schemes need to address. Unhedged inflation liability in pension schemes has increased significantly because the UK has endured a large rise in inflation in the past year or so.

This requires action – while inflation is a risk that pension funds may or may not decide to take, it should at least be one that is taken actively. Once that decision is taken – and presuming pension funds agree that they need to take an active approach to managing their inflation issue – then we believe an actively managed multi-asset strategy is a strong solution to the multiple sources of inflation in our economy. We believe this is the most effective way for pension funds to ‘mind the gap’.

Written by Stephen Jones, joint head of fixed income at Kames Capital

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