Inflation dominated the discussion at a recent board meeting at the $200 billion Teacher Retirement System of Texas. Meeting in person at the Austin-based fund’s headquarters, committee members heard how inflation is driving the market lower; remains fuelled by war in Ukraine, and has now triggered monetary tightening that threatens recession.
“We’ve had more discussions about inflation today than ever before,” said Jase Auby, CIO of the pension fund. “Inflation today is the worst it has been since 1982 – it’s a long time since inflation was at this level.” Auby was speaking after US CPI hit 9.1 per cent – although it has subsequently fallen a tad. In the 12 months through July, CPI increased by a weaker-than-expected 8.5 per cent.
The current market decline is less severe than the average US bear market – so far. Today’s ‘Inflation Breakout Market’ (the TRS investment team has named every bear market since the Great Depression) has so far seen the market fall 21 per cent over 178 days, compared to longer and sharper market falls triggered by the GFC and COVID when the market fell 56.8 per cent over 517 days before it bottomed and 34 per cent in 33 days, respectively.
Moreover, Auby noted that forward inflation prices, marked down at 2.3 per cent by 2024, indicate faith in the Fed’s ability to tame it by hiking interest rates. “We are seeing faith in the Fed’s ability to raise rates high enough to cause inflation to go down,” he said. “The Fed feels it can control inflation; and markets think so too.” Still, Auby warned of the recessionary implications of higher interest rates and flagged that Fed faith is also linked to economically painful historical examples. Former Federal Reserve Chairman Paul Volcker crushed inflation by raising interest rates to 20 per cent in the early 80s.
While inflation batters most of TRS’s portfolio one corner in private markets, a 6 per cent allocation to Energy, Natural Resources and Infrastructure (ENRI), is bucking the trend. “We are expected to provide protection during inflation and have performed as expected,” Carolyn Hansard, senior director in the private markets division that includes a 17.7 per cent allocation to private equity and a 14.4 per cent allocation to real estate, told committee members.
The portfolio sets TRS apart from peer funds, many of which are shutting down fossil fuel investments. “We are one of the few people investing in energy and it’s paid off,” she said. On a one-year basis, the portfolio has returned 18 per cent while over a three and five year period it has generated an IRR of 5.7 per cent and 6.2 per cent respectively.
TRS is currently eyeing investment opportunities in natural gas. Europe’s scramble to find alternative sources of gas away from Russia after the invasion of Ukraine has spiked demand for natural gas. Demand is also set to benefit from gas now being labelled a green investment by European Union policy makers alongside nuclear energy. “Demand for gas has led to record prices across the globe,” said Hansard.
US groups, able to produce LNG cheaply, are poised to take advantage of global demand. TRS is eyeing LNG infrastructure opportunities especially export facilities on the US east coast which could provide a valuable alternative export point for north eastern producers, currently relying on exporting facilities on the Gulf coast. “Growth in gas demand is also a US story,” she said. “US exports are currently 10 per cent but they are expected to climb to 25 per cent.” Moreover Canada, which has plentiful gas, also lacks LNG export facilities. “The only way to ship it [Canadian gas] is to get it to the Gulf coast,” she said.
Hansard said TRS has been investing in natural gas for the last four years in a range of LNG and pipeline facilities across the US. Today, unknowns include the European energy crisis actually accelerating the transition away from fossil fuels altogether. She also questioned if one global gas price, and gas parity, will emerge.
The ENRI portfolio was set up in 2013 with fossil fuel investment at its core in the hunt for inflation protection and uncorrelated returns. Hansard noted that infrastructure investments in the energy sector have a lower risk profile and are less correlated to energy prices than direct investments in energy. Infrastructure has delivered the most consistent returns in the allocation, which has outperformed its benchmark six out of the last 12 years.
The portfolio is split between funds and principle investments. Hansard noted that although funds investments have outperformed principle investments in recent months, principle investments perform better over time – and fund investments give important access to these investments.