Inflation spectre should scare investors back to text books

Inflation is a big risk for most pension funds around the world. The question is: what do you do about it? The interesting point, though, is if inflation is a ‘fat tail’ risk, maybe it’s already been too widely signalled.

Most developed countries outside the Asia Pacific region currently have interest rates near zero. They also tend to have excess labour and production capacities, big fiscal deficits and inconsistent growth prospects.

The whole western world is worried that high inflation is a real possibility in the next couple of years. In fact, it’s either that or stagflation, which the world hasn’t seen since the 1970s.

At a recent conference convened by Mercer Investments, this topic was dissected with respect to what a pension fund can do in preparation for either inflation or deflation. The consensus was that most portfolios are probably not well-structured to withstand either high inflation or deflation.

This is the Mercer advice:

• Traditional balanced portfolios should implement an enhanced diversification strategy through increased exposure to portfolio diversifiers, such as ‘real’ assets, that can provide protection against inflation and deflation.

• Traditional diversification  measures have shortcomings in that many asset classes have similar return drivers. A factor-analysis approach can also be considered to better understand the true diversification in the portfolio.

• The addition of a deflation or inflation satellite portfolio is a hedge against unexpected inflation outcomes or negative inflation.

Of course, pension funds need to consider the price currently being paid for assets with hedging characteristics. Which is the whole point of the discussion.

If the majority of investors consider inflation in the west to be a real threat, then markets will react accordingly. These sorts of thematic bets invariably turn out to be disappointing on the downside. Investors usually go with the general flow and usually get mediocre relative returns as a result.

Generally, changes in inflationary trends tend to be gradual, however, in the interesting times we currently find ourselves in, those trends can hasten. The US is not in recession but it feels as if it is. So is much of Europe.

Fiduciary investors could do well to brush off their old high-school economics text books. The inflation/deflation debate, which has very significant consequences, will be with us for some time.