For institutional investors with a very long term time horizon, inflation lurks like a sometimes unwelcome guest at the table where asset allocation decisions are made and strategies set. It is an implicit (or sometimes explicit) bogey when setting an expected rate of return and the force that can set liabilities on an upwards gallop, just as returns seem ever more elusive. In the recent weeks the oil price has headed towards $70, the highest level since 2014, and its slow creep over recent weeks has been proven at the pump, where consumer awareness of higher prices is likely to come quickly and sharply.
In an institutional portfolio equities tend to provide a modest hedge against inflation, as do fixed income instruments such as bank loans, high yield and convertibles, while other asset classes are designed to act as a more explicit hedge – infrastructure and real estate (with index-linked payment streams or rents), TIPS and sometimes commodities. It is interesting, therefore, that TIPS holdings seem to be at relatively low levels, based on the intrinsically low level of returns that such investments yield today. An explicit tracking of inflation is not enough, if the return is based on a Treasury yield that doesn’t pass muster.
In a month like April, when commodities soared, inflation concerns become very real, and the stuff of every conversation with a money manager. Anecdotal evidence suggests that the cost line is creeping upwards in real estate management as construction costs mount due to scarcity of both supplies and labor and this is not always being matched by top line rent increases. While in the US recent tax reform has had a windfall effect on many corporate earnings, this has perhaps masked margin compression caused by inflationary forces.
There are no “magic bullets” for institutional investors facing this unwelcome presence of inflation, and it seems prudent at the moment to remain in a hyper state of awareness – perhaps the weekly filling of the gas tank can act as a reminder. Asking about a portfolio’s sensitivity to inflation at every opportunity might assist in deriving a pattern through the noise. Being aware of currency impacts is also instructive – e.g. in the UK a firming of Sterling may have caused the official CPI rate reported there in March (2.3%) to fall from a month earlier (2.5%) and to the lowest level since March 2017. Meanwhile in the US, the inflation rate hit the Fed’s 2% target in March, although some commentators are already arguing that is peaking. While official measures may be imperfect, corporate performance will reflect the real story, at the rare interludes when other noise dies down. It is a question of “watch this space”.