Inflation is investors' primary concern
Inflation is centre stage at the moment. The U.S. consumer inflation rate is 7.5%, a level not seen for more than 30 years. Central banks are confident that the supply-side factors behind it will fall back, and they will have it under control over the next twelve months. The jaw-jaw of multiple interest rate rises continues. Investors and consumers are more sceptical because they see what’s happening on the high street.
In our annual inflation survey only six weeks ago we suggested that inflation would drop back before any sustained rise. That is still our central view: economic growth remains fragile (e.g. the most recent US quarter was almost all inventory build-up); food and energy price rises will act as a tax to reduce consumer demand; and central banks’ institutional memories of the 1970s and 1980s are still strong. At Linchpin we think they are more likely to err by tightening policy too harshly.
LGPS liabilities have no inflation cap
However, there is clearly a scenario where a more inflationary psychology takes hold and/or the authorities feel obliged to turn to the magic money tree of quantitative easing once more. Inflation might stay above 5% for a number of years, combined with relatively low growth. For UK pension funds whose liabilities are linked to inflation (unlike the U.S. where pensions tend to rise in nominal terms) this is the dangerous scenario. It is particularly so for funds like the LGPS where, unlike much of the private sector, there is no cap.
Mitigating inflation risk – Linchpin panel debate
At our recent panel debate on de-risking we touched on how best to mitigate the inflation risk. The private sector does it by holding a portfolio of index-linked gilts, using leverage to mitigate the opportunity cost. But the risk of doing this is of ‘de-returning’ the portfolio as well as de-risking it, and forcing higher contributions or lower pension pay-outs. The travails of the Universities Superannuation Scheme (USS) make a good case study in this respect.
Our panel clearly favoured an approach where inflation hedging is done by holding assets with inflation-linked properties rather than via index-linked gilts. The obvious one is infrastructure where, at least at the more regulated end of the spectrum, the underlying assets are substantially linked to inflation and at the same time give a positive real return. Other real assets, real estate and even equities will to a lesser extent perform a similar function.
Duration risk in infrastructure
But these all tend to be long duration assets, and if inflation is sustained at more than 5%, it is almost certain that long bond yields will be a lot higher than they are now. That means that the present value of their future earnings stream will be marked down, perhaps considerably so. The question is whether that matters to a pension fund.
One of the points which came out of our panel debate was a reminder that pension funds have a period of accumulation (more contributions than pay-outs) and a period of decumulation (the reverse). So, if an infrastructure asset is effectively an index-linked annuity (i.e the promise of an index-linked income stream in the future in return for a capital down-payment today), a pension fund may not care if the present value is marked down so long as the inflation-linked income stream is delivered.
The price paid for infrastructure does matter
At Linchpin we would argue that, while that may be true, the price paid does matter. The obvious point is the level of risk accepted in return for the level of income delivered. Index-linked gilts provides perfect protection but at a high opportunity cost. Infrastructure involves substantially more risk (regulatory, political, execution, economic) and less certain protection, but provides a much better return.
Infrastructure also carries duration risk, much like index linked gilts. That is a good match for private sector pension funds whose liabilities also have long duration and whose discount rate is based on the gilts swap curve. It is less clear a match for open public sector funds which are less obviously in the decumulation phase, and whose discount rate is nowadays based on either the underlying assets or inflation.
There are also more nuanced points about the nature of the infrastructure assets purchased, which may affect their duration. Are they leased assets? If so, there will be less or nil value at the end of the contract? How long do the contracts last? How will they finance new assets and will there be equity dilution? Is there reinvestment risk?
Infrastructure is only part of a good mitigation strategy
Most LGPS funds are raising infrastructure weightings today to mitigate the inflation risk because they do not wish to go down the private sector route of leveraging and purchasing index linked gilts. There is no shortage of supply of infrastructure projects to invest in, but the ‘hot’ market increases the risk that funds will overpay for the infrastructure they are buying. Their inherently long duration nature makes that particularly true in a market where bond yields are rising and the infrastructure ‘risk premium’ is falling. At Linchpin, in the light of the heavy fine levied on Southern Water (and indirectly on its shareholders), we also think that political and regulatory risk is understated.
In summary, infrastructure is one way for the LGPS to mitigate the risk of sustained high inflation. But the risk of over-paying today is growing, and we believe any risk mitigation strategy should be based on a broader array of tools. That might even include opening the private sector’s toolbox.
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