In Brief

• In our recent article, “The Great Comeback: The Outlook for Inflation and the Implications for Pension Funds”, we showed why a period of high inflation is a risk scenario that pension funds can no longer discount. While “hiflation” is not our central scenario, it does merit consideration, and mitigation, as we enter the post-Covid era.

• In this article, we show why core real assets are expected to provide greater resilience to high inflation than index-linked bonds, and explain why real assets should be considered as a primary source of inflation protection in pension fund portfolios.

• In particular, while inflation linkage may be reflected in income streams from index-linked bonds and from real assets, it is important also to consider the impact of higher inflation scenarios on asset prices. While a hiflation scenario, with rising real yields, would be expected to have a negative impact on asset prices generally, we find that the impact would be more negative for index-linked bonds than for real estate. 

Look beyond index-linked bonds  

With future inflation expectations on the rise, the natural inclination for many pension funds is to turn to index-linked bonds to provide the inflation protection they need. However, because the duration effect on index-linked prices can swamp the inflation-linkage baked into their income payments, “linkers” may not deliver the inflation protection that investors are hoping for in periods of higher inflation, unless they are held to maturity.  

We’ve seen this effect in reverse in recent times, as the impact of falling real yields on index-linked prices has massively outweighed the linkage of their income payments to (weak) inflation. The result is that the returns from index-linked bonds have trumped just about everything else over the last decade, despite persistently low inflation.   

When inflation is high, the opposite can be true. In our previous article, “The Great Comeback: The Outlook for Inflation and the Implications for Pension Funds”, we featured three potential medium- to long-term inflation scenarios: lowflation, managed Inflation and hiflation. Our research suggests that returns from index-linked bonds may be particularly challenged in our hiflation scenario, which we associate with rising real yields and a loss of confidence in a country’s policy and the economic management (Exhibit 1). In a high inflation environment, the positive components of index-linked return may be cancelled out, or even outweighed, by the negative impact of the normalisation component. 

Exhibit 1A: Price impact on index-linked bonds in a hiflation scenario, gbp

Source: J.P. Morgan Asset Management 2021 Long-Term Capital Market Assumptions; data as of 30 of September 2020.

Exhibit 1B: Price impact on index-linked bonds in a hiflation scenario, eur

Source: J.P. Morgan Asset Management 2021 Long-Term Capital Market Assumptions; data as of 30 of September 2020.

In a high inflation scenario, in which real yields remain stable and only nominal yields increase, index-linked bonds offer paltry protection. At current real yields of - 2.9% in the UK and - 1.4%¹ in Europe, index-linked bonds are almost guaranteed to provide negative real returns: the only question is the degree of negativity. 

It is possible that real yields could fall further, as investors seek to set a floor on portfolio real returns, resulting in a price action that gives holders some protection via a “flight to quality”. However, we see this outcome as unlikely, given just how negative starting yields are, and more consistent with hyperinflation than a high inflation scenario.

Consider core real assets

An alternative solution to index-linked bonds may be provided by core real assets. Core real assets can provide effective inflation protection because about 80% or more of their returns are driven by income rather than capital appreciation. As income is generally linked to inflation, the overall return from real assets therefore also has a significant link to inflation.

Our research suggests that inflation protection from core real assets may be stronger than index-linked bonds in a hiflation/rising real yield scenario—as suggested by the generally higher correlations and levels of gearing to inflation for real assets (Exhibit 2). 

Exhibit 2A: Inflation correlation for major asset classes, gbp

Source: J.P. Morgan Asset Management 2021 Long-Term Capital Market Assumptions; data as of 30 of September 2020. White centre = domestic only, Solid colour = global. Beta calculations do not allow for any potential time lag in correlation of illiquid assets to inflation.  

Exhibit 2B: Inflation correlation for major asset classes, eur

Source: J.P. Morgan Asset Management 2021 Long-Term Capital Market Assumptions; data as of 30 of September 2020. White centre = domestic only, Solid colour = global. Beta calculations do not allow for any potential time lag in correlation of illiquid assets to inflation.  

The price protection provided by real assets may also be boosted in the current environment by a continuation of post-Covid fiscal support, combined with a reluctance on the part of investors and owner-occupiers to engage in development activity given demand-side uncertainties. Such an outcome is likely to be most observable for higher quality real assets that are ahead of the curve in terms of technology-enablement and sustainability credentials.   

Real assets are not immune to inflation risk

While we believe real assets should provide more effective inflation protection than index-linked bonds, investors should note that our hiflation scenario could still have an adverse price effect in real estate markets. Real estate prices, as represented by the spread of real estate yields over sovereign bonds, for example, are linked to supply and demand in the real estate occupier market. As a result, the spread of real estate yields over bond yields will tend to increase as the economy weakens, particularly in a stagflationary environment. 

If hiflation is associated with lower real GDP growth, then rental growth expectations—and by extension real estate prices—may be impaired. Similar arguments can be applied to the wider real asset universe, including infrastructure and transportation assets. 

Diversify globally to reduce real estate price impact

Even so, the impact of our hiflation scenario on real estate prices would be expected to be very diluted compared to the impact on index-linked bonds. Investors also have the opportunity to stabilise the price of real estate portfolios by investing globally, so that local supply/demand factors in real estate markets can be diversified, and by ensuring exposure is maintained to a broad spread of global real assets beyond core real estate, to include infrastructure and transportation assets. 

We will look in more detail at globally-diversified real asset portfolios in our next article in this series, while you can read a detailed discussion of the case for diversified global property allocations in our recent white paper, “Going Global in Core Real Estate”.²

Adding real assets to pension portfolios

We looked at the impact of adding a global real asset composite allocation to a range of sample European pension portfolios, funded from either current bond holdings, current equity holdings, or current domestic real estate holdings. Because increases in portfolio beta to inflation may be offset by increases in overall levels of volatility, we have measured the portfolio impact using a combined metric: beta to inflation/volatility. The changes in this metric are illustrated in the heat map (Exhibit 3).  

Our research indicates that beta to inflation/volatility is improved in all cases where global real assets are added to portfolios. Given bonds have a deeply negative beta to inflation, the effect is strongest when the allocation to real assets is funded from existing fixed income holdings. Funding a real assets allocation from equities gives a more muted inflation beta uplift, as would be expected, but is also supported by a diversification benefit.  

Finally, globalising existing domestic real estate portfolios, as might be expected, gives a more marginal result given that domestic real estate has the strongest starting beta to inflation, and the changes in volatility are relatively small for reallocating regionally within the asset class.

Exhibit 3: Portfolio beta to inflation/volatility

Source: J.P. Morgan Asset Management 2021 Long-Term Capital Market Assumptions; data as of 30 of September 2020. Global real asset composite comprises 60% Core Real Estate / 40% global infrastructure. Real estate allocated 50% US, 30% Europe and 20% Asia Pacific. Infrastructure includes 40% allocation to transportation infrastructure. US real estate and infrastructure hedged to GBP / EUR.

Conclusion

Despite their stated link to inflation, index-linked bonds may not, ironically, be the answer to high inflation risk. Also, while domestic real estate exposures have long been a mainstay of pension allocations for the inflation protection and income they provide, our research suggests that other influences on real estate prices can serve to undermine this function. 

We find instead that pension funds may achieve more robust inflation protection by adding an allocation to core real assets. In particular, our research shows that a globalised exposure to core real assets can help diversify price influences and improve the overall resilience of pension fund portfolios to any future high inflation scenario. 

¹ Source: 10 year real yield on index-linked gilts and French Index-Linked Bonds respectively, Bloomberg, as at 31 December 2020

² Sorca Kelly-Scholte, Paul Kennedy, Pulkit Sharma, Shay Chen, “Going Global in Core Real Estate: The Case for Diversified Global Property Allocations in Pension Portfolios.” (J.P. Morgan Asset Management Portfolio Insights, December 2020).

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