Is now the time for the LGPS to buy inflation protection?
The long-term impact of the Covid-19 outbreak on inflation is of critical importance to the LGPS, given scheme liabilities are so strongly linked to consumer prices. With the market’s long-term inflation expectations still subdued despite concerns over the inflationary impact of recent fiscal and monetary easing, it may look attractive to add inflation protection to portfolios. But should the LGPS be buying?
Long-term inflation pressures
Covid-19 has clearly delivered a disinflationary shock to the economy in the near-term. People simply aren’t buying stuff. However, the massive fiscal boost from policymakers in response to the virus outbreak has led many investors to ask whether, in the longer term, we could see strong upward pressure on inflation.
As we discuss in the recent mark-to-market update to our 2020 Long-Term Capital Market Assumptions1 , we agree with the basic premise that the fiscal and monetary policy response to the Covid-19 outbreak could be inflationary in the medium term. We have noted in particular how central banks have softened their stance on inflation targeting and how they’ve signalled their willingness to allow inflation to run above target for a time if needed to support growth.
Obstacles and headwinds
However, while there is clearly the potential for recent events to boost long-term inflation pressures, inflation expectations have remained fairly subdued since the policy response to the Covid-19 outbreak was announced. While they have ticked up in recent months, they are still no higher than they have been over the last few years. It’s also worth noting that investors had similar expectations for higher inflation as we came through the global financial crisis. Yet inflation has been moribund ever since.
Inflation expectations haven’t moved much in recent months despite fiscal and monetary stimulus
One reason why inflation expectations have remained subdued is that recent actions by governments and central banks may not, by themselves, be sufficient to create a long-term inflationary spike. A significant rise in inflation expectations would require fiscal and monetary policy co-ordination through the recovery as well as through the crisis, and we would need to see the distribution of income between labour and capital shift in favour of labour.
It’s also true that many of the structural forces that have acted as headwinds to inflation in recent years remain in place, such as the advance of technology (which is driving down labour costs and increasing price competition) and ageing demographics in the developed world.
Buying inflation protection
With inflation expectations currently subdued, adding inflation protection to portfolios is cheap for investors who are concerned by the inflationary impact of recent policy easing. However, adding protection may not be simple given the debate around the alignment of the retail price index (RPI) measure of inflation to the consumer price index (CPI) is still unresolved.
If RPI is aligned to CPI, as proposed, there will be an immediate impact on the value of inflation-linked instruments—the vast bulk of these contracts are linked to RPI rather than CPI and would therefore become less valuable if future RPI is effectively revised down to match lower CPI levels. The government consultation paper launched in March was, against expectations, silent on the issue of compensating holders of index-linked Gilts for this loss in value.
While the alignment issue remains unresolved, it would not seem an opportune time to buy RPI-linked instruments, even if investors believe that markets are underpricing inflation.
The advantages of global real assets
An alternative source of long-term inflation protection is global real assets, which generate income streams that are implicitly linked to inflation but are not exposed to changes in how official measures are managed. Many local authority schemes already have sizeable allocations to domestic real assets, mainly through UK real estate holdings. However, our research suggests that adding globally diversified core real assets exposure can provide a better long-term hedge against UK inflation than UK property alone.
Our analysis, based on our 2020 Long-Term Capital Market Assumptions, shows that adding a 5% allocation to global real assets would produce a greater reduction in volatility versus inflation for the average LGPS compared to allocating a further 5% to UK property. Our recent paper, Going Global in Pension Real Estate Portfolios, shows how globalised exposure can boost diversification benefits and provide access to a greater range of investment opportunities.
If you would like to discuss the points raised above in more detail, please don’t hesitate to contact your usual J.P. Morgan Asset Management representative.
1 For more details, see J.P. Morgan Asset Management Long-Term Capital Market Assumptions Mark-to-Market, Executive Summary, 30 April 2020.
2 2018/19 PIRC Local Authority Pension Performance Analytics Annual Review. PIRC = Pensions & Investment Research Consultants Ltd.