The new inflation regime

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Articles by Ben

Ben Crawfurd-Porter

Director – UK Institutional

16 January 2023

The investment regime has changed. That much was obvious to anyone looking after LGPS investments in 2022.

There was nowhere to hide as equities and bonds fell together. But the damage was not limited to these asset classes. Most others – from credit to infrastructure to property, across both public and private markets – also suffered. The assets investors were relying on to provide diversification became correlated with the rest of the portfolio, if in some cases with a lag.

The return of inflation heralds a shift from a regime that was extremely investor-friendly to one which is decidedly not.

History shows that, when inflation averages above 2.5%, most assets are positively correlated with one another – as we saw in 2022. The challenge in this new environment is that inflation will be not only higher on average, but also very volatile.

Higher inflation will challenge most LGPS diversification strategies. More volatile inflation calls for a more active and nimble approach – both to avoid risk and to take opportunities. The key question for those responsible for LGPS investments is clear: what is your plan for this new regime?

We posed this question to three LGPS professionals with different roles in the LGPS strategic asset allocation process.

Tim Mpofu, Head of Pensions & Treasury, London Borough of Haringey

The impact of sustained higher levels of inflation on both investment performance and funding requirements remains a key focus for me going into 2023. LGPS benefits will be uplifted by 10.1% this coming April and, depending on the outcome of the actuarial valuation, we may have to contend with a cashflow requirement (to pay pension member benefits) in the foreseeable future. Perhaps the new interest rate environment may require careful consideration of allocations to income generating asset classes – such as traditional fixed income – that have largely been overlooked in recent years, when yields were historically low.

With this in mind, the high-level plan is relatively straightforward – review the current investment portfolio and identify key sources of risk and return, assess and reaffirm investment objectives in light of the actuarial valuation outcome and explore investment opportunities with the support of the fund’s investment advisors. However, the real challenge remains the same – to strike an appropriate balance between asset diversification, portfolio growth and income generation. Perhaps a more formidable challenge in this new regime than in the last one.

William Bourne, Independent Advisor, Linchpin Advisory

The first implication of higher average inflation is that the cost of capital will be higher. That presents opportunities for those with money to invest. However, it won’t be enough just to invest in an asset class and expect to harvest the returns, as has been the case for the last 25 years. Investors will need to invest actively and show discrimination on price and timing. LGPS funds should review their investment governance processes, in order to be more nimble.

As for asset classes, fixed income and especially index-linked bonds have become more investable, but I expect yields, especially UK gilts, to rise, so timing will be of particular importance. While higher bond yields have negative implications for the valuations of all asset classes, my biggest concern is infrastructure. Whilst new commitments may be well positioned, I suspect much recent investment has been at the wrong price.

What’s my plan? In the short term, I expect further corrections in most asset classes, public and private, so I am happy if my LGPS clients keep duration short. In the longer term, I shall encourage them to use experienced managers and to consider broader mandates. I expect allocations to fixed income to rise over time, but only when the yield justifies that. I am not advising major asset allocation changes, though that may come in the future. And the best diversification may come from having the courage to invest in niche rather than mainstream strategies. My two recent favourites have been crematoria and an old-fashioned bond trader making money from arbitraging liquid bond markets.

Andrew Singh, Head of Real Assets Research and LGPS Investment Advisor, Isio

Given the risk rising inflation poses to our LGPS clients, in recent years we have been advising them to build inflation protection in their portfolios through allocating to areas which can offer returns inherently linked to inflation. These include long income property, residential property, and infrastructure equity and debt. This has helped during the transition to the challenging investment regime we now find ourselves in.

Given the fragility of the financial system, we expect further volatility both in the inflation market and more broadly, which creates opportunities for our clients to capture. We believe there is merit in allocating to investment mandates such as diversified growth, absolute return and multi-asset credit which offer flexibility and have scope to move asset allocation quickly to capture these opportunities as they arise. If these mandates can in addition offer a degree of inflation protection, this is also attractive for our clients.

Key messages

These plans share three key common themes:

Inflation risk to LGPS liabilities, cashflows and asset values puts the emphasis firmly on the types of assets that can help to protect against this or meet higher income requirements.
More active asset allocation is needed to cope with volatility in financial markets.
Opportunities are being thrown up by this new regime, creating potential for long-term investors such as the LGPS – providing they can inject sufficient diversification and flexibility into portfolios.

The challenge is achieving an appropriate balance between portfolio growth, income generation and diversification.

At Ruffer, we believe it is diversification that will require the biggest shift in existing LGPS asset allocations. But it can also deliver the most relative upside.

LGPS investors should seek diversifying strategies that can protect against inflation risk, react nimbly to more volatile markets and, ultimately, use these characteristics to capture opportunities.

Crucially, such a strategy should be liquid, particularly at times of stress. That will allow LGPS funds to realise the allocation’s uncorrelated returns to meet obligations whilst having the flexibility to seize opportunities elsewhere in its portfolio. We have been pleased to see some LGPS funds benefit from this strategy so far in the new regime.

This financial promotion is issued by Ruffer LLP. The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This document does not take account of any potential investor’s investment objectives, particular needs or financial situation. This document reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. Read the full disclaimer.

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