According to Jignesh Sheth, head of strategy, Investment Consulting at JLT Employee Benefits: “If inflation doesn’t go up, pension funds may be better off not paying that [additional cost].”
To a large degree, the price of inflation also gives a misleading projection of where long-term inflation expectations are.
Tapan Datta, head of asset allocation at Aon Hewitt, says: “Market inflation pricing has rocketed up in the last few months, which can be misleading as it suggests inflation expectations have done the same, but that is not the case.”
Datta and other experts point to a considerable supply/demand imbalance in the inflation- linked gilt market as well as differences in underlying liquidity and relatively low issuance that give rise to what Datta says is a “very distorted” picture of the way inflation expectations have risen. “They have gone up a bit,” he says, “but over 20 to 30 years it is unlikely a substantial rise will be sustained.”
SHORT-TERM INFLATION DRIVERS
In the short term, at least, inflation is “guaranteed to increase”, says Olivier Lebleu, head of international business at Old Mutual Asset Management (OMAM). “The question,” he says, “is what nature that inflation takes.”
A quarterly survey by Barclays released in November showed expectations for inflation over the next year rose to 2.2%, up from 1.7% in the previous survey three months earlier. Looking out a little further, the survey showed inflation expectations one to two years ahead rose to 2.7%, up from 2% three months prior and the highest level since mid-2014. Five-year expectations rose 0.7 percentage points to 3.7%.
Much of the changing inflation outlook is based on relative currency moves. Over the last year, sterling has fallen 20%, fuelled mainly by the Brexit vote, after which the pound fell 15% against the dollar. That has given rise to the so-called ‘Marmite Effect’ of pushing up producer input prices given the translation effect of currency moves.
According to John Dewey, head of investment strategy at Aviva Investors Global Investment Solutions: “Producers are trying to raise prices as a result. While it’s not clear how much can be passed on, there will be some direct pass through which will push up consumer prices.”
CASHFLOW PRESSURE
The prospect of rising inflation paints a difficult background for many institutional investors. Those with liabilities to meet will see their cashflow needs increase, which will only be exacerbated as more scheme members reach retirement age in the coming years. Those schemes that are already cashflow negative will face a particularly challenging few years.
The interest rate rises that would typically be expected to off-set increases in cashflow requirements are unlikely to come through any time soon.
The Bank of England (BoE), like its US and Japanese counterparts, has already signalled its willingness to allow inflation to overshoot its 2% target. The bank revealed updated economic forecasts in early November showing the biggest overshoot in its modern history. It forecast that consumer price inflation (CPI) would rise to 2.7% by November 2017.
