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By M. Isi Eromosele
In the wake of the worst global financial crisis since the Great
Depression and continuing economic uncertainty, many institutional investors
should take a hard look at their asset allocation structures and the risk-mitigating
defenses they have in place.
While economists are still debating about whether inflation
or deflation is the bigger short-term risk, institutions should take the time
now to consider how well positioned their investment portfolios are to better
manage the longer-term threat of rising inflation.
Massive amounts of global liquidity combined with record low
interest rates and tentative signs of global growth appear to be setting the
stage for rising inflation. However, many endowments, foundations and pension
plans have not yet positioned themselves adequately to protect their portfolios
against inflation.
While they may not perceive the threat of inflation as
immediate, they should adjust their portfolios now to avoid paying a premium
for inflation hedging assets once inflation expectations pick up.
They should pursue a strategy that is aimed at providing inflation
protection, enhanced diversification and the potential for excess return. This
combines allocations to inflation-sensitive equities, inflation-linked bonds
and actively managed commodities.
Each asset class should have a dedicated, specialist
portfolio manager who draws on deep expertise in each of these areas.
Risks for Future Inflation
There is no global consensus about whether deflation or inflation
presents the bigger threat at the moment. The case against inflation points to
the high levels of excess productive capacity and high unemployment in the U.S.
Meanwhile, the U.S.
output gap, which is the difference between potential GDP and actual GDP
and correlates with employment levels, is still firmly in negative territory. Over the last two years it has shown the worst declines in
more than 20 years.
Unemployment remains stubbornly over 8 percent and most
economists do not expect to see significant improvements until well into next
year. Productivity gains and technological advances are both dampening the need
to increase hiring.
Moreover, tighter lending standards are constraining the
availability of credit to fuel spending. As a result, inflation expectations, at
least for the short term, remain subdued.
Meanwhile, concerns about rising inflation center around the
vast expansion of the monetary base that resulted as the U.S. Federal Reserve stepped
in to raise spending during the worst of the financial crisis to offset the
private sector’s drop in spending.
Over the last two years, the Fed has more than doubled its balance
sheet to $2 trillion mainly through the purchase of mortgage backed securities.
For the moment, most of that cold cash is sitting on the balance sheets of
American banks. The concern, however, is that those reserves could quickly turn
into hot money if they are inserted back into
the economy.
At the same time, the growing levels of government debt
raise worries that foreign buyers of U.S. Treasuries could begin to lose confidence
in the American government’s ability to manage its fiscal challenges and cease buying
U.S. government
debt.
This could impose severe downward pressure on the U.S. dollar
and increase the risk of accelerating inflation. Uncertainties over the future
of oil and gas also revive fears of a 1970s-style supply shock that could
ignite runaway inflation.
Allocating to Inflation-Hedging Assets
Because of the potentially devastating consequences of inflation
on the purchasing power of investments, investors should act now to position
their portfolios to weather a higher inflation environment.
A well-diversified mixture of global natural resources
equities, actively managed commodities, emerging market and real estate equities
and global inflation-linked bonds offers the most effective toolkit for dynamically
adjusting exposures to inflation hedges as macroeconomic and market conditions change.
It is astute to periodically review and adjust the
allocations within a controlled range to take advantage of dislocations and
opportunities in the marketplace.
Managed Commodities
Commodities present one of the most effective forms of inflation
hedges. They are typically highly correlated with inflation and lowly
correlated with other major asset classes.
So they can provide the opportunity to achieve both diversification
and liquidity to portfolios. At the same time, there are some well-known
investment challenges with commodities.
Commodities can be highly volatile, leading to large
drawdowns, and some commodity indexes can heavily skewed toward specific industries,
such as energy.
An active approach can seek to mitigate those challenges as
well as offset the potential negative costs involved in rolling commodity futures
contracts forward (e.g. if your investment is maturing at the wrong point in a volatile cycle, you can take steps to
counteract that).
Global Inflation-Linked Bonds
Like commodities, inflation-linked bonds, or linkers, typically
represent a natural hedge for long-term inflation and may provide overall
stability and diversification in a total portfolio.
The relatively risk-free component of linkers helps protect
the rate of return while their diversification benefits can help lower overall
portfolio risk. The difference in the liquidity of inflation-linked bonds
compared with that of U.S. Treasuries creates volatility and therefore potential
for active managers to generate alpha.
Customized Inflation-Hedging Strategy
There are many priorities to consider before deciding on the
appropriate implementation strategy based on your investment objectives and
risk tolerance. One of the first is whether to take an integrated approach to inflation-hedging
approach.
As for investment approaches, you should consider the trade-offs
involved in active versus passive management as well as with a static or
opportunistic asset allocation approach. In considering managers, there is the
choice between specialists and generalists, which could have important
implications for the depth and breadth of their expertise.
Finally, it is important for investors to recognize the
multiple layers of risk allocation involved in deciding upon an appropriate inflation
hedging strategy, ranging from the choice of asset class, manager, region, currency
and individual security.
Your choice of inflation-hedging asset classes and weightings
will vary according to such factors as your inflation sensitivity (perceived
versus realized), volatility tolerance and the liquidity trade-offs you are
prepared to accept.
There are many lessons to be learnt from the ongoing global
financial crisis. One of the most important one is that the time to protect
your investment portfolio against changes in economic conditions is before a
storm hits.
Long-term investors should think carefully now about their defenses
against long-term inflation.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
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2012 Oseme Group
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