Inflation protection excites

Tuesday July 8

The recent increase in headline inflation is a source of concern for global investors as it threatens to lower real financial returns.  Inflation for OECD countries touched 3.5% this spring, and the consumer-price index in May was up 4.2% year-on-year in the United States. Significantly, numerous commentators suggest inflation could remain a serious concern at least through the end of the year.

Inflation risk. While inflation poses a series of general macroeconomic risks, it also has significant implications for investment portfolios:

• Real returns. In periods with rising inflation, real returns on assets that offer no inflation protection fall. For example, the 1% real return on a 3% certificate of deposit is eroded completely when inflation rises from 2-3%.

• Asset-liability management. Rising inflation affects investors with specific liabilities, such as defined benefit pension funds. Indeed, promised pension benefits in some cases are indexed explicitly to inflation. In short, revised expectations of higher inflation will force these funds to reconsider the size of their liabilities and, in some cases, push them from over- to under-funded status.

Inflation protection. The recent uptick in inflation has ushered in renewed interest in financial products and assets that offer inflation protection:

1. Bonds.  Some debt offerings have built-in inflation hedging, but risk protection comes at a price. Returns on government bonds are extremely low, suggesting that significant uptake will be reserved for only the most conservative investors.
2. Equities. Investing in equities can be useful if restricted to certain 'inflation-proof' sectors, such as emerging markets, energy or consumer staples. Since these are partially responsible for jumps in inflation, they are seen as safe.
3. Real assets. In inflationary periods, investors typically will reallocate some of their portfolios into tangible assets, such as gold, commodities, real estate, food, timber, or even art.
4. Infrastructure. With all the benefit of being a 'real asset', infrastructure also tends to come with inflation-linked cash flows that have greater immunity to business cycles.  However, offerings remain constrained by politics -- selling public assets to private investors leaves many uncomfortable.
5. Structured products. While recent market turmoil surrounding the sub-prime crisis damaged much of the structured credit business, inflation-linked derivatives are attracting renewed interest. Nevertheless, these strategies can be extremely costly. Moreover, they require high levels of financial competence. As such, while most pension funds have resources with which to implement a complicated swap strategy, they do not have the internal governance capacity to manage such an investment strategy.

Numerous inflation protection options are available to investors. However, the high costs -- in terms of lower yields or actual price -- and imposing constraints -- in terms of supply, capacity, and competencies -- suggest that most investors will remain vulnerable to increasing inflation risk in the near term.