Natasha Brown examines what the latest inflation report means for schemes
The most striking aspect of last week's inflation update from the Bank of England (BoE) was the revelation that the consumer prices index (CPI) was unlikely to reach the bank's 2% target before 2017.
Governor Mark Carney singled out weak inflationary pressures in the UK and the eurozone, as well as the fall in global commodity prices, as part of the reason for this. The appreciation of sterling has not helped either (PP Online, 12 November www.professionalpensions.com/2380992).
Hermes chief economist Neil Williams (pictured) says the governor's announcement was far from a game-changer, but that it confirmed there was no sign of an interest rate rise before autumn next year.
"Where the eyebrow was raised is that some in the financial markets were hoping that Carney would prove them wrong and bring that expectation forward, a bit like he did for the Mansion House speech earlier this year. It was certainly a shift into a more dovish gear from Carney," Williams says.
The pensions industry is fully aware that the low base rate is constraining gilt yields, with a profound impact on defined benefit (DB) scheme liabilities.
Barnett Waddingham partner Matt Tickle says the announcement demonstrates that schemes have to get used to the idea that this environment is here to stay.
It also means schemes need to be prepared to hedge their risks when gilt yields are in a more favourable position, such as when they were close to 4% earlier this year.
Tickle says: "Those opportunities are going to come around again because markets are always volatile. It's a reminder that you may need to take those fairly quickly rather than sitting and waiting for yields to go back to where they got to in the early 2000s. That's not happening any time soon."
Although the slowdown in core eurozone countries like Germany and France is hurting inflation, the poor outlook cannot solely be blamed on overseas economies.
Williams explains that although quantitative easing (QE) has managed to push up asset prices as expected, consumers have chosen to pay down debt rather than spend.
Despite this, he is optimistic about the recovery. "I'm probably more upbeat than most, solely because I still believe the housing market in the UK is warmer than many think."
The benefit of low inflation for schemes is that it means any inflation-linked increases to pensions stay low too, helping to curb the extent of the guarantee.
However, the wider implication is that it shows the UK and global economy is far from booming, making it harder for institutions to find decent investment returns.
"It's indicative of a lack of economic activity, and a lack of growth, which potentially starts to feed through to equity prices," Tickle says.
As a result, schemes should be looking to alternatives like private debt and the loan market to help plug their deficits.
Tickle adds: "The yield that you're getting on those loans is as good if not better in many cases than the yield on the equivalent bonds in the same companies, yet you sit higher up the capital structure."
Nevertheless, the economic outlook is less than rosy. Williams concludes: "The backdrop to the UK is still a dark cloud.
"The eurozone may be looking better from the point of view of some of the peripheral countries, but the next part of the story is about the bill payers –Germany and France."
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