John Atkin of M&G sets out more predictable inflation-matching alternatives to the ‘roller coast ride' of commodities.
If clarity and certainty are a pension fund investor’s best friends then it’s worrying that some are intrigued by the idea of using commodities to protect against inflation.
This kind of roller coaster ride may be exciting on a stag party in Las Vegas, but it’s less desirable if you’re responsible for hedging trillions of pounds of inflation-linked liabilities.
The rationale behind using commodities for this purpose is that things like food and precious metals have an intrinsic worth to humanity, and thus should move in line with inflation.
This may be fine in theory, but history shows that over the last 15 years, the relationship between commodities and inflation has been more like a dodgy celebrity marriage than a match made in heaven:
Over that period, commodities have not done a brilliant job of matching inflation. They’ve been very volatile, particularly at the height of the crisis in 2008. And, for all the extra risk, commodities eventually only outperformed inflation by the tiniest of margins.
For pension funds, who ideally need their returns to be predictable and frankly – a little boring – commodities seem like an odd choice, particularly as markets look likely to remain quite ‘interesting’.
While mitigating against inflation risks is hugely important to pension funds, the value of protecting against deflation shouldn’t be entirely forgotten either. Some have been arguing the case for likely deflation for years, and while we’re not convinced it’s coming, we’d be loath to rule it out entirely.
After all, a serious economic slowdown in the emerging markets (which the World Bank believe is a genuine risk) could yet make it happen.
In this environment, it’s worth noting that assets which typically perform well during high inflation usually suffer during deflation, which is not great news for pension funds who generally need their assets to grow to help plug their deficits.
So if commodities might not be the best solution, where can pension funds find inflation (and deflation) protection providing returns that are accurate, predictable, stable and frankly unexciting? We think there are a handful of suitable investments and allocating to each creates what we’re calling the diversified ‘inflation opportunities’ strategy.
The first opportunity lies in prime long-lease property. This involves buying prime commercial real estate and leasing it back to businesses, such as supermarkets.
The ‘coupons’ come in the form of rent, which will typically increase explicitly with RPI.