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Scott Minerd, the global CIO of Guggenheim Partners, recently tweeted his thoughts on two of the biggest risks facing institutional investors. He predicted “US inflation problems are years away,” adding that US interest rates will likelier fall than rise because of current market turbulence.
For many CIOs, the two risks cannot be separated. “Interest rate risk will only become an issue if inflation risk rises sharply,” says Stefan Dunatov, CIO of the UK’s Coal Pension Trustees Investment. “This can happen in two ways. Either inflation rises sharply and central banks are forced to raise rates, or the bond market anticipates inflation is likely to rise sharply and forces rates at the very short end higher. Either way, you can’t have rate risk without inflation risk.”
For the UK’s pension lifeboat fund—the Pension Protection Fund (PPF)—fast-rising rates are the biggest problem.
According to CIO Barry Kenneth, if the fund has hedged effectively, it is essentially left with a cash-based benchmark. With the PPF’s high proportion of global bonds, credit, and other debt, rising rates potentially spark a duration problem.
A different perspective comes from America. Frank Ahimaz, CIO of the Museum of Modern Art in New York, says he’d be very surprised if investors were concerned about inflation over interest rates—but that a rising-rates market should worry investors, particularly if they’re investing in emerging markets. “We tackled our developed interest rate exposure by moving all our securities to floating rate notes,” he says. “Our gut feeling is it will be 12 to 18 months before the Fed does anything to rates, and then it will be little by little.” Ahimaz has no exposure to emerging market securities, but fears for those who do. “Let’s say you have some exposure to Turkey, where they’ve seen a 500 basis points increase to rates overnight. I can only imagine what impact that would have,” he says.
Deflation risk is also creeping up the agenda. Aviva pension CIO Ian McKinlay explains that he manages that risk by delta hedging as inflation expectations fall or the volatility of inflation rises. He also carries a reserve for deflation risk.
“The pricing of linkers suggests the market worries more about inflation than rates,” he adds.
He’s right: For many, inflation is the far scarier prospect. Centrica pension CIO Chetan Ghosh speaks for many pension funds when he highlights the added cost caused by inflation increases.
“If inflation is 10%, then we need to pay our pensioners 10% more,” he explains. “Interest rates and inflation expectations matter for the mark-to-market position, but as inflation also affects the benefit promise, we attach greater importance to our inflation risks.”
Pension funds that bought inflation hedges back in 2008 might be feeling the pain, given the low inflation environment we’ve endured for the past five years.
Low inflation levels have at least one benefit, however, in cheaper hedges. Yet the question remains: Should you buy insurance while it’s cheap, or ride it out for a couple more years?