Does anyone have a crystal ball I can borrow?
18th May, 2022
I’m sure most of us remember the national lottery in the 90s and the interesting pleasure of watching Mystic Meg with her crystal ball predicting the future. We all knew everything she said was entirely made-up, but I guess that was half the fun! Apologies to my economist friends out there, but there are some similarities with what you do…
And that brings me swiftly onto a discussion about inflation, a key issue for trustees with significant consequences for both assets and liabilities. Inflation has been rising at the fastest rate in 40 years, currently at an eye watering 9% p.a. The Bank of England’s Monetary Policy Committee (MPC) expect inflation to peak towards the end of the year, as one-off increases in global energy prices and tradable goods have already been felt. In response, the MPC has begun to increase interest rates; most recently increasing the base rate to 1% in May. It’s a precarious tightrope they must walk in the months ahead. They need to tackle inflation whilst ensuring they do not over tighten to avoid stifling the economy. The MPC forecast inflation falling to their 2% target in about two years’ time but there is much uncertainty surrounding this estimate. I’m sure the MPC would appreciate a functioning crystal ball at this time!
The current inflationary pressures are not limited to the UK, high inflation is being felt globally. The real value of many assets is quickly eroded during periods of high inflation, and this could have large consequences for global investment markets. Under a high inflationary environment, growth orientated assets, such as equities and property, typically fair the best. Diversified, multi-asset portfolios can also fair well as investment managers can tilt their asset class exposures accordingly. However, asset that simply maintain their nominal value or yield, such as cash and fixed yielding bonds, will see their real value fall.
On the other side of the equation, a scheme’s liabilities will be pushed higher with inflation; particularly through pension increases and deferred revaluations. Yet, a scheme’s funding position could, potentially, improve in a period of high inflation. This is because rising inflation, from already high levels, may have only a limited impact on liabilities due to caps on pension increases and deferred revaluation. Also gilt yields are likely to increase as the market adjusts to sustained high inflation and this will act to reduce liabilities depending on the extent a hedging strategy is in place.
Schemes with high levels of hedging in place will broadly move in a way that maintains the funding position of the scheme, making inflation less of a concern. Although it’s worth flagging that following the recent sharp increase in inflation, many schemes are now significantly over hedged against inflation risk. It’s worth trustees ensuring they understand the hedged position, especially following periods of significant change in inflation or yields.
My Crystal Ball is faulty…
We do not know what will happen with the economy over the coming year. It’s a complicated, interrelated system that is inherently difficult to predict. Trustees should continue to challenge their investment consultants to explain how the scheme’s investment strategy will perform under different economic scenarios, including understanding any hedges in place. Yet, the heart of discussions must remain the same. Strategy must remain focused on the long term and on the ultimate aim of meeting the scheme’s liabilities.
 Bank of England Monetary Policy Committee Minutes May 2022: Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 4 May 2022 (bankofengland.co.uk)
 Over tightening is when rates are raised too much and/or too quickly in a way that limits economic activity.