Institutional portfolio manager explains the risks and avenues for return presented by a higher inflation economy
Even after this current bout of high inflation is dealt with, many economists and analysts have predicted that inflation will rest at a higher rate for the next decade or so. That is due, largely, to the ‘four Ds’: debt, demographics, deglobalization, and decarbonization. In North America our high rates of consumer debt, our aging populations, our choice to onshore more of our industries, and the need to decarbonize our economies should all drive prices higher over the medium to long-term. There are countervailing forces, such as the promise of AI and technology to boost productivity and lower prices. Nevertheless pension plans must contend with a future where inflation rests higher.
Kevin Minas explains that the risk of higher sustained inflation offers a mixture of challenges and opportunities to pension funds. The institutional portfolio manager at Mawer Investment Management states that while defined benefit pension plans will have to cope with greater liabilities, the market opportunities in an elevated inflation environment should be able to offset a greater benefit payout. Defined contribution plans won’t have that same liability increase and should see more upside. Key to any question of slightly higher inflation, however, is a discovery of where inflation will actually sit over the coming years.
“I agree with the premise that there is likely to be higher inflation than there has been for a while, but the debate is now around what we actually consider to be structurally higher inflation,” Minas says. “Are we talking half a percentage point above the target range of one to three per cent? Because that alone is meaningful, especially as inflation expectations get embedded…Ultimately even small increases in what the structural level is can have very big ramifications in terms of market expectations.”
Minas explains that the role of central banks will be key to both real inflation and inflation expectations. The timing of an eventual cut may signal to markets how high a central bank is willing to let inflation run. The Bank of Canada, he says, is contending with the issue of fiscal policy from the federal government that runs contrary to their monetary policy. The feds are still spending and running huge deficits right now, which adds some fuel to the inflationary fire. That makes taming inflation all the harder for BoC Governor Tiff Macklem.
The impact of this environment on pension plans splits evenly between inflation indexed and non-indexed benefits. Non-indexed benefits are in a relatively good place, Minas says. Their liabilities should actually fall due to inflation as their discount rates rise. He notes that inflationary periods have historically been strong for risk assets on the whole. While there is variation within that wide category, there’s a greater chance of appreciation that reflects a higher nominal growth environment. The great risk, however, is if we enter a period of stagflation, where inflation stays high but growth lags. That may be more problematic for risk assets and non-indexed pension plans.
Defined benefit pension plans are more challenged, Minas says. Their liability will be determined by the nature of their inflation index, but they will broadly have a more difficult time from a risk-return standpoint. Real return bonds may help offset that risk, but the relative paucity of those assets in Canada may mean defined benefit pension plans take a more aggressive line with their asset mix to outpace their growth in liability.
Minas highlights some of the assets that could provide the right returns to match a sustained inflationary environment. Those include real return bonds, despite the lack of issuances by the Federal Government. That could also include infrastructure, which many larger pension funds already own as an inflation hedge. Private credit and other assets with a floating rate can offer a meaningful connection to overnight rates, which should remain high if inflation stays elevated. Minas also sees opportunities in public equities, which many pension funds had pared back on in recent years. The key to that asset class, however, is an understanding of which businesses can effectively pass on their higher costs related to inflation and which businesses cannot.
“This is an argument as to why active management should be considered a bit more than it was over the last 20-30 years when beta was giving you so much value,” Minas says. “Whether that’s in fixed income, equities, or other asset classes. In the past few decades if you just bought the broader index it didn’t matter much whether companies had pricing power or not, because everything did well in a low inflation cheap debt environment. When the cost of debt becomes higher and inflation rises, the environment becomes more strained for less competitive businesses. I think that suggests that active management across asset classes is something that plans should be thinking a bit more of.”
