The only certainty is uncertainty

by Simon Cohen   •  
Blog

Inflation has been rising at the fastest rate in 30 years, currently at an eye watering 9% p.a. The Bank of England’s Monetary Policy Committee (MPC) expects inflation to peak towards the end of the year[1], as one-off increases in global energy prices and tradable goods have already been felt. In response, the MPC has begun to increase 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[2] to avoid stifling the economy and pushing us into a recession. The MPC forecast inflation falling to their 2% target in about two years’ time, but there is much uncertainty surrounding this estimate.

The real value of many assets is quickly eroded during periods of high inflation; if the MPC is unable to bring inflation under control this could have large consequences for investment markets. Under a moderately high inflationary environment, growth facing assets often fair the best, especially those assets with inflation linked cashflows, such as property, as rent typically increases with inflation.   Diversified, multi-asset portfolios can also fair well as investment managers can tilt their asset class exposures accordingly.  However, assets that simply maintain their nominal value or yield, such as cash and fixed yielding bonds, will see their real value fall over time. 

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. Whilst gilt yields are likely to increase, to help reduce sustained high inflation, this will act to reduce liabilities depending on the extent an interest rate hedging strategy is in place.

For schemes with hedging, assets 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 the recent sharp increase in inflation means the level of inflation hedging for many schemes has increased, as liabilities linked to inflation become more fixed as caps “bite”. It’s worth  ensuring you understand the hedging position of your scheme, especially following periods of significant change in inflation or yields.

Focus on the long term

We do not know what will happen next with the economy over the coming year. It’s a complicated, interrelated system that is inherently difficult to predict. You should continue to engage with your investment consultants to explain how your 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.

[1] 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)

[2] Over tightening is when rates are raised too much and/or too quickly in a way that limits economic activity.

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