SIMON MUMME: Which securities can you use to manage this interest rate risk? SUSAN BUCKLEY: You can use derivatives or cash. We favour derivatives, such as interest rate swaps or inflation swaps, because they’re very liquid and you can target particular parts of the curve. The conversation turned to holistic approaches to managing inflation risk by employing assets other than fixed income instruments. GERARD PARLEVLIET: People used to say equities were a good inflation hedge, but the longer term numbers will show you it’s not necessarily so. Why aren’t they? Because it really comes back to pricing power, doesn’t it? If there’s inflation and the company’s got pricing power, then it’s okay in an inflationary environment. If it doesn’t have pricing power, the margin’s getting eroded away. So I’m wondering whether people should be thinking: when we talk about active approaches to fighting inflation, how do you target it actively among everything you invest in, not just on the bonds side? SIMON MUMME: Until the financial crisis, the investment environment was relatively benign but super funds still haven’t been able to meet their CPI-linked liabilities. With all the inflation defences that investors have at their disposal – from infrastructure linked to rising revenue streams like hospitals or toll roads, to equities, commodities, inflation-linked bonds – why haven’ t those liabilities been met? GERARD PARLEVLIET: Because they’ve had one major bet in the portfolio, and that’s been equity-directional. Everyone went on this equity binge, they didn’t target equities that were going to protect for inflation, they just said, ‘let’s have this,’ and if the equity markets performed strongly, you got this great return, and if they performed poorly, you didn’t meet it. SEAN HENAGHAN: I think it’s a little more subtle than that, actually. I think it was the leverage that crept into every asset class that created the problem.
GRAEME HARMAN: Just think about the maths. Let’s say you’ve got a toll road worth $100 and it’s totally leveraged and earning $5 of toll road toll payments and then inflation comes, and it’s indexed, so you get $5.50 next year. Meanwhile, if the 5 per cent you’re paying on your interest has gone to 10 per cent because inflation is suddenly 5 per cent instead of zero, the arithmetic doesn’t work, no matter how much the toll road’s used and how much the tolls are CPI-linked. SEAN HENAGHAN: If the world can de-leverage ahead of inflation becoming a problem, it becomes more manageable. DON RUSSELL: Fortunately, my task is to achieve 4.5 per cent real returns over 10 years. But the duration of most chairmen tends to be less than 10. If we start skewing our approach to take account of short run views about inflation in isolation, I suspect we end up doing a disservice to our objective and to our members. It’s just one factor that you need to build in while you try and achieve these longer run targets. KRISTIAN FOK: If you look at alternative investments that you might want to use for protection, to some degree the effectiveness of them really depends on the Government’s response to inflation. So you can put in a very long-term, cash flow-oriented investment – like an infrastructure asset, for instance, with 20-plus years of cash flow. Now, if the Government’s response is to actually raise interest rates, then that infrastructure asset’s going to be very adversely affected in terms of valuations. If the Government concludes there’s a high sensitivity to interest rates because so many people have mortgages, and decides to pull back on government spending, then that’s a very different sort of argument in terms of the worth of that asset. So it is a very difficult task to try and futureproof a portfolio purely on inflation grounds. The conversation turned to other potential weapons against inflation.
