The growing importance of inflation hedging in Asia

“Asian clients who genuinely have embedded inflation risk have a problem. They have very few options and coping with inflation risk is at the top of my list of concerns when I speak to clients,” says Peter Ryan-Kane, Towers Watson’s Head of Portfolio Advisory for the Asia-Pacific region.

 As he points out, the big trend of falling interest rates and falling inflation is something that everyone has got used to: “Many people have had their whole careers in only this environment. Most people only see a significant downward trend. But in the last two years, there has been a reversal of that trend. For entities with defined liabilities, it has been a wake-up call. Hong Kong pension funds, long term sovereign wealth funds etc have seen inflation move onto their radar screens.”

 Allianz Global Investors in a recent survey found that 67% of baby boomers across Hong Kong, Singapore, South Korea and Taiwan cite inflation as their greatest retirement concern with the fear of outliving their assets and the fear of the impact of poorly performing capital markets the chief concern for 35% and 31 percent respectively. Not surprisingly, the second batch of inflation-linked bonds issued in Hong Kong in June was oversubscribed by four times by 330,000 local residents.

 In a low interest rate environment, a low risk investment that tracks inflation is very appealing, but with the government issuing just HK$10bn ($1.3bn), its main effect may be to just educate the retail public on the attractions of inflation linked bonds as an asset class, rather than providing a major portfolio opportunity for institutional investors.

Rising inflation is a new phenomenon for many, says Ryan-Kane. “Over the last 30 years, we have seen extremely correlated inflation outcomes in every country on the planet, both developed and emerging. There has been a broad downward trend caused by a significant increase in global trade and the capacity to source things on a global basis.”

 Deepening disconnect

Post the financial crisis however, the deepening disconnect between the economies of the developed world and those of the emerging is resulting in very different outlooks for future inflation. While the developed world may be printing money through quantitative easing, and issuing unprecedented amounts of government debt, the paralysis of many economies means that capacity constraints are not an issue and excess capacity provides a dampener on inflationary pressures.

 Workers are struggling to maintain their jobs rather than being in a position to demand higher wages. Emerging Asia however, with much higher GDP growth even in a downturn, but with per capita income still much lower than the developed nations faces a different set of pressures. The Towers Watson stance, according to Ryan-Kane, is there will be a meaningful difference between inflation in the US and inflation in Asia going forward, so that the framework used over the last 30 years will be less effective. “In the US, there is substantial overcapacity and a process of deleveraging so there is little inflationary pressure. In Asia, it is running at capacity.”

 The nature of inflationary pressures in emerging Asia is very different from that faced by the developed world. Ryan-Kane points out a large proportion of Asian inflationary pressures are exogenous and in particular, rising food and energy prices. In lower income countries, much more of a family’s income is spent on food and energy so there is a very different spending basket to that seen in developed markets. There is less that you can do if you are facing a domestic market driven inflation cycle where assets are going to be priced accordingly. The ability to hedge against endogenous risk factors is limited.

 “Certain cures are a challenge, like looking for assets that move with inflation. Many traditional assets that are correlated to inflation are correlated to US dollar inflation. For example, commodities are priced in US dollars. There is not much index-linked debt in Asia so investors look to US index linked. Fund managers are pushing inflation hedges that are tied to the US dollar.”

 Managing inflation risk

How institutions should manage inflation risk depends very much on the actual nature of the risks the institutions face, which may actually be very different from those faced by their ultimate beneficiaries. This in itself creates fundamental issues which are often still barely addressed, if at all.

 As Ryan-Kane explains, corporate pension schemes have liabilities for the next 30 years. While liabilities may go up, they are protected somewhat as they are generally over funded. Moreover, in countries such as Korea, Hong Kong and China, the corporate pension schemes are only a small part of the balance sheet whereas in the UK, it can be the biggest component.

 Most Asian corporate pension schemes pay a cash lump sum on retirement. They are DB in that the benefits is prescribed as a function of years of service etc but it is paid as a lump sum and not as a guaranteed annuity. The state pension schemes in Malaysia, Thailand, Korea, Taiwan etc all have funds that are effectively DC. All these funds will return the investment earnings plus the contributions. So the inflation risks the schemes face is zero. Instead, all the inflation risk is faced by the beneficiaries.

 In theory, the investment should be structured to beat domestic inflation. For example, a Thai retiree dependent on a government pension fund should be concerned that the returns give CPI plus something. Across Asia, that is the critical problem. Individuals do not have the ability to hedge.

 Ryan-Kane sees two major issues that face the pension fund framework in many Asian schemes. Firstly if you are a beneficiary and feel that you are not inflation hedged there is not much that you can do about it; secondly, the fund is not accountable if it does not meet the objective of inflation hedging. “That framework worries me. The people most affected are not the people managing the fund.”

 Towers Watson itself attempts to tackle the issues in a number of ways. “We suggest that firstly, there should be a conversation that explores the issues. We’re having conversations with a sovereign wealth fund and a government minister to recognise the fundamental imbalance between the beneficiaries and the management of the fund. We find that it is not accountable. Secondly what kinds of asset strategies are most likely to be effective? What assets or groups of assets would do better in an inflationary environment?”

 Finding assets tied to domestic inflation should be a key objective and to that extent, a case can be made for “real domestic assets” such as equities and property. Allianz Global Investors in their survey found that inflation concerns are reflected in the choice of investment products that individuals consider suitable for retirement. Real estate, which is often regarded as being less affected by inflation, tops the list with 56% percent of mentions. Their preference for real estate is mirrored in another result of the survey. Of respondents, 97% own real estate for their personal use and around 20% for investment purposes. Other financial products considered suitable for retirement planning are deposit accounts (48%), life insurance (41%), fixed annuities and precious metals (31 and 30% respectively). Lifecycle and lifestyle funds rank far behind with 14% each.

 For institutional investors, real estate is attractive as it does have inflation hedging properties in the form of index-linking of rents and capital appreciation. But as Ryan-Kane finds, the challenge in Asia is to find institutional access to real estate as much of it is held by governments or by private investors. In contrast, in the US and the UK, the market has been disintermediated by REIT structures and others.

 Home country bias

Towers Watson finds the typical Asian institutional fund has a high local bias and so very exposed to the local market, particularly in markets where the producers are affected by inflation. Adding in infrastructure, real estate, long term equity holdings give long term real returns even if they can have short term volatility: “This can be a challenge when you deal with governments when ministers etc have short term horizons,” says Ryan-Kane.

 While equities are generally seen as an inflation hedge, Ryan-Kane argues this is not uniform. “Certain companies are price takers who will be hurt by inflation such as energy and food producers. In contrast, sectors such as telecoms and utilities can pass on higher inflation in the form of higher prices. In general, services are more inflation resilient and producers more inflation effected.”

 The home country bias can also distort the effectiveness of equities as an inflation hedge. “With equities, it is a chicken and egg situation. The home country bias in both bonds and equities is not necessarily due to a desire to hedge local inflation. Usually it is driven by the local regulatory environment. The assets and liabilities are aligned in local currencies, but not necessarily for well thought out reasons”.

One example of this may be the case of the Philippines where the Government Service Insurance System (GSIS) invested $1bn in global equities in 2008, outsourced to international fund managers, but more recently shifted back to 100% local assets. This was driven by the fact they had experience of international markets during a period when the return was lower than in domestic markets. Yet over the long term, it can be argued that the diversification and inflation hedging aspects of a more international equity portfolio would make it an attractive proposition.

 Towers Watson find the strength of the home country bias for debt portfolios among Asian institutions is a function of the historical real rates. Some countries such as Korea, India and Australia had real bond rates that were relatively high. Investors demanded this because of the currency, balance of payments etc. “These were irrelevant for domestic investors so they have done well” says Ryan-Kane, adding that in countries with balance of payments surpluses, it was the opposite. “Malaysia, Hong Kong and China are good examples of this. The real rates were negative in China. This was a function of monetary policy and interest rates managed to keep down the RMB.”

 Commodities

Towers Watson argue that commodities do offer a reasonable hedge as they are an input into inflation but care has to be taken on which commodities and the method of gaining access. “There is some interest in gold, some recognition that it is correlated to inflation. But is has the same issue of many inflation hedging assets representing dollar inflation rather than local inflation,” says Ryan-Kane.

 Towers Watson find that a lot of their clients have commodity exposure but, its effectiveness as an inflation hedge has been reduced over the last 4-5 years for a number of reasons. “Firstly in the case of oil, the relationship between spot and futures prices has changed. The huge contango in 2009 obliterated any other form of return and 2010 was not much healthier. The spot prices of commodities are very China driven. There is a disconnect with the futures prices; secondly there has been a huge fall in the returns form collateral. LIBOR is essentially zero and the credit constraints these days means that you have to have high quality collateral. So you have negative roll yields and collateral returns of zero, says Ryan-Kane. “Most people would say commodities are a reasonable hedge but not if you use futures to access it.”

 Gaining direct access to farmland and timber can also be worth exploring. “We like the idea of farmland but there are not so many ways of getting exposures except directly,” says Ryan-Kane. “The problem is that much of the returns experience has been due to an uplift in land value when it is in proximity to cities. When cornfields turn into cities, the land value increase dramatically.”

 Towers Watson is also keen on timber, although the return dynamics around timber are much more related to real growth than CPI. “It is driven around population growth and dwelling growth. With corn, you can plant more in response to demand. You can’t do that with timber if it takes 40 years to grow.”

 What is clear is that for Asian institutional investors, inflation-hedging assets of all types are going to be of increasing relevance.