Dr Mark Sniderman, Federal Reserve Bank of Cleveland, on QE & Inflation Hedging

February 11, 2013 in Pensions by Jessica

Source: Fundamentals

“When we look back on these QE programs we will conclude that above all else the implementation of these initiatives prevented a much more severe economic recession than the one that actually occurred in the U.S”

New York; Despite signs of economic growth institutional investors must remain sensitive to inflationary threats. Monetary policies have prevented an exponential growth rate yet the unpredictability of inflation means that flight plans must be made sensitive to the latest hedging strategies. Yet to what extent should U.S and Canadian pension plans hedge within their asset allocation?
As the market seeks to vary portfolios and safeguard investments one must consider the optimum inflation rate. Is it possible that the North American economy can create the economic ideal: low inflation but high domestic growth? According to The Federal Open Market Committee, a 2% inflation rate over the longer term is most consistent with good economic performance, but such a rate is not guaranteed.
The Inflation Hedging & Real Return, North America report, published by Clear Path Analysis, draws together chief investment officers and chief risk officers to discuss their inflation directed contingency plans and prepare for the unexpected during negative yields and potential inflation spikes.
According to Dr Mark Sniderman, Executive Vice President and Chief Policy Officer, Federal Reserve Bank of Cleveland, whilst the onus is on hyperinflation the impact of deflation must not be overlooked. Fortunately since 2008, “quantitative easing programs prevented the worst damage during this recent Great Recession” but can such measures continue to protect balance sheets?
In an insightful white paper, Allan Levin, Head of Inflation and Fixed Income Index Trading, North America, Deutsche Bank, discusses how pension plans can benefit from structural biases in the U.S market. He argues that “The need for inflation protection is universal – and arguably even greater for under-funded pension obligations.”
Levin, cites the following example; “assuming a pension plan is 25% under-funded, 133% of the asset portfolio would need inflation protection”, this of course being to offset the impact of inflation on the plan’s liabilities.
In doing so Levin cites consumer price index (CPI) linked instruments as one of these ultimate risk mitigations tools that can simultaneously be used as the proxy hedge for the Canadian market. In that; “inflation swaps typically imply higher levels of CPI by about 0.2%-0.4% per annum.”

In a separate paper Yigal Jhirad, Senior Vice President & Portfolio Manager, Cohen & Steers Capital Management, deals exclusively with the defined contribution (DC) plan approach to real asset diversification as a form of inflation protection.
Regarding their “100 Real Asset Blend” Jhirad illustrates that: “returns to the left represent a traditional portfolio allocation (60% stocks and 40% bonds). To the right we assume a 20% allocation to the real assets blend {..} with the remainder allocated 40% to stocks and 40% to bonds. The portfolio that included the real assets blend produced higher returns, with lower standard deviation.”
Donald Lindsey, Chief Investment Officer, Washington University Endowment Fund, is interviewed exclusively on the role of inflation-linked assets in the modern allocation plan. He states that in order to mitigate the impact of episodic inflation, you have to focus heavily on the implementation of such inflation-linked instruments as “just looking for generic exposure to commodities may turn out to be a very poor inflation hedge.”
According to Stephen Choi, Portfolio Manager and Director ALM, Derivatives and Fixed Income, Healthcare of Ontario Pension Plan, “With the recent downgrade of the 2013 economic growth outlook by Bank of Canada from 2.3% to 2%, I expect inflation will be a touch lower than 2%.”
So what implications does this have on Canadian flight paths? In debating asset diversification against concentration, Choi sees no clear cut but states that in: “our multi asset class investment portfolio demonstrates the application of diversification but within each asset class you will see some degree of concentration.”
Ultimately this pension plan has devised an asset blend with the appropriate inflation-linked tools to warrant that: “we don’t actually need a huge return just somewhere in the region of 6.5% will allow us to fund the plan.”