APAC execs warn against complacency on inflation

Asset owners and analysts in the Asia-Pacific region are expecting an ephemeral spike in inflation this year but gatekeepers warn that the potential for longer-term challenges should be shaping asset allocation decisions.

While it's far from a certainty, "we're definitely acknowledging the heightened risk of inflation over the medium term and we're advising clients to think about positioning for that," said Andrew Zurawski, associate director in Willis Towers Watson's research team in Hong Kong.

In the wake of last year's unprecedented monetary and fiscal policy response to the pandemic, the prospect of central bankers falling behind the curve in controlling inflationary pressures is "a risk that we can't be complacent about," agreed Cameron Systermans, senior portfolio manager and head of mainstream investments, Japan with Mercer Investments (Japan) Ltd.

And if inflation looks set to gather momentum across the globe this year, it's U.S. numbers that will be top of mind. "Definitely, we see the main risk in the U.S.," with the passage of its huge fiscal stimulus package at the start of the year and the Federal Reserve making it clear "they're happy to let inflation be above target for a period of time," Mr. Zurawski said.

"That's why we've changed our position from 'no, we're in a deflationary environment,' prior to COVID, to 'you need to think about the risks of inflation and here are some asset classes that can provide some hedge against that risk,'" he said.

A number of asset owners in the region predict only a short-term jump in inflation numbers as lockdowns come to an end this year, unleashing a wave of consumption that should temporarily lift goods prices well above last year's pandemic-depressed levels.

In the second quarter, U.S. consumer prices or producer prices could be up 4% year on year, but that should prove very temporary, falling back to more normal levels of around 2% by early next year, said Dong Hun Jang, chief investment officer of the 16.4 trillion won ($14.5 billion) Public Officials Benefit Association, Seoul.

But with monetary and fiscal policy in unchartered territory over the past year, some observers see room for missteps.

In the past, the Fed would have boosted rates if it anticipated inflation, but now it's willing to allow periods of above-target inflation to make up for periods of below target results while adding new criteria such as ensuring a broad range of social groups are benefiting from stronger growth, Mr. Systermans noted.

"By the time you hit all of those preconditions, there's a risk…that inflation is well above their 2% target and as a result they could lose control," he said.

Even on a short-term basis, spiking inflation numbers could prove disruptive for investors that haven't seen U.S. inflation figures with anything but a 1 or a 2 in front of them for 40 years now, potentially altering relationships between asset classes that have prevailed for decades, Mercer's Mr. Systermans said.

In an inflationary environment driven by a vibrant global economy, analysts said equities, infrastructure, real estate and commodities would all offer some protection for institutional portfolios. Sovereign bond allocations, meanwhile, would remain the source of choice for funds to shift into those asset segments.

Willis Towers Watson is "pivoting" some of its portfolios to real-asset type investments — including infrastructure and real estate — "where there are interesting and sustainable cash flows — income effectively — that have a sensitivity to inflation," said Paul Colwell, the firm's Hong Kong-based senior director of investments and head of advisory portfolio group, Asia.

POBA's Mr. Jang said the prospect of even a short-term pick-up in inflation has left his team looking for opportunities to add floating-rate exposures, including private debt, while continuing to boost allocations to real estate and infrastructure.

Mr. Jang said 61.1% of his portfolio was allocated to alternatives as of the end of 2020, up from 54.6% the year before. He declined to break out numbers for real estate and infrastructure. Only 6.2% of the portfolio was parked in fixed income, down from 10.6% the year before.

In other areas, analysts say currency hedging could take on greater importance if the U.S. market's expected role as the epicenter of global inflationary pressures causes the dollar to depreciate, reflecting relatively stable prices in other markets, including China.

Meanwhile, rising prices wouldn't affect all countries or markets to the same degree.

Inflation is more of a local story than a global one and the implications for asset allocation or a domestic book of business could be considerably different for asset owners in Hong Kong, Australia, the U.S. or Europe, Mr. Colwell noted.

Superannuation funds in Australia, for example, with allocations to growth or risk assets of 65% or more would be in a better starting place to cope with rising inflationary pressures than institutional investors with higher allocations to sovereign bonds in the U.S. or Europe, said Philip Naylor, a principal consultant with Melbourne-based Frontier Advisors Pty Ltd.

There's been no change in strategy at LGIAsuper on account of the prevailing outlook for inflation, said Troy Rieck, chief investment officer of the A$13 billion ($10.1 billion), Brisbane-based super fund. Mr. Rieck says his team anticipates higher — potentially materially higher — inflation over a 12- to 18-month period but nothing that is likely to get out of hand over the longer term.

The plunge in sovereign bond yields to rock-bottom levels, meanwhile, has found asset owners around the world continuing to trim their exposures to that asset class, which would suffer the greatest losses should inflationary expectations worsen.

The NZ$54.1 billion ($38.7 billion) New Zealand Super Fund, guided by its reference portfolio targets of 80% global equities, 20% global fixed income, is already well-positioned to benefit in an economy growing strongly enough to throw off rising inflation numbers, noted Michael Frith, the fund's Auckland-based chief economist.

And New Zealand Super's strategic tilting program — which uses overlays to buy broad asset segments trading below its team's fair value estimates or to sell assets it sees as overvalued — has been underweight sovereign bonds for some time, he said. The fund's annual report for its fiscal year ended June 30 showed only a 7% allocation to fixed income.

Mr. Rieck said "given that cash rates and bonds yields are so low, and are likely to stay that way for some time, (LGIAsuper) has been pivoting into alternative sources of sustainable income, which includes many forms of debt and credit, as well as infrastructure and property assets."

"Direct hedges of inflation risk, such as inflation swaps, are now trading at high levels compared to their prices over the last five years, so we'd prefer to look for assets with either low duration risk (e.g., floating-rate credit) or assets with growing cash flows (e.g. infrastructure) as better ways to deal with that longer-term challenge," he added.

Japan, meanwhile — at the forefront of deflationary trends globally in recent decades due to the country's fast-aging demographic profile — has seen the least activity when it comes to preparing for a potential surge in inflation.

In January, Japan's consumer price index — which rose 0.6% year on year in February 2020 just as the pandemic was beginning to shut down economies globally — dropped 0.6% from the year before.

Mercer has been encouraging its clients in the region to review their portfolios with a view to making them more resilient to inflationary pressures, but with Japan's demographic trends probably 10 to 20 years ahead of other developed countries, there's considerable skepticism there that prices will begin a sustained rise, Mr. Systermans said.

Konosuke Kita, Tokyo-based director of consulting at Russell Investments, said Japanese people aren't worried — or perhaps "cannot imagine" — inflation returning anytime soon.

But with Russell's clients in Japan sporting an average allocation now of 25.8% to currency-hedged global fixed income, more than double their domestic fixed income holdings of 11.5%, they will find that they have to deal with the fallout on their portfolios should U.S. inflation push higher, he said.

New Zealand Super's Mr. Frith said while the possibility that inflationary pressures get out of hand is "absolutely the risk that everyone is going to be watching for," conceptually the more interesting conversation would be "what happens if you don't get inflation" in the face of all this stimulus?

That possibility would prompt economists to re-examine models that had simply stopped explaining what was going on, he said.

"For most investors, it's those structural changes that kill you, that wipe you out" — things that sometimes only become clear in hindsight, like the fact that Microsoft Inc. and Facebook Inc. are now central to our economy, Mr. Frith said.