(November 8, 2012) – Investors, institutional and otherwise, have not recalibrated their inflation hedging strategies to a post-2008 economy, and one French researcher believes it’s about time they did.
“Considering the overwhelming debt overhang problem which looms over most sovereign issuers from industrialized countries, it is becoming increasingly clear that inflations will eventually be the last available weapon left in the state’s arsenal to fight bulging balance-sheets,” argues Nicolas Fulli-Lemaire in a whitepaper. He holds a PhD in economics, and is a research analyst at Amundi, the subsidiary asset management firm for Société Générale and Crédit Agricole.
“In truth, there is no silver bullet: inflation is solely linked to explicitly inflation-linked securities such as linked bonds or swaps,” Full-Lemaire writes. “All other asset classes have only time-varying hedging capabilities and therefore offer limited protection.”
Inflation volatility is higher now than it has been previously, and interest rates lower, making the conventional strategy of inflation-indexed bonds less appealing. Furthermore, Fulli-Lemaire notes that high demand for the small number of linked bonds available in the European marketplace puts a premium on the debt, even as long-term real interest rates have dipped under 0%.
For investors with sufficiently long time horizons, which institutional funds typically have, Fulli-Lemaire advises hedging against core inflation, as opposed to headline. “The obvious pitfall of this methodology is that to this date, no core inflation-linked asset exists,” the author points out. A pitfall, indeed.
However, Fulli-Lemaire does propose a solution for the long-term investors looking to cushion against inflation: a new derivative.
“To make-up for the lack of an investable asset, we could go forward by imagining a core versus headline inflation swap that would see long-term players receive a fixed rate for the spread between headline and core inflation and short-term players be on the other end of the trade.”
Full-Lemaire is one of a number of finance/economics experts engaged with the inflation hedging question. As Quantitative Easing has become a household term, research into hedging tactics has also spiked.
An article in the Journal of Alternative Investments detailed a robust study of infrastructure and inflation, and found the former did not live up to its reputation as a solid hedge. In fact, “infrastructure overall as well as its subsectors telecommunication, transport, and utilities hedge inflation neither particularly well nor any better than equities,” write authors Maximilian Rödel and Cristoph Rothballer of the Technische Universität München, Germany. “Only portfolios of infrastructure firms with high pricing power exhibit a slightly superior (yet not statistically significant) hedging quality at a five-year investment horizon.” Consequently, investors should “depart from the belief that infrastructure generally provides a natural hedge,” Rödel and Rothballer conclude.
Read Full-Lemaire’s full paper, “Alternative Inflation Hedging Portfolio Strategies: Going Forward under Immoderate Macroeconomics,” here.