Consultants Respond to Worries Over Sovereign Debt and Inflation

(February 17, 2011) — Top officials from the Group of 20 industrialized and developing nations have agreed to compile a set of indicators to limit global economic imbalances and better coordinate economic policies, the Wall Street Journal has reported.

Finance ministers of G-20 countries are set to meet in Paris this Friday and Saturday to discuss euro-zone debt crisis, currency policy, financial regulation, and improved economic coordination, vowing “coordinated policy action” to ensure “sustainable and balanced growth.”

“Sovereign risk is not just about Europe,” Cynthia Steer, managing director of investment strategy at Russell Investments, told aiCIO last month. “It’s about differentiating between countries and trying to understand the unique circumstances of countries, and about how they’re evolving in the monetary trilemma,” she noted, describing the trilemma as the confluence of stable exchange rates, capital controls and freely-set interest rates. “One can get two out of three, but rarely three,” she added.

“It’s profound, it’s going to continue, and it’s going to impact everything we do,” she said, going on to note that “For the first time in my years as an institutional investor, portfolios are going to have to understand inflation and deflation and live with that within the framework simultaneously.” In order to do this, she explained, institutional investors need to examine their portfolios within different risk parameters, looking at their sensitivity to inflation and deflation.

According to Steer, institutional investors are living in a new global economy that has evolved from an era of asset allocation to an era of country-focused risk. “It’s no longer just about the north or south,” she said. “It’s about which country has the better reserves, better balances, and ability to absorb capital flows, and deal with the monetary policy trilemma.”

David Ritter, Senior Vice President of LCG Associates, an Atlanta-based investment consulting firm, noted that the sovereign debt crisis and volatility have created an opportunity for skilled active fixed-income managers. “We’ve told our clients to review their current fixed-income allocations, recommending they become less focused on a benchmark,” he told aiCIO. “If you look at an overall diversified portfolio, fixed-income still tends to be less volatile than equities, so looking at unconstrained fixed-income strategies makes the most sense, giving managers the most ability to add value.”

Ritter noted that while emerging markets have been particularly susceptible to inflation and modestly increasing interest rates, domestic rates are at one of their lowest points. “With continued overall aggregate demand and supply imbalances and low credit growth, I don’t think inflation will be a big issue in the US in the short term.”