3% inflation confronts treasurers with investment strategy questions

News that CPI inflation has risen to 3% has sparked a debate about whether local authorities should start taking greater risks with their investments.

The official inflation rate ticked up slightly in September from the August reading of 2.9% to reach its highest level since 2012.

Experts have different opinions about whether the rise is just a blip or not, but authorities have been advised that they need to be aware of the risks a higher inflation environment could pose.

John Kelly, client investment director at investment manager CCLA, said: “From the local authority perspective, holding cash in this environment is resulting in a real and permanent loss of value.

“We expect to see more pressure to make resources work harder, which will mean increased allocations to those assets able to provide a reasonable initial level of income and then grow that income in the future as a means of both improving and protecting spending power.”

Mark Pickering, founding director at treasury adviser Arlingclose, said: “Inflation is the elephant in the room. If you are earning 0.5% on cash investments you’re doing reasonably well, but inflation is denuding the value of your portfolio by 2.5% a year.

“If we, as treasury advisers, sat in front of clients and said, ‘We’ve got a great investment strategy—invest in these banks and we guarantee you’re going to lose 2.5% through credit risk’, we would be laughed out of the room and expect to have our contract terminated.

“The inflation risk can be mitigated but this requires an appetite for risk substitution, education, and engagement with members if it’s to be successful in the long term.”

Timing

Authorities thinking of changing strategy need to ensure that they don’t leave decisions too late, according to Bob Swarup, principal at investment adviser Camdor Global.

“You want to think about pre-empting inflation up front while it is relatively cheap,” he said.

“Anything linked to inflation, people will buy it once inflation arrives, driving down the real yield. You don’t want to be behind the curve.”

However, some local authority treasurers believe it could be foolhardy to act before it is clear the inflation rise is not just a temporary phenomenon.

“I don’t personally think that a temporary uplift in CPI would be a reason to change investment strategy,” said Richard Paver, treasurer at Greater Manchester Combined Authority.

“Strategies should be aligned to the overall aims of balancing security, liquidity and yield and whilst different authorities take different views on the balance between these, the CPI results wouldn’t necessarily give rise to a need to change.”

Others, meanwhile, point out that inflation has been steadily rising for at least a year and believe that levels are unlikely to return to lows of recent years.

Kelly said this week’s inflation news, “is clearly an unwelcome headline but the pace of price increase has been rising for a year and probably has further to go before it peaks”.

He added: “Even then, when the effects of a weak currency drop out of the comparative data, it is unlikely that the rate will drop back much below 2.5%.”

Currently, CIPFA’s Treasury Management Code (TMC) recommends that councils adopt the statement: “This organisation regards a key objective of its treasury management activities to be the security of the principal sum it invests.”

However, some argue that the statement may need to be tweaked to make it fit-for-purpose in a high-inflation environment.

“CIPFA’s definition of capital preservation appears too narrow and we’ve always thought it should pay more attention to inflation risk,” said Pickering.

But CIPFA president Andy Burns, director of finance and resources for Staffordshire County Council, voiced caution.

“Although treasury management strategies tend not to be chasing yield, this approach could be challenged if inflation remains higher for longer,” he said.

“But the principles of security, liquidity and yield are still valid. I don’t think guidance needs to change—it is already clear.”

Income stream

Investment returns represent an increasingly important income stream for local authorities.

In 2016/17 in England they generated revenue of just over £1bn, compared with £660m in 2010/11, an increase of more than £300m.

In its response to CIPFA’s recent consultation on the TMC, the Local Government Association said: “It is therefore critical that that councils both retain the freedom to make appropriate investments and that the governance framework around this ensures that the public can be confident that they do so with due regard to accumulated risk, reward, prudence, sustainability and affordability.”

Swarup added: “Prudence is not a specific strategy. It is a call to arms to think harder about what you have got and planning for known and unknown unknowns. It doesn’t just mean sitting on what you have. If inflation is becoming a risk, it makes sense to think about the investment strategy and the borrowing needs.”

And he said that any higher inflation environment could fuel further the controversial trend by many councils to invest in property to generate returns.

“Councils investing in commercial property are buying a protection against inflation,” he said.

“Commercial rents are usually linked to inflation. But you need to do due diligence to understand the stability and sustainability of real returns, especially in the current macroeconomic environment.”

Separately, the RPI rate of inflation was up to 3.9% in September, meaning that this is the rate by which business rates will rise next year—almost double last year’s rise.

The chancellor is already under pressure from business groups to take action to protect businesses.

Helen Dickinson, British Retail Consortium chief executive, said: “Ministers mustn’t bury their heads in the sand. In his budget next month, the chancellor needs to get a grip on the matter and rule out a rise in business rates to help save shops, protect jobs, and preserve high streets.”

Last week it was reported that the government is planning to introduce a time limit for business rate appeals from April next year.

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