Bob Swarup: The corrosive impact of inflation 

Inflation has hit its highest level in four years. Bob Swarup argues that the news should prompt a rethink and better analysis to see “whether inflation risk might be mitigated through prudent consideration of the investment strategy and whether borrowing strategies could be optimised to mitigate funding pressures. “

Yesterday’s bullet won’t kill you. Tomorrow’s bullet just might.
Bernie Provan

Inflation is the saviour of central bankers and debtors, as it gradually devalues and destroys their debt burdens. But for savers and institutions, especially those with funding needs and liabilities, it can be a scourge – a corrosive curse in a low yield environment that shrinks their asset pools in real terms whilst accentuating their funding needs.

For the last decade, councils and treasuries have suffered greatly at the hands of austerity and low yields. As funding has declined, their investment returns have also slowed to a trickle. But despite the hand-wringing over optimising treasury yields and returns from other investment pools on or linked to the balance sheet, real returns have not been a topic of discussion.

Part of this likely is the deflationary environment that dominated much of the aftermath of the last financial crisis.  But part of it also is the lasting psychological impact of those years on the risk culture of councils, which has meant that their treasuries and investment pools are far too focused on yesterday’s problems and not tomorrow’s challenges. In their search for security, they forgot about the baby elephant in the room and it is rapidly growing through adolescence today.

A resurgent threat

In May 2017, inflation in the UK hit 2.9% — the highest in almost four years. Since flirting with zero throughout 2015, it began to rise steadily since and has accelerated since mid 2016.

Figure 1: Inflation in the UK over the last 5 years (Source: ONS, Tradingeconomics.com)

Brexit has played a clear role, as the fall in the value of the pound sterling led to more expensive imports and contributed to inflation. But other inflationary pressures are also building, notably the growing anger across society at low or stagnant wages and the impact of austerity, as exhibited starkly at the last election.

But it is also a double-edged sword. In more normal times, one might expect the Bank of England to raise interest rates to compensate but that has not been the case this time round. The economic uncertainty of the next two years, coupled with a fragile recovery and the political deadlock in parliament today, has meant that the Old Lady of Threadneedle’s focus is on nurturing growth, not sticking to her inflation target of 2%.

The result is not just dovishness today, but lower for far longer. This is brutally highlighted by the index-linked gilt curve, which is now below -1.5% for the nearly the next half-century.

Figure 2: UK index-linked gilt yields across the whole maturity curve (Source: Camdor Global Advisors). 

In other words, investors today expect a negative return in real terms for not just the foreseeable future but long into the future as well. Of all the challenges that treasuries face, this headwind to making money is by far the greatest one.

A holistic problem

But it is also a problem for the wider council balance sheet, making it important to both understand their impact holistically and thereafter to have a clear strategy to mitigate them. Consider the diverse impacts:

• Many councils have significant capital programmes
  • These will increase in cost in the event of any rise in (construction and cost) inflation.
  • Were any of this added cost to be borrowed, that would lead to further borrowing and revenue costs.
• Most councils also have added exposure to their pension schemes
  • Though these are separate legal entities, councils have funding plans that represent a long-term demand on revenues, and have a responsibility to make up any deficit.
  • Public sector pension liabilities are of long duration and index-linked to CPI with no upper limit, thus would increase dramatically in line with rising inflation. In contrast, the pension fund assets rarely have direct inflation exposure and are of shorter durations, so are highly unlikely to increase by as much.
  • Indeed, for the majority of local government pension schemes, any increase in inflation above the assumptions embedded in their liabilities leads to an increased deficit and decreased funding position. This is typically anywhere from 5-8% for a 0.5% increase in inflation.
  • That increases pressure on the council’s funding plans, as it directly impacts the journey plan. Either the path stretches out longer in time, or the council has to make larger contributions. That is an added drain on revenues, and lest it be forgotten, an added funding cost beyond just the contributions paid across.
• Treasury portfolios and other investment pools typically do not take inflation into account
  • Within their treasury portfolios, councils have myopically focused on counterparty risk and credit ratings, rather than wider risks such as inflation.
  • Therefore, most assets held with treasury portfolios have high credit ratings but low yields, well below 1.5% – the approximate threshold for real yields to turn positive today. Only a small minority are directly index-linked.
  • While other investment pools such as property have link to inflation, both historically and through rent levels, for example, this is not an explicit focus within the investment strategy.
  • An inflationary environment may also encompass growth risks, in which case forward looking returns would decline, impacting revenue budgets and assumed pension returns.
• Other revenue impacts, e.g. wage inflation, which will impact both the cost base of the council as well the contributions made into pension funds.

Caveat investor

The above highlights starkly the threats lurking amongst the balance sheet of the council today thanks to inflation. On the whole, council assets are unlikely to keep apace with inflation as they are structured today.

The overwhelming conclusion is the need for councils to examine their balance sheet holistically, given the risks that can hide amongst different facets. Even if small in isolation, in aggregate, they can be large and potentially crippling. In the absence of analysis and action, councils risk facing further funding pressures thanks to the vagaries of the economy, rather than policy,

To manage these risks, it is important to councils to rethink their approach to risk management and their approach to investments. True security extends past just counterparty risk to understanding the impact of other risks that might also cause catastrophic losses. By examining these across the whole balance sheet, one can consider whether there is any compensatory return to be derived from the asset portfolio that might mitigate some part of these risks, whether inflation risk might be mitigated through prudent consideration of the investment strategy and whether borrowing strategies could be optimised to mitigate funding pressures.

A holistic framework that examines all the investment pools together and sets them against revenue and capital budgets is needed.

Otherwise, in the absence of thought, we risk looking forever backwards only to miss the pitfalls ahead.

Dr Bob Swarup is Principal at Camdor Global Advisors, a macroeconomic, investment and risk advisory firm focused on helping local authorities innovate to meet today’s unique challenges. He may be contacted at swarup@camdorglobal.com.