Record inflation level prompts concern for treasury returns
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Photo by Paul Van Der Werf
Rising inflation threatens the returns on local authority treasury assets, according to experts in the wake of news that the UK’s consumer price index (CPI) had reached its highest level in four years.
The Bank of England said on Tuesday that inflation had reached 2.9%, more than the 2.7% economists were expecting.
David Green, strategic director with Arlingclose, said the rate was still within the Bank of England’s target bracket of one to three percent. But he also warned that local authorities with large sums still on deposit in banks would feel the effects of inflation.
“Short-term bank deposits provide no protection against inflation when the bank rate is so much lower than CPI.
“If you are holding onto the cash for a couple of months, that isn’t much of a problem.
“But many local authorities have sat on large piles of cash for many years, and will continue to do so, but are investing as if it will all be spent in the near term. That is when inflation really bites into the purchasing power of your cash.”
Bob Swarup, principal at Camdor Global Advisors, said inflation would affect both treasury management and pensions at local authorities: “Real returns fall and it becomes harder than ever to eke a return and, importantly, to meet funding gaps from these returns.”
Some councils have taken steps to mitigate the effects of inflation.
David Green said: “A small number of authorities have some inflation protection in their treasury portfolios by holding index-linked bonds, where the capital sum and income grow directly with inflation.
“More commonly, local authorities hold property investments (both direct and indirect through funds) where capital and income also rise over time.”
Bob Swarup said: “Assets are tough today. Index-linked gilts are very expensive and trading at negative yields, which is hard to stomach for investors.
“There are other index-linked securities, and another option is to seek out real assets as well as private assets. Some will have direct index linkages, while others are either correlated to inflation or have higher returns that provide more of a buffer.”
Other observers told Room151 that investments in assets like solar farms, such as those by Swindon and Warrington would also serve to help offset the effects of inflation.
However, there are concerns about the underlying advice and approach for treasury managers. One commentator expressed concern at the degree to which CIPFA’s treasury management code of practice demands a consideration of inflation risk.
A random sample of council TMSs revealed that some include reference to inflation in detail while others either ignore the subject or make only passing reference.
The treasury management code is currently under review with a fresh draft expected by the end of this year and in time for the 2018-19 financial year.
Neil Sellstrom, treasury management and pension adviser at CIPFA, said inflation was one of the key issues the review was considering. He had added that a section of the current code, drafted in 2011, requires treasury managers to set out their approach to key risks, among them inflation.
“The code is under consultation and that [inflation] is an area we are looking at. There’s likely to be a greater emphasis on explaining exposure to various risks, including inflation.”
Bob Swarup believes the underlying issue is the approach many councils take to risk. He said councils “focus far too much” on counterparty risk and ratings, despite the lessons of the Icelandic banking crisis. Ratings alone are not enough and fail to adapt fast enough to balance sheet problems in crisis situations, he said.
“A more holistic approach is needed where treasury management functions should analyse and rank all their risks, for example inflation and counterparts risks, understanding the impact, and then decide if and how they can be mitigated. That is real security because you are thinking about the downside beyond just ratings and defaults.
“That is of most benefit to the council as it leads to more secure outcomes and higher real returns, something that is increasingly important in today’s constrained environment where funding has also been falling and revenues are under pressure.”
