Kames Capital: How pension funds should react to the news of deflation

Following the news that the UK Consumer Prices Index (CPI) fell to -0.1% in September, Peter Ball, director of institutional business, and Colin Dryburgh, multi-asset manager at Kames Capital, look at how pension funds should react to the news of deflation, especially as this follows a period of very low inflation.
 
 
Kames director of institutional business Peter Ball says: “UK pension plans have long term strategic holdings in UK index linked gilts.  We would argue they could get better value elsewhere to enhance returns but will they really move away from such strategic holdings?
“Where pension plans invest in more flexible products like strategic or absolute return bonds or even some DGFs, they should question their managers about any UK IL holdings.”
 
Kames Capital multi-asset manager Colin Dryburgh says: “The recent collapse in commodity prices has been the principal factor driving global inflation lower.  Oil prices have more than halved since the middle of last year.
 
“Core inflation measures (i.e. ex food and energy) have also declined but it is difficult to estimate the impact of lower commodity prices on core goods inflation.  Virtually every good that we purchase has an energy component in its cost structure. What many have overlooked is that measures of services inflation in both the UK and US have held up during the recent headline inflation deflation decline and are currently running at around 2.5%.  (Despite today’s generally weak inflation data, UK services inflation actually increased during the month.) ‘Services, rather than goods, tend to be the largest sector of developed economies and services inflation should better represent domestic inflation pressures because developed economies import many of the goods which they consume.
 
“Despite the recent collapse in the oil price it is currently trading at a level which is similar to where it was at the start of the year.  Unless oil prices dramatically collapse again then one should expect the deflationary energy and commodity impact on year-on-year rates of inflation to ease in the coming months.
 
“As an aside, should deflationary pressures escalate from here then policy makers would ultimately react with expansionary fiscal policy and sooner or later inflation would take hold.  In this scenario the risk is that policy makers do too much and that in years to come we are then worrying about too much inflation rather than too much deflation. Therefore now is not the time to alter ones portfolio to position for full blown deflation. Investors in inflation-linked bonds should look to the US as a source of longer-term inflation protection.  Longer-dated US Treasury Inflation Protected Securities (TIPS) have performed poorly this year and now offer real yields which are high relative to their recent history.  By contrast, longer-dated UK inflation linked bonds have performed relatively well this year.  The spread between the real yield on US TIPS and UK index-linked gilts is currently at historic highs of almost 2%*.  (As recently as 2012 the spread was almost zero.) One should not throw the towel in on inflation protection strategies but one should seek the best value available and the US is currently the place to go for that. We have recently altered the asset allocation in our Diversified Growth Fund to reflect our preference for US TIPS.”
 
 
*UK index-linked gilts use the RPI measure of inflation which tends to be slightly higher than CPI.  On a like-for-like basis it is reasonable to assume that the yield spread is in excess of 1%.