Transcript LASERS Asset Allocation Follow Up

San Jose Police & Fire Department Retirement Plan
Inflation Linked Assets
September 15, 2009
Allan Martin
Partner
Carolyn Smith
Partner
Edward J. O’Donnell III, CFA
Consultant
NEPC, LLC
One Main Street, Cambridge, MA 02142
Tel: 617-374-1300 Fax: 617-374-1313
www.nepc.com
CAMBRIDGE I CHARLOTTE I DETROIT
LAS VEGAS I SAN FRANCISCO
Registered Investment Advisors
What are Inflation Linked Assets?
• Assets that have intrinsic value; investors value their inherent
utility
– This value is less eroded by inflation (unlike paper assets)
• Inflation-sensitive equities: Real Estate, Infrastructure, Energy,
Agribusiness
• Commodities
• Inflation-linked bonds (e.g. TIPS)
• Timber
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Why Invest in Inflation Linked Assets?
• Many hard assets offer real after-inflation return and valuation
protection; better inflation-hedge than financial assets
– Help protect purchasing power
• Diversification – Inflation Linked Assets have low correlations…
– To traditional asset classes and are counter-cyclical (rise when many others fall);
– Among one another; and
– Which lowers overall portfolio volatility, providing higher risk-adjusted return
• Important consideration for client portfolios, many are underexposed
– Liabilities are sensitive to rising inflation
• Inflation can be the highest risk portfolios face
– Inflation Linked Assets provide portfolios insurance against inflation
– Inflation insurance is currently cheap
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Why Invest in Inflation Linked Assets Now?
• Can accomplish long-term strategic objectives while taking
advantage of current pricing opportunity
– Access long-term inflation protection and diversification benefits as part of
strategic allocation
– Current short-term, low inflation (or deflationary) expectations run counter to
long-term inflationary pressures facing U.S. and global economy
2.50%
Average Monthly Returns
GSCI Index Grow th
600
500
Portfolio Value
2.00%
1.50%
1.00%
0.50%
400
300
200
100
4
Jan08
Jan07
Jan06
Jan05
Jan04
10 Yr Treasury
Jan03
S&P 500
Jan02
Falling Inflation
GSCI
Jan01
Jan99
Rising Inflation
Jan00
0
0.00%
Inflation-Sensitive Assets – Currently Cheap
• Near term - Low inflation likely
– Weak overall economic demand
– Strong dollar in “flight to safety”
– TIPS pricing in very low 5-10
year inflation expectations
– Commodities pricing reflects low
expected economic growth
• Medium term - Inflation could
rear its ugly head
– Stimulus expands money supply
– Increased government
borrowing will put pressure on
the Dollar
– Commodities prices to rise on
growing economic activity
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Strategic Allocation Considerations & Risks
• How much Inflation Linked exposure is currently in the Fund?
– Initial decomposition (strategic vs. tactical)
• What are the liquidity needs and time horizon?
– TIPS are most liquid; Timber least
– Distinguish between public & private markets
– Complement public with private strategies; core and opportunistic
• Potential Risks
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Volatility of individual investments
Macroeconomic trends and cyclicality
Low correlation and market timing
Improper benchmarking
Cash collateral
Manager-specific risks: selection is key
Auditors’ concerns; AICPA and SFAS 157
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Summary & Takeaways
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Inflation can be the highest risk portfolios face
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Liabilities are sensitive to rising inflation
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Inflation Linked Assets provide insurance against inflation
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Employee wage and salary increases; cost of living adjustments for retirees
Inflation insurance is currently cheap
Diversification
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Balance liquid core investments with less liquid satellite investments
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Highly Liquid Exposure
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Less liquid exposure
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Infrastructure
Timber
Benchmarking can be challenging
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TIPS
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Strategic or tactical allocation
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Included in inflation linked assets or fixed income allocation
Commodities
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Long Only as well as Long/Short manager
Consider creating a “inflation linked assets” category, which would include real estate, commodities, TIPS,
infrastructure, timber
Each individual strategy would have its own return and risk expectations along with its own benchmark
Include allocation to Inflation Linked Assets in future asset allocation
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TIPS
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TIPS
• Treasury Inflation-Protected Securities
– Designed to protect investor purchasing power from rising inflation
– Guarantee investors a real rate of return when held to maturity rather than a
nominal one
• Structured with fixed coupon rate set at the time of original issuance
– Represents the real rate of return required by investors at that time
– Bond’s principal is adjusted upward based on changes to CPI
– With fixed coupon rate applied to the growing principal balance, interest payments
rise with inflation
– Never adjusted below Original Face
• TIPS are the most direct and pure inflation hedge
– Cheap, safe, liquid means of inflation protection
– More easily understood by clients than many other inflation-hedge assets
– Risks
– Interest rate paid is lower than equivalent treasuries
– Lowest expected return among inflation linked assets. The higher your benchmark
for inflation linked assets, the less you can rely on TIPS to meet your objectives.
– Interest rate paid is lower than equivalent treasuries
– Deflation: if U.S. economy suffers from deflation, these securities won’t be useful
– Marketability – not as easy to trade on the open market as non-indexed treasuries.
– CPI Calculation - Many Economists, including Greenspan, feel CPI is overstated. If
the government decides to switch to another inflation measure, then the CPI
adjustment won't be as valuable.
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TIPS – Current Outlook
• Very popular; demand continues to rise despite current low yield (1.3%)
– Investors willing to give up yield in exchange for protection
• Best performing asset class in late 2007
– Flight to quality during credit crunch and uncertainty favored Treasuries
– Rising expectations for future inflation favored TIPS even further
• Now working when other assets are not; a strategic asset worth having
– US real rates at the short end are negative. Flight to quality and rise in oil
prices has been dramatic and good for the TIPS. While US rates have led the
pack, rates in foreign markets are still relatively high.
• Core inflation rose from its y/y low of 2.1% last summer to 2.5% in
January, and latest core report was slightly slower based on discounting
in retail activities and auto rebates, offsetting higher shelter costs as
rents rise.
– To the extent that businesses have been able to pass along their higher
costs, however, this estimate could be too low.
– Fed is counting on core inflation remaining low so that they can keep easing
to relieve distress in the financial system, and avoid stagflation.
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TIPS and Implied Inflation
TIPS implied inflation breakevens (Treasury yield – TIPS Yield) from the smoothed series that the
Federal Reserve puts out
Breakevens today are still below peak levels reached in 2005 and 2006
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Commodities
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Commodities: How They Work
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Three drivers of commodity returns
– Spot price
– Roll Yield
– Collateral Yield
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Spot price: supply and demand
– Supply shocks: real and perceived. Depends upon where you are in the supply chain.
OPEC, Copper strikes in Peru, and green energy on Uranium.
– Demand elasticity: at what price of gasoline would you take the bus or buy a Prius?
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Collateral Yield: rising tide floats all boats
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Majority of commodity exposure gained via derivatives, especially futures
Investors maintain margin at broker for futures collateral; typically T-Bills
Rising inflation pushes nominal yields higher, enhances commodity returns
LIBOR is cost of financing; many commodity approaches actively manage the
collateral in a LIBOR strategy to offset these costs
Roll Yield: Backwardation & Contango
– Backwardation: upward sloping reinvestment curve; negative roll yield
• Headwind to rolling-forward contracts & maintaining exposure
– Contango: downward sloping reinvestment curve; positive roll yield
• Tailwind to rolling-forward contracts & maintaining exposure
– Passive investment experiences these & is powerless; only holds near-term issues
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Benefits of Commodities Investing
• Implementation is simple, inexpensive, and liquid
• Commodities are a strong portfolio diversifier
– Returns are negatively correlated with equity and bonds; asset
class return drivers are very different
– Reduce overall portfolio risk
– Correlation of returns among commodity sectors is also low
– High 0.24 industrial to precious metals; low 0.07 metals to agriculture
– Commodity returns are positively correlated with inflation
– Especially when unanticipated (e.g. supply shocks)
– Provide protection & diversification when needed most
– Headwinds to equities & bonds are tailwinds to commodities
Correlations
Equities
Bonds
GSCI ER Index
-0.20
-0.36
DJ-AIG ER Index
-0.19
-0.10
14 years ended December 31, 2004
(1.0 is perfectly positively correlated, -1.0 is perfectly negatively correlated)
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Commodities: Major Sectors
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Energy
Metals—industrial and precious
Agriculture—hards, softs, and livestock
Low correlation among and within sectors
– Diversification benefit can dampen volatility if actively managed
– Yet some inter-dependence—e.g. energy costs & aluminum
production
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GSCI and DJAIG Commodity Index Sector Components
Source: Commonfund
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Inflation
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Inflation Point/Counterpoint: The US Fed
Inflation Will Rise
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Inflation Will Fall
Printing money: Fed is increasing the monetary base to
fund various stimulus packages; greater money supply
makes the USD worth less. The “soft landing” is likely
impossible – policy makers face a fielder’s choice
between high unemployment and high inflation.
Stimulus policy: current fiscal and monetary policy are
geared towards spurring economic growth out of
recession, not towards containing inflation
Risky assets: Fed has more higher-risk assets on its
balance sheet than ever before (e.g. significant ownership
in faltering banks, auto, mortgage, health-care, and
insurance companies). This potentially alters the yield
investors require for holding US Treasuries. It also
undermines investor confidence in the US.
Underfunded liabilities:
Social Security, Medicaid,
Medicare, PBGC, and Military Benefits to name a few
There is growing unease with regard to CPI as a viable
inflation measure and TIPS as an effective inflation hedge
The Bernanke buffet: the smorgasbord of measures
offered up by the Fed (e.g. quantitative easing; buying up
investment banks and mortgages) is difficult to take
away, once corporations and consumers get used to it.
Stopping the stimulus party could prove to be a
politically unpopular move.
Bernanke has not learned the lessons of 1990s Japan, and
is walking the US down the same sorry path
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The Fed is competent. It will control money supply
appropriately, by withdrawing reserves at the
appropriate time; not too slowly (causing higher
inflation) nor too quickly (stunting recovery and
leading to deflation) i.e. it will stick the soft landing.
The Fed is aware of the exit problem. It will start the
process of exiting excess supply when the economy is
below full employment and inflation is below the (2%)
target. If the Fed misses the bulls-eye, we may see
inflation greater than the 2% target--say 3 or 4%, but
not hyper-inflation.
Excess reserves on bank balance sheets will lead to
credit expansion; greater velocity of capital will reduce
the need for greater supply
Market measures of inflation (e.g. CPI) and forecasts
for inflation (e.g. TIPS implied inflation) both speak to
a very low-to-moderate inflation environment going
forward
Bernanke savant: Ben is an astute scholar of the great
depression, one who is determined to avoid repeating
its policy mistakes
Inflation Point/Counterpoint: Other Central Banks
Inflation Will Rise
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Russian and Chinese bankers are suggesting a new
global reserve currency through IMF SDRs or a
market-basket, possibly including gold
China is likely to continue selling US Treasuries, or at a
minimum, temper future purchases; increasing price
pressure and USD supply.
Asian central banks diversifying away from US
Treasuries
China is on a commodity buying spree.
China
continues to diversify its portfolio away from being a
major currency manager to owning and operating
inflation linked assets (e.g. buying up oil fields and
copper mines) as well as focusing on encouraging
domestic consumption.
Inflation Will Fall
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IMF forced selling of gold will help maintain value of
all fiat currencies is competent.
Inflation Point/Counterpoint: The US Dollar
Inflation Will Rise
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US dollar is likely to resume its long-term secular
decline in value.
We are in unchartered waters relative to Europe and
Japan with our bank nationalizations, auto buyouts
and national healthcare - hard to say we are any
different.
The current dollar rally is being buoyed by a "flight to
quality", a misnomer if there ever was one
All signs point to a US dollar that is less attractive to
global investors:
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Inflation Will Fall
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Fed funds rate near 0%
Unemployment near 10%;
Negative to low GDP growth
High % of GDP in debt
Explosion of risky assets on Fed balance sheet
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Emerging markets' debt is becoming more local in
nature, and less USD-based.
Emerging markets
balance sheets are strong relative to their developed
world counterparts; emerging markets have gone from
being borrowers to lenders.
China is definitely trying to decouple from US
consumer dependence and move towards a mixed
consumer/export economy
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Currency is a relative value game; US is looking better
able to recover from this crisis than most developed
nations
If Treasury yields rise, USD will become more
attractive
Lower USD value also makes US goods cheaper stimulating exports (and economic growth), if USD
declines more rapidly than other currencies. Demand
for USD will rise, elevating currency value to new price
point equilibrium.
Much of emerging markets' debt is USD-based; they
are not likely to repatriate this any time soon
China and US are in symbiosis with regards to
borrowing and lending; we need each other to grow
our economies
Inflation Point/Counterpoint: Commodities
Inflation Will Rise
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If global stimulus packages are successful, they will
ultimately lead to greater demand for natural
resources; after a period of lower global inventories,
higher commodity prices are sure to come…
Supply destruction:
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Global inventories are lower
Lower commodity prices are causing significant costcutting measures—e.g. Capex is down significantly
Global supplies are insufficient to meet long-term
population growth and industrialization needs
The current state of supply destruction is setting up the
next, inevitable commodity price rally
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Demand: long-term, sustainable demand for global
natural resources is likely to improve as credit markets
recover, lending standards widen, and companies
begin to spend and produce more materials. Emerging
markets are undergoing an industrial revolution and
rapid urbanization; these powerful forces move global
demand for natural resources.
Dollar effect on commodity prices:
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Inflation Will Fall
Commodities trade & price in USD
Weakening USD will be bullish for commodities as
marginal global investors will demand more commodities.
Emerging market currencies become more valuable and
increase incremental demand for commodities.
Commodities have rallied year-to-date, in large part
due to speculation that longer-term inflation risks are
rising; in part due to a decoupling of emerging markets
from the developed world consumer
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Current commodity prices properly reflect a global
economic slowdown
Supply: current inventories are sufficient to meet
lower demand in slow growth environment;
consumers and companies not spending
Demand:
near-term demand for commodities is
declining on the global economic slowdown and a
lower investor risk appetite
The year-to-date rally is purely speculative in nature;
in reality, the fundamental balance between supply
and demand has reached a new (and lower)
equilibrium price point
Inflation Point/Counterpoint: The Consumer
Inflation Will Rise
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Inflation Will Fall
Developed world: once credit markets recover and
lending standards improve, consumers will borrow more
and spend again---increasing demand for essential
resources *
Leverage (on personal and corporate balance sheets) is an
essential component to moving the wheels of capitalism; it
will come back *
Ultimately rising home prices would certainly boost
consumer confidence and spending; home equity will
once again become income to spend *
Rising unemployment rates are unsustainable; jobs will
recover and companies will resume growing and
spending. Unemployment is a lagging economic indicator.
Emerging world: consumer preferences are changing;
with rising wealth comes rising demand for global natural
resources
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Food: increased demand for more protein-based diet is highly
correlated to GDP growth
Energy: increasing demand for fuel from factories and cars
Infrastructure: building roads, airports, and bridges at a very
rapid pace; rampant industrialization and urbanization
requires energy, power, and transportation--and lots of
industrial metals
Precious metals: new wealth eager to display its shiny status
* None of these have materially happened in Japan
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Developed world: the need to increase savings rate is
an important lesson learned from this financial crisis
Corporations face higher cost of borrowing; rising
capital costs make earnings expectations and profit
margins lower
Consumer no longer 2/3 of US GDP; government
spending likely to rise, but not enough to offset more
conservative consumers
Political momentum towards climate change makes
traditional energy sources unattractive in a carbonsensitive
marketplace;
consumer
preferences
changing
Emerging world: though the emerging consumer may
drive demand for global natural resources, the trading
partners are different (they are decoupled from us)
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Emerging markets are focusing on more domesticallyoriented sectors; becoming less and less dependent on
export-driven sales to the developed world consumer.
Markets like Brazil and China trading more goods and
natural resources with each other; taking other markets
out of the supply/demand equation
Emerging markets are beginning to solve domestic
demand needs with domestic inventories; importing less;
decreasing global demand measured on market
exchanges
Appendix
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Stocks and Bonds Underperform in Periods of Rising Inflation
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Countercyclical Nature of Inflation Linked Assets
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Countercyclical Nature of Inflation Linked Assets
Correlation of S&P Index with Commodities, Bonds & Other Equities
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Inflation Linked Assets: Supportive Tactical Momentum
• Several global trends are in place that may favor inflation linked assets
– Robust demand
• China, India and the rest of emerging markets (e.g. Brazil, Emerging Europe) are
growing rapidly. As these regions industrialize, capex on inflation linked assets
increases, as does global trade (as very few produce the materials they need to
grow).
– Limited supply
• Volatile price history, long lead times, political instability, and significant capital
requirements have constrained investment
– Shifting asset preferences
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Commodities emerging from a 20-year bear market
Inflation increasing
Global demographics
Commodity supplies
Investors seek uncorrelated return streams during uncertainty and volatility in
traditional capital markets
– Inflation is on the rise
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Real Return – Inflation Linked Strategies
Liquid
Hedge Funds
Private
TIPS
TIPS
Commodities
Commodities
Commodities
Energy
Energy
Energy
Infrastructure
Infrastructure
Infrastructure
Real Estate
Real Estate
Real Estate
Timber
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Vehicles for Inflation Linked Exposure (not
including GAA)
TIPS
Real Estate, Infrastructure, Timber
a)
Within Core Bonds
a) Direct Purchase – Separate a/c
– commingled pools or separate a/c
b) Public Equities
b) Exchange Traded Funds (ETFs)
c) Private Partnerships
c) Direct, dedicated investment
d) Some hedge funds
Commodities
Energy (Oil and Gas)
a) Public Energy Funds
b) Exchange Traded Funds (ETFs)
c) Private Energy Partnerships
a) Direct Physical Investment
b) Portfolio of Commodity-Related Stocks
c) Commodity Futures – Enhanced Index
d) Private Partnerships
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