I started work in the 1980s; back when the world was busy dealing with the aftermath of the 1970s financial crisis. On the liability side, the UK government was implementing preservation and mandatory indexation to protect pensions. While on the asset side, investors were demanding other things.
The 1970s had been truly awful for investors (unless you happened to stash some gold…). So much so that even the government had listened to investors and was forced to issue a new type of security in 1981 – the index-linked gilt.
I remember talking to some senior actuaries who lived and worked through the 1970s. There was the philosophical, and somewhat actuarial, question of “will the price of Consols fall below their yield?”, which would have occurred if long-dated yields surpassed 20% – which they nearly did. But the real question was “is there anything we can invest in to protect against inflation?”. Which is where the issue of my beloved index-linked gilts comes in: a response from the government who realised they had to be nice to investors to make up for the 1970s. The debate, however, was how negative real yields would be once these miracle assets were issued.
You see, despite the fact that equities are a real asset (meaning they earn profits based on sales into the real economy), they get pasted price-wise by high inflation in the short term. They always have done and always will. It’s just a function of the way they make profits from the residuals of lots of costs (which gets harder as inflation rises) and the action of discount rates on long-dated earnings. It’s probably ok in the long term, but most pension funds aren’t proper long-term investors anymore. And frankly, if you can see a bullet coming – you dodge it, right?
So, if we think a bullet’s coming – and we have to stay invested to get those ‘gilt+ returns’ then what can we do? Well, there are some risk premia assets that would likely perform relatively well in higher inflation regimes. These include commodities, REITs, momentum and renewables. But you need to ensure high quality execution.
However, if you’re clever enough to know high inflation’s coming, then do something much more drastic: sell your equities and just hold index-linked gilts.
Unless indicated, these are the views of the author’s and may differ from those of the firm.