2012-ny-invest-sym-p5

INFLATION HEDGING FOR INSTITUTIONAL INVESTORS, NORTH AMERICA PU

BLIS

HED

BY

FEBRUARY 2012

THE ONLINE REPORT WHERE U.S. AND CANADIAN PENSION PLAN REPRESENTATIVES AND INSTITUTIONAL INVESTMENT GROUPS EXAMINE STRATEGIES TO MITIGATE THE EFFECTS OF RAPID INFLATION RATE CHANGES.

SPONSORED BY

Cohen & Steers25 years of

Leadership InnovationExpertise

Cohen & Steers pioneered REIT investing more than 25 years ago. Through our longstanding leadership, we have fostered a culture of knowledge, innovation and advocacy on behalf of our clients. Today we are a global asset manager focused on real assets and committed to delivering superior investment solutions and results.

For more information, please contact:

Stephen Dunn, EVPDirector of Institutional Marketing

212 446 9187

[email protected]

Global real estate securitiesPrivate real estate multimanager strategies

Real assetsGlobal listed infrastructure

Large cap valuePreferred securities

NEW YORK • LONDON • BRUSSELS • HONG KONG • TOKYO • SEATTLE

cohenandsteers.com

CLEAR PATH ANALYSIS: INFLATION HEDGING FOR INSTITUTIONAL INVESTORS, NORTH AMERICA 3

ROUNDTABLE DEBATEWHAT COCKTAIL OF INFLATION-LINKED ASSETS ARE MOST RESPONSIVE TO INFLATION OVER THE SHORT AND LONG TERM?

MATT MALONEY: How do you measure inflation in the context of what it is that you are trying to hedge or manage in the asset portfolios that you are constructing?

RABI DE: First, understand what your inflation risk is in your liability projections. It could be contractually the Retail Price Index (“RPI”) index-link in the UK or Consumer Price Index (“CPI”) in Canada and only salary growth in the U.S. This gives you a lot more discretion as to how you hedge inflation. If the discounting curve is the real return bond in Canada then you should be measuring inflation using that. You are managing inflation to deliver a promise and your measure should be consistent with the promise.

MATT: Yigal, how do you measure inflation given the broader context of the question today?

YIGAL JHIRAD: In the U.S., the standard measure has been CPI. There have been many products built around beating CPI, including TIPS or inflation swaps. However, we believe that CPI understates true inflation due to adjustments that the Bureau of Labor

Statistics (BLS) has made over time. There are alternate measures such as shadow government statistics, which is produced by economist John Williams and attempts to normalize CPI for all of the adjustments that have been made. If we look at the numbers since 1980, we’ve averaged about 4% for CPI and 8% based on shadow statistics. Our view is that actual inflation is probably somewhere in between – maybe about 6%, close to the trend line of Treasury Bill returns.

It is also going to depend on the specific pension plan and what liabilities they are trying to hedge. That is a complex area. What you look for in a benchmark is to be able to deliver a measure that could be correlated to overall inflation within the liability side of the fund. I believe CPI or Treasury Bills plus a hurdle would be an appropriate metric. So CPI plus 400-500 basis points or rolling 3-year Treasury Bills plus 250 basis points may be appropriate investment targets.

MATT: Michael, I’ll let you round out the discussion with your thoughts on this, either reacting to what you have heard so far and your own views as well.

MATT MALONEYPension Risk ConsultantAon Hewitt

MODERATOR:

YIGAL JHIRADSenior Vice President & Portfolio ManagerCohen & Steers Capital Management

PANELLISTS:

MICHAEL HORST: We use CPI when we are discussing returns and inflation with various constituents. Internally we may look at HEPI which is a lot less followed outside of academia. It’s a Higher Education Price Index and it largely runs ahead of CPI as much as it shadows CPI. Part of the problem in higher education is that, as David Swensen made it simple for people to understand in his book many years ago, we are not a terribly scalable industry. Nobody wants to be in a class with 100 other students, they want to be in a class with 10 students. This works against your economies of scale and makes our inflation rate a little higher than that which is reflected in CPI.

MATT: When you think about what you are trying to match Michael, whether it’s a pension liability or something broader, how concerned are you with a momentary valuation of that obligation versus the longer term need to outpace inflation?

MICHAEL: We are much more concerned with the long term. Although our constituents often focus on short term performance, we are trying to beat CPI over the longer term

RABI DEInvestment Manager, Group PensionsShell Oil Company

MICHAEL HORSTAssistant Vice Chancellor & Investment ManagerTexas Technology University System


which we make the assumption to be about 3%. We have a 5% spend rate but it is a pretty high hurdle given what the risk premiums are today. I’m a little concerned with making that in the medium term at least.

MATT: Rabi, what are your thoughts? I know I heard you allude to being concerned about the underlying discounting curve and those types of metrics. Is it really a mark to market number that you are worried about or are you thinking of it as a balanced objective with the longer term need to meet a hurdle rate?

RABI: It varies from jurisdiction to jurisdiction. Except for a few countries, such as Hong Kong, Singapore, Belgium, Switzerland, etc., liability is increasingly being marked to market, which increases our contribution volatility. In North America we have two plans, Canada and the U.S. In Canada we use government real return bond yields to discount liability for solvency calculation, which is fairly draconian. In the U.S., we don’t have inflation adjustments built into our pension promise. We are required to use the U.S. high quality corporate bond yields to discount liability. Risk to us is the contribution risk arising from the shortfall. A cash call may come at an inopportune time for the business. In Canada we use the liability hedging portfolio as the starting point, so it’s all centred around the real return government bond. We then deviate

from that in a measured way. We invest in growth assets to earn higher returns so as to lower the long term cost of providing pensions. In the U.S., inflation adjustment is a discretionary thing so we are left dealing with short term inflation and to the extent it affects the salary growth. Another way

WHAT COCKTAIL OF INFLATION-LINKED ASSETS ARE MOST RESPONSIVE TO INFLATION OVER THE SHORT AND LONG TERM?

of managing liabilities is by altering the promise. For example, this could be moving from a lifetime annuity to a lump sum payment on retirement, curing both the longevity risk and the inflation risk to a high degree. Yes we are more sensitive, increasingly more so, to the marking of the liability to market.

YIGAL: What we look at is constructing a strategy for the medium-to-long term that would be an effective hedge against inflation, have an attractive risk/return profile and diversify an investor’s portfolio of stocks and bonds. Inflation and the drivers of inflation are very complex. They could be monetary induced, cost induced, or demand induced. Therefore, in order to try to target inflation as a whole, you really need to think about having a diverse mix of real assets that would be effective in providing purchasing power protection against multiple drivers of inflation. As a result, what you come up with should be more balanced. It should, however, be a strategy that does not require market timing and one that an investor would feel comfortable implementing at any time. So it should have an attractive risk/return profile in periods of lower inflation and maximize return during periods of rising inflation. In addition, it should complement, and offer

diversification within, an overall portfolio of stocks and bonds.

MATT: For the corporate clients that I work with, their main

exposure is in the form of salary. Inflation is in the context of benefit delivery and, in many cases, a core driver of the ultimate benefit promise. The way in which it is tied in is often very difficult to tease out into an investment strategy. Also many pension plans have used particular

plan designs to limit long-term salary increase risk. There is also increasingly a shift in corporate pension plan sponsors towards higher degrees of fixed income allocation for the purpose of hedging the valuation of their mark-to-market liability. As a result, the

remaining asset pool is aggressive in its need to seek out highly diversified alpha strategies. In that regard, it becomes the ultimate real return strategy because those assets are there solely as diversifiers and to support the ongoing cost of the plan. In our business as advisors, we find ourselves in a situation where you are tasked with finding some measurement or benchmark. That benchmark is difficult to pin down so we often times fall back on CPI as an objective standard in spite of its shortcomings. In looking back out to the market, CPI provides one measure of the performance of the non-fixed income portfolio.

I’d like to ask each of you therefore, what do you think is the right blend of assets to meet your objectives? Recognising that everyone has their own set of objectives, what is that right mix of assets in your mind for providing inflation protection?

MICHAEL: We look at inflation protection in a group that we refer to as real assets. We are allocating about 5% to unhedged commodity strategies and we are allocating about 8% to hedged real asset strategies (those being commodities or commodity equities etc). We also bucket a Commodities Trading Advisor (“CTA”) firm in there. We then have about a 12% target to private real assets, which is a little heavy on the energy (oil & gas) side but it has some real estate in it and some infrastructure aspects as well, although primarily

"In order to try and target inflation as a whole, you really need to think

about having a diverse mix of assets"

"We invest in growth assets to earn higher returns so as to lower the long

term cost of providing pensions"



around power. Our feeling is that is the right mix to help protect us against inflation over the long term.

YIGAL: Exposure to real, hard, tangible assets, specifically commodities, real estate, natural resource equities, gold

and some portfolio diversifiers, would be an effective blend of real assets that in turn should provide an attractive risk/return profile over time. This mix could also maximize returns in periods of elevated inflation. These asset classes have the commonality of supply constraints and they are sensitive to inflation, but they also have a relatively low correlation to each other. You end up with a balanced mix of real assets that can stand on their own, but also excel in periods of higher inflation. With respect to portfolio diversifiers, those specifically would be short dated fixed income instruments that have exposure to resource intensive currencies in countries like Australia and Canada. These can also act as shock absorbers and blend nicely with the real assets to create a really robust risk/return profile over time. We do not believe any one of these assets can stand on its own against all types of inflation. You want to have a diversified real asset mix and our research shows that this is the mix that really has worked over time.

MATT: Rabi can you give us your thoughts on the right balance?

RABI: For our Canadian plan, the liability hedging portfolio is exclusively made of real return bonds. Real return bonds and inflation linked bonds in Europe are perhaps the most robust defence against surplus volatility or contribution volatility. In the U.S. where there is no such explicit inflation sensitivity of surpluses, the best offence

is perhaps the most efficient defence. You make higher expected return from your growth part of the portfolio. Money is fungible and if you have excess return over your liability hedging portfolio, you can pay for all of your un-hedged risk, be it from longevity or

inflation-related salary growth. In U.S. we have a higher allocation to equity and private equity. We also have direct real estate. In Canada, there is more allocation to

liability hedging assets; we have a little bit of infrastructure with an income tilt as well. It also depends on the expertise of the portfolio manager or the inhouse team and their ability to select these products. Some of the real assets come in the form of private equity type set ups. Obviously we have Real Estate Investment Trusts (“REITs”) in our equity portfolio. We have typically shied away from gold and precious metals. Being a commodities company we have never had large exposure to commodities and so have not indulged in that asset class, so far. As an ex-commodity trader, I am aware of the risk of rolling futures passively to gain exposure. More sensible is to have exposure to physical commodities, e.g., farmland, timber, etc. Getting commodity exposure through natural resource equities is also a sensible strategy, although we don’t do that at present. That is, in a nutshell, what we do; equity and plain vanilla growth strategies, some real estate, infrastructure with income tilt and real return bonds in Canada.

YIGAL: Rabi made some really good points. I particularly like 'the best defence is a good offense'. Each one of the core sleeves in our strategy, namely REITS, commodities and natural resource equities, can benefit from active management. When we thought about developing a strategy around our

objectives for a real assets strategy, our goal was to manage those assets that we have expertise in, such as REITS and fixed income, and engage sub-advisors to actively manage the commodities and natural resource equity allocations. Our overall thesis is that we would have a disciplined and tight top-down asset allocation strategy with active bottom-up portfolio management by best-in-class managers.

MATT: We tend to shy away from public equity markets whether we are talking about REITs or whether we are talking about the contingent assets of public companies. They all have high volatility equity-like behaviour: we avoid advising our clients to step into equity exposure in the public market because of the price dynamics. While you can make the argument that equities tend to outperform those inflation markers over time, we avoid all of those security types due to pricing concerns and tend to spend more of our time on real bonds as far as paper assets are concerned. We make use of commodity futures as well. And core private real estate has a place, because in the core private real estate market investors are not as exposed to the kind of pricing volatility found in the case of public REIT markets.

YIGAL: One of the important objectives for us was to incorporate liquidity. To us, liquidity enables the strategy to be nimble and also provides managers the ability to add value by actively trading

within each asset class. In addition, not all equities are the same in their ability to protect against inflation. The assets classes we chose, namely, REITs and natural resource equities, not only provide inflation protection, but also provide performance that exhibit low correlations with other real asset

“…liquidity enables the strategy to be nimble and also provides managers

the ability to add value…”

“…the best offence is perhaps the most efficient defence…”



strategies such as commodities. We believe that the diversification that REITs and natural resource equities provide is a powerful benefit to a real assets strategy. In addition, our goal is to provide a solution that could be adopted by defined contribution participants as well as defined benefit plans and endowments. By using liquid investments we are able to implement a fully diversified global portfolio across these asset classes quickly and at a cost that is not prohibitive to any potential investor.

RABI: I know there is a concept of ‘risk parity’ where it says that even if you have even a modest allocation to equities, most of the volatility of the portfolio comes from that equity because equities are a lot more volatile than fixed income. If you want to trade off that equity volatility, either you have to give up that return potential or you have to take up some of the non-market risk that is associated with an alternative portfolio; be it credit risk, counter party risk, operational risk, leverage, valuation risk, or liquidity risk. One has to be cognisant of all of these things. If you trade one set of risks for another then you have to have the ability to manage the risk so that you can harness the premium.

Some companies have a better balance sheet than others. Oil companies are in a different place than airlines with respect to inflation because of the nature of their business and so the risk appetite for volatility is higher. Even tolerance to volatility depends on the minimum required funding regime. In Norway or Denmark you have to cure your short fall the day before yesterday! In the U.S you get to amortize over a few years, it’s not nearly as draconian. You also get to pick your own discount rate, a little bit, in which part of the curve and so on. The balance of growth and liability hedging assets depends on your risk-reward utility as a sponsor.

MATT: Recognizing the high degree of uncertainty that exists today, we don’t have the luxury of sitting on the sidelines with someone else’s money. What is your perspective, Yigal, as to where these markets are today and how attractive they are for implementing the kinds of portfolios we have been talking about today?

YIGAL: We see significant inflationary pressures coming from multiple areas. One headwind is the extraordinarily

accommodative monetary policy we are seeing in developed markets around the world. We’ve seen balance sheets increase significantly over the last three years. In addition, while emerging markets growth has moderated a bit, there is still significant demand pushing up prices. Finally, natural supply barriers and geopolitical issues are affecting commodities. Inflationary pressures exist and we have seen food, oil and gas prices rise. However, we are not trying to time the market, so as I mentioned before, our goal is to build a strategy that is well positioned to excel in periods of high inflation, but also offer an attractive risk/return profile over the long term.

MICHAEL: I echo a lot of Yigal’s thoughts. We wanted some exposure in the unhedged (long) commodity market in case there was a sudden tick of inflation in commodity prices. We have been a little bit careful in implementing those strategies, in not over weighting energy, particularly to the degree that the common indexes do. We put a little more in hedging strategies because we knew that too much in long commodities would mean high volatility in those strategies and that would be difficult to stomach. We thought the hedging strategies would take some of the volatility out, whilst

still protecting us from inflation. I’m a believer in having assets in the ground or on the ground that are actually making real returns. Based on supply and demand, which we buy into, the emerging countries are going to continue to grow and demand more. I’m not by any stretch a great economist but the government has injected an enormous amount of liquidity and I am unconvinced that they are going to be able to remove that at the most opportune time, hence we’d like to

protect ourselves from monetary inflation which I feel is going to come eventually.

RABI: We have low inflation and low growth so we

should be in the recovery phase but we have a cycle of deleveraging going on in the background. Bonds tend to do well in low growth and low inflation environments, but given the very low yield, equities seems to be the only hope for real returns over the medium-to-long term and we are not changing our strategy as a result. We continue to have exposure to emerging market equity and globalized equity portfolios. In Canada we still continue to have our real return bonds, just because it gives us a smoother ride. As an investor I would think that equity looks attractive notwithstanding the deflationary threats that exist in the markets because of the financial crisis.

“One headwind we are seeing is the extraordinary accommodative monetary policy we are seeing

in developed markets around the world”


ROUNDTABLE DEBATEWHAT MACRO-ECONOMIC ISSUES DO INSTITUTIONAL INVESTORS NEED TO BE AWARE OF IN ORDER TO EFFECTIVELY HEDGE INFLATION RISK?

VIVIANNE RODRIGUESUS Capital Markets ReporterFinancial Times

MODERATOR:

PANELLISTS:

DONALD W. LINDSEYChief Investment Officer & Professorial Lecturer in FinanceThe George Washington University Endowment Fund

THOMAS CAMMACKSenior Investment ManagerTeacher Retirement System of Texas

JULIA CORONADOChief North American EconomistBNP Paribas Corporate & Investment Banking

The other contributing factor to lower inflation was monetary policy. Monetary policy makers worked very hard to put in place credible institutions to control inflation. This was also a global phenomenon and contributed to both the globalization and improved institutions leading to a dramatic reduction in global inflation. What we’ve seen early on is a gradual rise in living standard in a lot of emerging market countries. We seem to be at a bit of a cross road.

One of the phenomenons of the last ten years has been the leverage boom in the U.S. and Europe. This ultimately proved to be unsustainable. In the U.S., what we saw when the housing market burst and the bubble crashed was a high deflationary force. In fact, we still have on-going leveraging and high unemployment that is really restraining wage growth and purchasing power in the U.S. It feels like we are set for a similar process albeit perhaps a more orderly one in Europe whereby the countries which had taken on excessive debt loads are now putting in fiscal

austerity programs. That is going to lead to slow growth and de-leveraging there.

In the near term there will be a natural cap on inflationary pressures because countries that are facing an inability to absorb higher cost without tipping their economies over will end up getting stuck in a range where they see high inflation, as we saw in the U.S. last year, tip them over leading to a decline in inflation. We therefore get trapped in the range.

Looking at global trends a few years down the road, we see a situation where the global economy has largely absorbed a lot of the excess capacity that existed. China will have developed and wages will be rising very rapidly there as well as elsewhere in Asia. What we are therefore seeing is a disinflationary dividend of globalisation having been played out. The economy is a much bigger place and we are consuming a lot more energy and food. Supply has not kept pace and so the supply constraints are a lot more

VIVIANNE RODRIGUES: Julia, could you give us your vision on how the global economic environment is changing and what effect this massive transformation is going to have on the U.S. and Canada?

JULIA CORONADO: I’ll answer that with a tilt towards the inflation area implications. What has been the most striking development in the last 30 years is the globalization of the economy. We had a lot of countries enter the global economic system which created a sentiment in financial markets starting from the late 70’s and going through to the 90’s that this was a wonderful disinflationary force. We had a lot of activity shifting from high cost countries to low cost countries and that put a lot of downward pressure on a broad set of prices. In addition, the global economy was considerably smaller and there were fewer demand and supply constraints on commodities, so broadly speaking we went from a world of very high inflation driven by the oil price shock down to very low rates of inflation.


WHAT MACRO-ECONOMIC ISSUES DO INSTITUTIONAL INVESTORS NEED TO BE AWARE OF IN ORDER TO EFFECTIVELY HEDGE INFLATION RISK?

binding. Whilst we don’t necessarily worry a lot about inflation in the near term, further down the road the global economy is tilted towards an inflationary period rather than a deflationary one. That is certainly a challenge for investors, to balance these great uncertainties in the near term whilst facing a longer term trend towards inflation rather than deflation risks.

DONALD W. LINDSEY: I would want to reinforce one of the points Julia made that was particularly important and that was with regards to the globalization of the economy. What I am concerned about is the extent to which the Federal Reserve really has control of monetary policy and inflation as they had in past decades due to the linking of economies globally. One of the factors that have been cited is the monetisation of the debt, in the fact that the U.S. has a large balance sheet. There are a number of analysts who say that it doesn’t matter because lending is not taking place. I feel concerned however that due to their being such a large percentage of U.S dollars owned by foreign central banks, that they don’t start demanding a higher risk premium and that in fact does limit the Federal Reserve’s ability to control inflation.

VIVIANNE: Having understood that, I would pose a question for all of you; to what extent do you believe the Federal Reserve can affect monetary policy?

JULIA: The Federal Reserve has a very difficult set of choices. You have an economy that still doesn’t seem to be gathering enough self-sustaining momentum. By acting you might be setting the stage for inflation pressures down the road, so do you stand by and do nothing when the economy is still in such a fragile spot? Of course, the risk-reward for any central banker is to not let the economy tip over on your watch

as that is not your job, hence they have taken aggressive policy action, as any central banker would. Time will tell what the unintended and intended outcomes of these policies are.

THOMAS CAMMACK: I agree with Julia and Donald in that essentially we have this tug of war between deflationary forces and inflationary forces. The inflationary forces are

quantitative easing and fiscal stimulus. The deflationary forces are de leveraging as well as demographics,

especially in western countries. The result longer term will be inflation but not inflation in everything. We’ll have inflation especially in necessities such as energy and food.

VIVIANNE: Given your experience as an investment manager, Thomas, how are you handling this scenario? For example, what types of change have you made to your allocations in regards to shifting inflation?

THOMAS: We haven’t made any recent changes. Two years ago, we set up a precious metals fund which is getting close to a billion dollars in size now. We were concerned about growing government debts, not only in the U.S but in other parts of the world as well. With these debt deflationary forces in effect, central banks are forced to print money. That’s why we established the precious metals fund but we are also looking at other investments that may provide an inflation hedge and we are working at that right now.

VIVIANNE: I also wonder, Donald, if you consider TIPS to be an attractive strategy for the long term investor given recent demand for them?

DONALD: We approach an inflationary environment from an asset allocation stand point rather than from a hedging standpoint. The distinction there is that you cannot adequately prepare for an inflationary environment by just adding a marginal allocation to one asset class,

particularly TIPS and commodities. They play a role in the overall asset allocation but because for endowments our main objective is growing purchasing power, we are always going to be very heavily weighted in equities. We are not going to have any clear signs as to how the current inflation situation will be resolved that would allow us to all of a sudden throw a switch and ramp up inflation hedging. We have to prepare for today’s environment.

We take the perspective that structuring our equity portfolio is very important. We are tilting towards companies that have an elastic demand curve where they can pass on increased cost to their demand market. What industries you are invested in within equity markets is going to be extremely important going forward. In the instance of a declining U.S dollar, high value add type U.S. manufacturer’s will have significant advantage. Their profitability will be boosted by a declining dollar.

VIVIANNE: We have headline and core inflation rising during 2011 and both Donald and Thomas handle investments with a long term horizon in mind. How high are we at this stage taking inflation into consideration as a risk to portfolio allocations?

THOMAS: I agree with Donald’s comments as regards asset allocation. That is how we approach it as well. People get fooled by thinking that inflation is, for example, only 3%. Well 3% certainly doesn’t sound high but if your Gross Domestic Product (“GDP”) is growing at 1-2% then it actually is very high relative to your growth. Indeed, inflation has come down over the last several months but it is important not to get fooled by the absolute level of inflation and think more about the longer term implications.

VIVIANNE: Do you believe inflationary pressure is a function of monetary policy across the globe and that we are living in an era of low interest rates or is it really a pressure from commodity prices or salary changes?

"We seem to be at a bit of a cross road."


JULIA: Longer term inflation trends are certainly more a function of the global economy rather than the current stance on monetary policy. The current stance of very low interest rates reflects the disinflationary, deleveraging pressures that the global economy faces, particularly in the U.S and Europe. We can always move to higher rates as inflation picks up. I do see the recent pickup as more of a function of commodity and supply issues though. The miss match in global demand between the countries that are growing very strongly outside of the U.S and Europe, are the ones driving the strength in demand for commodities and higher prices that we all have to pay. In some sense, monetary policy is trying to offset the damage those higher prices have on our economy.Addressing a comment made earlier; we are going to see a lot of shipping and relative price movement. The point was made that a lot of the inflation in the coming years, coming from the globalisation, will be focused on goods and commodities and energy prices. That in turn will probably lead to downward pressure on services prices. We have already started to see that. When the economy was booming, we were in the middle of a housing bubble and it was easy for industries like medical care and education to generate 5% increases year after year. That is already starting to come to an end with us seeing a lot more pressure from consumer bargaining, pushing down prices in the service areas. That is just the start of a longer term trend.

VIVIANNE: The Federal Reserve has said that interest rates will remain low until 2013 or perhaps the beginning of 2014. Could we be in a situation two years from now where the Federal Reserve will have to play catch up and start tightening very quickly? Would that effect institutional investor's allocations and strategies?

DONALD: There are a couple of aspects that concern me with regard to inflation ahead. Firstly; housing demand has shifted from home ownership to rental

properties. You have people who have looked back and seen the results of the housing crash and they no longer view houses as a good investment. In addition to that, it is much harder to qualify for financing so people that may have been able to finance a new home purchase before the bubble crashed can’t do it anymore. What that means is rental property prices are increasing at a significant rate and if that sustains it will have a tremendous impact on inflationary expectations.

THOMAS: The Federal Reserve will need to raise interest rates at some point down the road. The problem is they won’t be able to raise them to a positive real level. In other words, they are backed into a corner where we are likely to have negative real inflation adjusted interest rates for a long time and this will feed into inflationary expectations.

VIVIANNE: It is a big debate, how you can actually bring interest rates from zero in an economy to a high enough level fast enough to fight inflationary pressures if they really pick up.I wonder now whether each of you would risk an inflation forecast for 2012, assuming rates will be zero for some time but we might see some quantitative easing still around in the U.S.?

JULIA: We are estimating both core and headline inflation to be around 2% for the year. We don’t expect downward pressure on energy prices but the upward pressure seems limited by a sluggish economy, a recession in Europe and a slowdown in China, at least in the near term. As Donald mentioned, there is some upward pressure on rents but we’ve seen a supply response. Down the road, that will probably abate but in the near term it will be a source of upward pressure.

Meanwhile we have seen a lot of decline in goods prices so some of the path through higher energy costs last

year has faded. Consumers have been bargaining prices of items like cars and clothing down in the last few months.

Overall we are looking at a slower global economy in 2012 reflecting the European recession and a slow down in China. In balance, this year does not seem to look like a break out year for inflation and it will be somewhat more moderate than we saw last year.

DONALD: As I am not an economist, I am going to cheat and give a range! I agree with Julia. I believe that headline inflation will be between 2-2.5% this year and certainly no higher than 2.5%. The biggest risk to any inflation this year is energy prices. We could see significantly higher energy prices but if that happens it will be transient because that will slow down the economy and in turn will prevent the rate of inflation from rising any further.

THOMAS: I’m looking for a headline of around 2.5% and core of around 1.5%.

VIVIANNE: Thank-you very much to the panel for your time and we can finish on that point.

WHAT MACRO-ECONOMIC ISSUES DO INSTITUTIONAL INVESTORS NEED TO BE AWARE OF IN ORDER TO EFFECTIVELY HEDGE INFLATION RISK?

"..the risk-reward for any central banker is to not let the economy

tip over on your watch..."


WHITE PAPERSTRUCTURING AN ASSET ALLOCATION STRATEGY FOR CHANGING INFLATION RATE ENVIRONMENTS

The vast majority of institutional investors today do not have any experience investing in an inflationary

environment. Consequently, investors do not have the tools to approach asset allocation when inflation rises. Anyone who started their career as far back as thirty years ago has always operated in an environment of stable rates of inflation. Investors should focus on the various scenarios that can bring about inflation going forward and how to best structure portfolios under these various scenarios.

The great inflation debate has been very active in the past few years among economists, portfolio managers and analysts. Those who do not see inflation on the near or intermediate term horizon site high unemployment, slow economic growth and the very large output gap as indicators. Those who disagree take the view of Milton Friedman that “inflation is always and everywhere a monetary phenomenon”. They cite the massive expansion of the U.S. Federal Reserve’s balance sheet from the quantitative easing programs QE1 and QE2 as a foreshadowing of inflation.

In the summer of 2011, Federal Reserve Chairman Ben Bernanke, addressing the issue of a recent rise in the rate of inflation, clearly articulated his view that current inflationary pressures are likely transitory in nature. At the end of the year, this definitely appeared to be true. Yet what should investors look for going forward? How will they know when macroeconomic events are a precursor to a sustained rise in inflation? There are multiple scenarios investors must consider in addition to analyzing the potential causes of increasing inflation as well as how to adjust asset allocation.

Inflation can come from a positive output gap, meaning the aggregate demand for goods and services exceeds the potential supply. Cost-push inflation is caused by persistent rises in input costs such as raw materials and labor. Finally, monetary inflation, which is perhaps the most controversial notion with regard to how it actually brings about inflation, is said to be caused by a sustained rise in the aggregate size of the money supply in a given country. This increase in the supply of money, as it relates to the recent quantitative easing programs by the Federal Reserve, results from the monetization of the growing fiscal deficit through central bank purchases of Treasury securities.

One of the most often cited reasons why inflation is not a concern is the large negative output gap. The argument is that the U.S. simply has too much production capacity. The housing market has been in a slump for several years and new household formations are stagnant, thus depressing the demand for furniture, appliances, utilities and a wide array of other goods and services. One aspect of this issue that appears to be overlooked is that demand for housing has shifted from owned homes to rental housing. In the wake of the financial crisis, mortgage financing has become far more difficult to obtain and the desirability of home ownership greatly diminished in light of plunging home values. Housing or shelter is the largest component of the Consumer Price Index (CPI) and measures the rent that homeowners could obtain if they were renting it out to a tenant. Thus, this measure, owners’ equivalent rent, has gone through periods in the past when it is slowing while house price increases are accelerating, and we are now in a period when housing prices are declining but rental rates are rising. According to real estate research firm Reis Inc., U.S. apartment vacancies fell to a ten year low in the fourth quarter of 2011. This is causing rents to rise and will certainly impact inflationary expectations if sustained.

The risk of cost-push inflation in the coming years may be higher than what has been widely publicized. By now everyone is aware of the potential inflationary impact of higher commodity prices. While some commodity prices actually did decline in 2011, the S&P GSCI Spot energy index gained 8.75% for the year. However cost-push inflation is widely regarded as a low probability. One argument supporting this view is that price increases in commodities are transitory and there is little connection to long-term increases in the rate of inflation. It is certainly logical to assume that at some point price increases will reduce aggregate demand and prices will decline. Another view is that artificially low interest rates have brought about a large flow of investment capital into commodities, thus bringing about price spikes unjustified by demand. There is very little fear of sustained increases in wages given stubbornly high unemployment and a decline in unionized labor. However, this is exactly where the focus is needed as labor shortages are likely to be a much larger concern going forward. Rising wages and labor shortages are already present in emerging markets, particularly China and Brazil. Emerging markets were once a deflationary force but are now an

DONALD W. LINDSEY, CFAChief Investment Officer and Professorial Lecturer in FinanceThe George Washington University Endowment Fund


inflationary force. It is certainly possible that given changing demographics and the aging population, coupled with a lack of critical skills training in certain industries, that the U.S. could experience a labor shortage within a few years, even though it is expected that older workers will be extending their working years and pushing back retirement.1

It is very difficult to predict if and when the monetization of the fiscal deficit will bring about inflation. However, the current fiscal condition of developed market countries is unsustainable. Even though U.S. Treasury yields fell after the U.S. credit rating downgrade, a time will come when yields could soar, accompanied by a large decline in the dollar, unless momentous and bold policy changes are enacted to reverse the surge in debt. U.S. Treasury securities are no longer a rational investment but merely a tool for emerging market central banks to implement their monetary policy. It is unwise to assume any type of orderly transition to a period of more normal interest rates.

In essence, one should not assume that any one factor can prevent inflation from appearing, whether it is a high unemployment rate, a large output gap, or a specific monetary metric. Inflation can surprise us due to a number of seemingly unrelated factors. Inflation is not a homogenous condition or monolithic event where clear and timely signals exist to warn us it is near. Consequently, it is futile to seek out simple solutions to inflation risk through marginal allocations to one or two asset classes. The concept of inflation hedging is misguided as it implies purchasing some type of insurance on an existing portfolio. Inflationary regimes can run for long periods of time and wreak havoc. It is important to prepare for inflation by identifying broad and sweeping changes that should be made to the current asset allocation. The traditional concepts of adding inflation protected bonds (TIPS) or commodities are inadequate.

Adjusting the portfolio for increases in inflation should be anchored to the concept of protecting the present value of future cash flows given that rising inflation raises the discount rate for these cash flows and thus the required rate of return. This may not happen by adding TIPS or commodities. Tips can create losses from duration risk and the volatility of real interest rates. The inflation protection of U.S. TIP’s is completely tied to changes in the CPI. If rates rise without a corresponding increase in the CPI, losses will occur. Therefore, although certainly preferable to nominal bonds, they are by no means a complete solution.

Commodities have attracted massive amounts of financial capital given their gains of the last decade as well as a number of new investment vehicles that are available to gain exposure to commodity price changes. The problems have been well documented. Investment vehicles that use futures contracts are dependent on the relationship between spot and futures

prices. A market that is in contango means that the futures price is above the spot price and rolling into the next futures contract upon expiration of the current contract can create a loss. This means that commodity prices can be increasing while futures based strategies can generate a loss. The key characteristic to keep in mind is that commodities, until sold, have no underlying cash flow. Thus the returns are entirely dependent on being able to sell a commodity in the future at a higher price. This does not provide for a great deal of flexibility in pursuing an investment strategy.

As already mentioned, marginal changes through the addition of an allocation to TIP’s or commodities are inadequate, the vast majority of the portfolio must be restructured. In the case of long-term investors with a goal of maintaining or growing purchasing power, this means making significant changes to the equity allocation. In an environment of rising inflation, investors must disregard the structure of equity indices and be willing to structure an equity portfolio that will deviate significantly from any broad based equity index.

The focal point should be on investing in the stocks of companies where the demand for their product is inelastic. In essence, look for companies that can pass any increased costs on to their end market. We should expect that earnings multiples will continue to contract going forward as stocks continue to price in ultimately higher interest rates. At best, we can only expect earnings multiples to stay the same. Consequently it is very important to focus stock selection on companies that can continue to grow earnings per share in an inflationary environment. In addition, portfolio managers should focus on stocks of companies that have a history of consistently paying dividends as well as increasing the dividend per share. Growing cash flows in an inflationary environment is very important and can play a strong role in protecting the share price from the negative impact of inflation. This means that industry selection will be paramount. Investors need to avoid stocks in industries where rising input costs will squeeze profit margins. This requires analyzing the value chain for select industries. As an example, investors want to own the companies that provide the inputs for grain, such as fertilizer and seed companies, rather than the companies that use grain to make their products. However, not all commodity companies are necessarily good stocks to own. Investors should seek companies that are the lowest cost producers in their sector.

By dramatically restructuring the equity portfolio along with adding commodities and inflation protected bonds, investors can successfully navigate through an inflationary environment. The focus needs to be on asset allocation, not inflation hedging.

STRUCTURING AN ASSET ALLOCATION STRATEGY FOR CHANGING INFLATION RATE ENVIRONMENTS

1 Barry Bluestone and Mark Melnik, “After the Recovery: Help Needed. The Coming Labor Shortage and How People in Encore Careers Can Help Solve It”, Kitty and Michael Dukakis Center for Urban and Regional Policy, Northeastern University.

TO READ MORE FREE REPORTS VISIT:

www.clearpathanalysis.com

© Clear Path Analysis 2012

This article is for informational purposes, and reflects prevailing conditions and our judgment as of this date, which are subject to change. It does not constitute

investment advice or a recommendation or offer. We consider the information in this article to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. There is no assurance that any historical trend illustrated above will be repeated in the future or any way to know in advance when such a trend might begin. There is no guarantee that any market forecast set forth in this article will be realized. Please consider the investment objectives, risks, charges and expenses of any Cohen & Steers fund carefully before investing. A prospectus containing this and other information may be obtained by visiting cohenandsteers.com or by calling 800.330.7348. Please read the prospectus carefully before investing. Risks: A real assets strategy is subject to the risk that its asset allocations may not achieve the desired risk-return characteristic, underperform other similar investment strategies or cause an investor to lose money. The risks of investing in REITs are similar to those associated with direct investments in real estate securities. Property values may fall due to increasing vacancies, declining rents resulting from economic, legal, tax, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions An investment in commodity-linked derivative instruments may be subject to greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. The use of derivatives presents risks different from, and possibly greater than, the risks associated with investing directly in traditional securities. Among the risks presented are market risk, credit risk, counterparty risk, leverage risk and liquidity risk. The use of derivatives can lead to losses because of adverse movements in the price or value of the underlying asset, index or rate, which may be magnified by certain features of the derivatives. The market value of securities of natural resource companies may be affected by numerous factors, including events occurring in nature, inflationary pressures and international politics. Because the strategy invests significantly in natural resource companies, there is the risk that the strategy will perform poorly during a downturn in the natural resource sector. Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. This article must be accompanied by the most recent applicable quarterly Cohen & Steers mutual fund fact sheet(s) if used in connection with the sale of mutual fund shares.

2012-ny-invest-sym-p5

Documents

Transcript of 2012-ny-invest-sym-p5