As more evidence emerges to suggest that inflation is here to stay for longer than previously expected, superannuation funds such as Cbus and UniSuper are setting their sights on equities, real assets and interest rate futures to counter the effects.

Mark Ferguson, head of total portfolio management at Cbus said that it has become increasingly murky how long the timeframe for this "transitory" inflation that the Federal Reserve has been touting would be.

"We really only know how inflation is going to evolve once it comes down from these supply-driven highs, and by that stage, if it truly isn't transitory, then it's more than likely that markets will come to the conclusion that the Fed is well behind the curve. And that may cause a few challenges at that time, so it's certainly not getting any clearer at the moment," he said.

However, he does believe that “higher inflation will remain around for a little bit longer than is currently expected. And I think that's what will be probably the major cause of volatility in equity markets over the next 6 months”.

On November 10, the US labour department announced that its consumer price index – a common indicator of inflation – had risen 6.2% from a year ago, the biggest rise since 31 years ago.

A survey conducted by Asset Owner Insights found that 30% of asset owners view interest rates and inflation as the biggest portfolio risk in the next six months.

UNDERWEIGHT FIXED INCOME

Ferguson shared that the fund will remain overweight on risk assets and had begun reducing allocation to fixed income three years ago in response to lower-for-longer interest rates.

“Despite the recent increase in yields, we do think that the increased levels of debt globally, which obviously increased exponentially given the fiscal support required for Covid, will keep interest rates lower for longer or even lower for even longer,” he said.

“So we were lucky in the sense that we reduced our strategic allocation to fixed income a few years ago, as I just said, we're also underweight from a more dynamic asset allocation point of view.

Real yields of 10-year US Treasuries have been in negative territory for the past year, tracking at -1.11 on Friday (November 19).

Despite rising inflation, the Federal Reserve has kept interest rates near zero, but have begun reducing asset purchases. Still, investors are on tenterhooks over when the Fed will start tightening its monetary policy to rein in inflation.

Former US treasury secretary Steven Mnuchin said last week that he expects inflation and 10-year US Treasuries to settle around the 3-3.5% mark eventally.

ABNORMAL MARKETS

However, Ferguson also pointed out that capital markets have been acting out of the norm lately.

“There are two interest rate hikes priced in for the second half of next year. That pricing hasn’t rattled equity markets at all, which is quite surprising,” he observed.

In addition, “we saw the US 10-year bond yield rise about 10 basis points the night of the inflation print, so it's the bond markets that are behaving a little bit out of the ordinary in that even with the increased market pricing of rate hikes, it hasn't all been one way for bond yields,” he added.

He added that “there are a few nuances going on” that could explain these market movements.

“Part of that story is if markets believe that long-term mutual interest rates aren't higher than they were in the past, then the more that they price in interest rate hikes. That means that if the central banks do follow that and end up removing policy accommodation quicker than they otherwise would have, then that will actually have a dampening effect on demand and long bond yields will come down. So yield curves are flattened.”

That said, the A$65 billion ($47 bllion) Cbus still believes that global, and especially US bond yields “have the path of least resistance” and the fund has positioned its allocations for higher inflation.

“Inflation will obviously subside from the current levels. The current level is transitory, but it's how far and how much it subsides after that's going to be the key to the market pricing of interest rates,” he said, adding that it would probably be early next year that the inflation situation would become clearer.

REAL ASSETS

Cbus has also started allocating "fairly significantly" to real assets mostly in the domestic market.

"Across property and infrastructure, we see those asset classes as a ballast for the portfolio and they should do reasonably well in an inflationary environment. Even in the case where inflation is running a bit ahead of expectations and equity markets stutter a little bit, we should get some meaningful stability from the property and infrastructure asset class."

The A$101 billion ($73.3 billion) UniSuper is taking a similar approach to guard against inflation, using real assets as well as equities and interest rate futures to counter its effects.

“Our real assets should be relative beneficiaries of higher inflation,” David Xu, senior investment analyst, told AsianInvestor. “Throughout the year we’ve also opportunistically tilted towards publicly listed companies that we believe have strong pricing power, and used interest rate futures to reduce the interest rate sensitivity of our fixed interest exposures. The latter has helped to partly mitigate the impact of rising global bond yields.”

He added that the reopening of economies leading to pent-up demand combined with supply chain disruptions have created the high inflation rates, but that these should ease eventually.

“Recent data suggests that the increase in inflation is getting more broad-based and likely to persist for longer than previously expected. However, as supply chains work through their current bottlenecks, people return to the labour force and demand conditions normalise, inflation should ease back to pre-pandemic levels,” he said.

“Longer term there is little evidence to suggest we’ve entered a new regime of structurally higher inflation, let alone whether central banks will sit idly by,” he added.