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Inflation is a great unknown risk for endowments and foundations but building resilience to protect against it is a key to growing perpetual portfolios for future generations.

Inflation is the enemy of long-term investors and one of the biggest economic uncertainties for the coming year. Concerns are rife over the return of global inflation, amid supply shocks and soaring energy prices as the economy recovers from Covid-19.

US core inflation rose to 4.6 per cent in October, its highest level since 1991, while the consumer price index (CPI) increased 6.2 per cent year-on-year.

Mercer is working closely with investors to build resilience to inflation into their portfolios. But also, crucially, to avoid panicking and potentially overreacting to an uncertain trend that could either be transitory or long term.  

Moving target

Most endowments and foundations have perpetual portfolios – they are intended to be around forever for the benefit of future generations. Trustees effectively act as great-grandparents, looking to shepherd assets for an infinite time horizon.

The investment goal for endowments and foundations must be to sustain ‘intergenerational equity’, which means maintaining or even growing today’s purchasing power over very long periods of time. To achieve this, investments must generate returns that, at a minimum, keep up with the rate of inflation.

The big challenge in today’s environment is that, because these institutional investors typically release 4-5 per cent each year in grants, they need returns of 4-5 per cent plus inflation just to stand still.

Inflation at higher levels makes it much harder to generate excess returns to achieve intergenerational equity, especially when interest rates are still very low. It is possible to raise the probability of reaching the investment goal of excess returns above inflation by investing the bulk of portfolios in equities or equity-sensitive investments, but this comes at the price of higher volatility and risk.

It is worth remembering that endowments and foundations are not all affected by the same rate of inflation. For example, US colleges and universities use the Higher Education Price Index (HEPI), which is generally higher than CPI because most of their costs come from paying salaries of faculty who typically see wage increases slightly higher than CPI.

Find out more about how HEPI impacts your portfolio in our research paper.

Don’t panic!

Measuring and predicting inflation is very difficult. Inflation is one of the great unknowns and where it will end up is anyone’s guess. Many professional investors who are paid to predict inflation, such as some global macro hedge funds, have a dismal record of accurately predicting it.

Historically, every time we have seen higher inflation, it arrives for different reasons and in different ways. It is important to remember that inflation isn’t the enemy itself; rather it is the background economic environment that affects investors’ portfolios. For example, if inflation is fuelled by an overheating economy, stock-heavy, growth-orientated portfolios will benefit and see returns increase.

Conversely, if inflation happens concurrently with stagnant growth or even a recession, maintaining intergenerational equity becomes much more problematic because returns from equities and equity-sensitive assets is low. This has been rare, however.

At Mercer, we do not believe this latter scenario is playing out in the current economic environment. Global growth remains positive and supply-side constraints seem to be temporary and driven by strong demand. The uptick in energy prices is of course worrying and will continue through this winter in the short term, but energy markets have historically adapted and are likely to do so again in this cycle.

Look to the long term

Attempting to predict short-term inflation is futile. We do not believe that investors should try to predict exactly what inflation will be, and then reposition portfolios.

Instead, investors need to focus on making sure their portfolios are resilient to short-term inflation without placing a big ‘bet’ on higher long-term inflation. If inflation is high for the next two years but then falls, does this matter so much if the portfolio has a very long-term investment horizon? Yes, investors might suffer from lower returns and degradation of equity in the short term, but this is reversible if inflation subsequently falls.

It is also worth noting that inflation at current levels seems high given the very low inflation environment of the past few years – but it is not that high in a historical context.

That is why, when it comes to stress testing and scenario modelling, we believe one-year inflation data is far too volatile to be useful to adjust the strategy of perpetual portfolios.

It is much more helpful to look further into the past and consider examining rolling five- or ten-year data. Through this approach, we can keep our eye on the long term and be more resilient. Thinking about what the future could look like based on long-term historical inflation data means we can build lessons from the past into the structure of portfolios into the future.

One of the lessons from the past is that equities (stocks) perform well during modest inflation, under 7 per cent.  Real assets and other inflation-sensitive investments have historically performed even better when inflation moves above 7 per cent – although the challenge is that not all types of real assets generate the same level of long-term returns as stocks.

It is impossible to accurately predict where inflation will go from here. At Mercer, we believe that building short-term resilience in portfolios to help protect against these risks is vital to ensuring endowments and foundations can sustain and grow their portfolios for future generations.

Texas Hemmaplardh is the Co-Head of US Endowments at Mercer.