A short list to manage inflation risk

Inflation has skyrocketed globally following unprecedented pandemic-related policy stimulus as well as pervasive supply chain disruptions due to lockdown restrictions and the war in Ukraine. In the United States, the annual inflation rate has risen to 9.1% as at June of this year, the highest since November 1981 and well above the Federal Reserve’s inflation target of 2%. In its turn, persistent inflationary pressures have triggered the US Federal Reserve to sharply hike interest rates and strike an increasingly hawkish tone. The mix of rapidly tightening financial conditions, persistently high inflation, and weakening leading indicators significantly raise uncertainty and cloud the economic outlook.

Not surprisingly, pension fund managers have been thinking carefully about how they should manage the risk of inflation over their investment horizon and make long-term funding ratio decisions in a relative vacuum of reliable information. Here we propose two ways to manage inflation risk:

Scenario analysis can support a comprehensive assessment of inflation risks and facilitate robust decision-making under uncertainty. All of a pension plan’s strategic investment and funding policies can be reviewed together to understand how they interact and influence each other. Scenarios allow critical insights to help manage assets and liabilities when viewed against the fund’s risk appetite, demographics and funding policies.

1. Stochastic Scenarios

The big question then is how can pension funds adjust their Asset/Liability policies without stretching their limited resources or building bespoke analytics and scenario models? At Ortec Finance, we have a solution. Our Economic Scenario Generator integrates short and long investment horizons consistently across all asset classes and economies while adhering to important stylized facts such as non-normality of distributions, which in the case of inflation, results in the scenarios having more upward than downward dispersion. Every month, the Economic Scenario Generator is updated to include the most recent market conditions that affect the scenario distribution. It provides realistic stochastic risk and return scenarios for all relevant time horizons and balance-sheet-level applications simultaneously, bringing consistency and efficiency to enterprise-wide investment decision-making and risk management. 

2. Deterministic stagflation stress tests 

Besides offering the tools to perform stochastic stagflation portfolio analyses, Ortec Finance also offers deterministic stagflation stress scenarios by filtering specific circumstances within the scenario distribution. In the stagflation worldview, inflation is elevated, while economic growth remains low. The purpose of stress testing is to create risk awareness and to test the robustness of investment strategies. Stress tests and alternative worldviews provide valuable insights into the impact of uncertain future economic and financial market developments to support investment decision-making.  

Using Ortec Finance’s proprietary Asset-Liability Management software, GLASS, these methodologies enable pension fund managers to run continuous stochastic analysis for high inflation and even stagflation scenarios across their asset portfolios and liabilities. By optimizing the benefits of combining several asset classes in a portfolio (including private assets, listed assets, commodities, government and corporate bonds, real estate and credit risk, among others), GLASS allows pension fund managers to address inflation risk by analyzing their balance sheets from both sides of the equation, conducting detailed portfolio analysis, scenario planning and reviewing their policies through a holistic lens. That, in turn, leads to a more sustainable long-term funding ratio, lower overall risks and greater agility in the market.  

While uncertainty still circulates about the longevity and aggression of inflationary pressures, pension fund managers need to be alert, informed and agile. We believe those using GLASS to achieve efficient, consistent, realistic and independent scenarios will be best positioned to manage these pressures – as well as any others that may emerge.