William Dinning: The resilience of CPI+ objectives in an inflationary world

06 Feb 2024 Expert insight

William Dinning considers the resilience of CPI+ objectives in an inflationary world.

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In the face of soaring inflation rates and seemingly unattainable consumer price index (CPI)+ objectives, questions have arisen about the relevance and achievability of these targets. Many risk mandates have struggled to keep pace with their CPI+ objectives in recent years, with 2022 marking a particularly extreme example. However, it is crucial to assert that despite the current challenges, CPI+ objectives remain valid and meaningful. In this article, we will emphasise two primary reasons for this assertion and illustrate how they can guide investment strategies in the current environment.

The time horizon perspective

First and foremost, the CPI+ objective should be evaluated over the specified time horizon for each risk mandate. For instance, at Waverton, a growth mandate encompasses a seven-year time horizon. While recent inflation levels have surged, the market’s expectations suggest a return to the central bank’s target of approximately 2% for UK CPI. As of the time of writing, in October 2023, the five-year inflation swap in the UK is priced at 4.2% for the retail price index (RPI), equivalent to roughly 3.0% for CPI. This swap rate is based on the average inflation over the next five years, indicating that the market anticipates inflation falling back to target levels given that CPI is currently 6.7%. The conclusion is the same in the US and euro area where the five-year swap is currently at 2.7% and 2.6% respectively.

Should these market expectations materialise, a sterling-based growth portfolio’s average CPI+ actual return over the seven years starting in 2022 would be approximately 8% per annum (15% in 2022, 9.3% in 2023, followed by 6.5% from 2024 to 2028). This exceeds the presumed 5.5% return at a 2% CPI, but it could conceivably be achieved.

Moreover, when 2022 is excluded from the seven-year calculation, the average CPI+ return from 2023 to 2029 would be around 6.8%, assuming current inflation swap pricing proves accurate and a return to 2% CPI by 2029. We therefore continue to think that the CPI+ metric is one important way there is to gauge expected returns for various risk mandates.

The changing landscape of fixed income

The second compelling reason to maintain faith in CPI+ objectives is the dramatic shift in the expected returns from fixed income investments. These returns are currently higher than they have been since the pre-financial crisis era of 2007, creating a more favourable environment for diversified portfolios to achieve their targets.

Historically, one of the primary obstacles to meeting CPI+ targets in a diversified portfolio was the persistently low expected returns on bonds in the wake of the great financial crisis. Central banks’ responses, characterised by zero interest rates and quantitative easing, led to subdued bond returns. However, the tide has turned, with gilt and US Treasury yields now hovering around 5% and the expected return from bonds is the best it has been for at least 15 years.

For example, the current 10-year gilt yield stands at 4.6%, and when adjusted for the 10-year inflation swap rate of 3.9% (minus the 1.2% wedge to account for CPI), it indicates a “real yield” of 1.9% on the nominal gilt. A similar story unfolds in the US Treasury market, where the implied real yield is 2.2%.

In the inflation-linked bond market, a 10-year US inflation-linked bond boasts a real yield of 2.5%, while a 10-year UK index-linked bond yields 0.8%. Consequently, it is reasonable to expect that the expected return from government bonds is around 2% in real terms, a stark contrast to the -1.0% expected real return two years ago.

Once corporate bonds are included, which offer additional yield, the expected return for the entire fixed income asset class is conservatively estimated between 2.5% and 2.75% in real terms today. These higher returns significantly contribute to the foundation of a diversified portfolio, potentially allowing for an upward adjustment of CPI+ targets.

In light of these factors, we currently advocate a tactical overweight allocation to fixed income relative to our strategic benchmarks, believing that fixed income returns are poised for a healthier outlook. In this environment less of the total return needs be generated by equities, although we still expect their real asset characteristics to continue to help to protect against inflation and drive returns.

As inflation expectations moderate, the CPI+ framework remains relevant and robust, offering investors a valuable tool to navigate the complex investment landscape. Despite recent underperformance relative to CPI+ targets, it is essential to acknowledge that the future holds promise for these objectives to once again serve as reliable guides for expected returns across various risk mandates.

William Dinning is chief investment officer at Waverton

Charity Finance wishes to thank Waverton for its support with this article  

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