INFLATION H EDGING FOR INSTITUTIONAL INVESTORS, NORTH A MERICA

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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.

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ROUNDTABLE DEBATE

WHAT COCKTAIL OF INFLATION-LINKED ASSETS ARE MOST RESPONSIVE TO INFLATION OVER THE SHORT AND LONG TERM?
MODERATOR: MATT MALONEY Pension Risk Consultant Aon Hewitt

PANELLISTS: YIGAL JHIRAD Senior Vice President & Portfolio Manager Cohen & Steers Capital Management RABI DE Investment Manager, Group Pensions Shell Oil Company MICHAEL HORST Assistant Vice Chancellor & Investment Manager Texas Technology University System

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, weve 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, Ill 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.

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. Its 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 its 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

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

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

YIGAL: What as a whole, you really need to think we look at is about having a diverse mix of assets" constructing a strategy for the medium-to-long term that would RABI: It varies from jurisdiction to be an effective hedge against inflation, remaining asset pool is aggressive in jurisdiction. Except for a few countries, have an attractive risk/return profile its need to seek out highly diversified such as Hong Kong, Singapore, and diversify an investors portfolio alpha strategies. In that regard, it Belgium, Switzerland, etc., liability is of stocks and bonds. Inflation and the becomes the ultimate real return increasingly being marked to market, drivers of inflation are very complex. strategy because those assets are there which increases our contribution They could be monetary induced, cost solely as diversifiers and to support volatility. In North America we have induced, or demand induced. Therefore, the ongoing cost of the plan. In our two plans, Canada and the U.S. In in order to try to target inflation as a business as advisors, we find ourselves Canada we use government real return whole, you really need to think about in a situation where you are tasked bond yields to discount liability for having a diverse mix of real assets with finding some measurement or solvency calculation, which is fairly that would be effective in providing benchmark. That benchmark is difficult draconian. In the U.S., we dont have purchasing power protection against to pin down so we often times fall inflation adjustments built into our multiple drivers of inflation. As a result, back on CPI as an objective standard pension promise. We are required to what you come up with should be in spite of its shortcomings. In looking use the U.S. high quality corporate more balanced. It should, however, be back out to the market, CPI provides bond yields to discount liability. Risk to a strategy that does not require market one measure of the performance of the us is the contribution risk arising from timing and one that an investor would non-fixed income portfolio. the shortfall. A cash call may come at feel comfortable implementing at any an inopportune time for the business. time. So it should have an attractive Id like to ask each of you therefore, In Canada we use the liability hedging risk/return profile in periods of lower what do you think is the right blend portfolio as the starting point, so its inflation and maximize return during of assets to meet your objectives? Recognising that everyone has their all centred around the real return periods of rising inflation. In addition, own set of objectives, what is that government bond. We then deviate it should complement, and offer right mix of assets in your mind for diversification providing inflation protection? within, an overall portfolio of stocks "We invest in growth assets to earn MICHAEL: We look at inflation and bonds. protection in a group that we refer to as higher returns so as to lower the long real assets. We are allocating about 5% MATT: For the term cost of providing pensions" to unhedged commodity strategies and corporate clients we are allocating about 8% to hedged that I work real asset strategies (those being with, their main commodities or commodity equities from that in a measured way. We exposure is in the form of salary. etc). We also bucket a Commodities invest in growth assets to earn higher Inflation is in the context of benefit Trading Advisor (CTA) firm in there. We returns so as to lower the long term delivery and, in many cases, a core then have about a 12% target to private cost of providing pensions. In the U.S., driver of the ultimate benefit promise. real assets, which is a little heavy on the inflation adjustment is a discretionary The way in which it is tied in is often energy (oil & gas) side but it has some thing so we are left dealing with short very difficult to tease out into an real estate in it and some infrastructure term inflation and to the extent it investment strategy. Also many aspects as well, although primarily affects the salary growth. Another way pension plans have used particular

"In order to try and target inflation

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

WHAT COCKTAIL OF INFLATION-LINKED ASSETS ARE MOST RESPONSIVE TO INFLATION OVER THE SHORT AND LONG TERM?
is perhaps the most efficient defence. objectives for a real assets strategy, our You make higher expected return goal was to manage those assets that from your growth part of the portfolio. we have expertise in, such as REITS and Money is fungible and if you have fixed income, and engage sub-advisors YIGAL: Exposure to real, hard, tangible excess return over your liability hedging to actively manage the commodities assets, specifically commodities, real portfolio, you can pay for all of your and natural resource equity allocations. estate, natural resource equities, gold un-hedged risk, be it from longevity or Our overall thesis is that we would have inflation-related a disciplined and tight top-down asset salary growth. In allocation strategy with active bottomU.S. we have a up portfolio management by best-inhigher allocation class managers. liquidity enables the strategy to to equity and be nimble and also provides managers private equity. We MATT: We tend to shy away from public the ability to add value also have direct equity markets whether we are talking real estate. In about REITs or whether we are talking Canada, there is about the contingent assets of public more allocation to companies. They all have high volatility and some portfolio diversifiers, would liability hedging assets; we have a little equity-like behaviour: we avoid be an effective blend of real assets that bit of infrastructure with an income tilt advising our clients to step into equity in turn should provide an attractive as well. It also depends on the expertise exposure in the public market because risk/return profile over time. This mix of the portfolio manager or the inhouse of the price dynamics. While you can could also maximize returns in periods team and their ability to select these make the argument that equities tend of elevated inflation. These asset products. Some of the real assets come to outperform those inflation markers classes have the commonality of supply in the form of private equity type set over time, we avoid all of those security constraints and they are sensitive to ups. Obviously we have Real Estate types due to pricing concerns and inflation, but they also have a relatively Investment Trusts (REITs) in our equity tend to spend more of our time on low correlation to each other. You end portfolio. We have typically shied away real bonds as far as paper assets are up with a balanced mix of real assets from gold and precious metals. Being a concerned. We make use of commodity that can stand on their own, but also futures as well. And core private real commodities company we have never excel in periods of higher inflation. With estate has a place, because in the core had large exposure to commodities and respect to portfolio diversifiers, those private real estate market investors are so have not indulged in that asset class, specifically would be short dated fixed not as exposed to the kind of pricing so far. As an ex-commodity trader, I income instruments that have exposure volatility found in the case of public am aware of the risk of rolling futures REIT markets. to resource intensive currencies in passively to gain exposure. More countries like Australia and Canada. sensible is to have exposure to physical These can also act as shock absorbers YIGAL: One of the important objectives commodities, e.g., farmland, timber, and blend nicely with the real assets to for us was to incorporate liquidity. To etc. Getting commodity exposure create a really robust risk/return profile through natural resource equities is also us, liquidity enables the strategy to be nimble and also provides managers the over time. We do not believe any one a sensible strategy, although we dont ability to add value by actively trading of these assets can stand on its own do that at present. That is, in a nutshell, against all types of inflation. You want what we do; equity to have a diversified real asset mix and and plain vanilla our research shows that this is the mix growth strategies, that really has worked over time. some real estate, the best offence is perhaps infrastructure with the most efficient defence MATT: Rabi can you give us your income tilt and real thoughts on the right balance? return bonds in Canada. RABI: For our Canadian plan, the within each asset class. In addition, liability hedging portfolio is exclusively YIGAL: Rabi made some really good not all equities are the same in their made of real return bonds. Real return points. I particularly like 'the best ability to protect against inflation. The bonds and inflation linked bonds in defence is a good offense'. Each one assets classes we chose, namely, REITs Europe are perhaps the most robust of the core sleeves in our strategy, and natural resource equities, not defence against surplus volatility namely REITS, commodities and natural only provide inflation protection, but or contribution volatility. In the U.S. resource equities, can benefit from also provide performance that exhibit where there is no such explicit inflation active management. When we thought sensitivity of surpluses, the best offence about developing a strategy around our low correlations with other real asset around power. Our feeling is that is the right mix to help protect us against inflation over the long term.

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

WHAT COCKTAIL OF INFLATION-LINKED ASSETS ARE MOST RESPONSIVE TO INFLATION OVER THE SHORT AND LONG TERM?
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. still protecting us from inflation. Im 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. Im not by any stretch a great economist but the government has injected an enormous amount of liquidity and I YIGAL: We see significant inflationary am unconvinced that they are going pressures coming from multiple areas. to be able to remove that at the most One headwind is the extraordinarily opportune time, hence wed like to protect ourselves from monetary inflation which One headwind we are seeing is the extraordinary I feel is going to come eventually. accommodative monetary policy we are seeing MATT: Recognizing the high degree of uncertainty that exists today, we dont have the luxury of sitting on the sidelines with someone elses 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?

RABI: I know there is a concept of risk parity where it says that even if in developed markets around the world you have even a RABI: We have modest allocation low inflation and to equities, most low growth so we of the volatility of the portfolio comes accommodative monetary policy we are should be in the recovery phase but from that equity because equities are seeing in developed markets around we have a cycle of deleveraging going a lot more volatile than fixed income. the world. Weve seen balance sheets on in the background. Bonds tend to If you want to trade off that equity increase significantly over the last three do well in low growth and low inflation volatility, either you have to give up years. In addition, while emerging environments, but given the very low that return potential or you have to markets growth has moderated a bit, yield, equities seems to be the only take up some of the non-market risk there is still significant demand pushing hope for real returns over the mediumthat is associated with an alternative up prices. Finally, natural supply barriers to-long term and we are not changing portfolio; be it credit risk, counter our strategy as a result. We continue and geopolitical issues are affecting party risk, operational risk, leverage, to have exposure to emerging market commodities. Inflationary pressures valuation risk, or liquidity risk. One has exist and we have seen food, oil and gas equity and globalized equity portfolios. In Canada we still continue to have our to be cognisant of all of these things. prices rise. However, we are not trying real return bonds, just because it gives If you trade one set of risks for another to time the market, so as I mentioned then you have to have the ability to us a smoother ride. As an investor I before, our goal is to build a strategy manage the risk so that you can harness that is well positioned to excel in would think that equity looks attractive notwithstanding the deflationary the premium. periods of high inflation, but also offer threats that exist in the markets an attractive risk/return profile over the because of the financial crisis. Some companies have a better balance long term. sheet than others. Oil companies are in a different place than airlines with MICHAEL: I echo a lot of Yigals respect to inflation because of the thoughts. We wanted some exposure nature of their business and so the risk in the unhedged (long) commodity appetite for volatility is higher. Even market in case there was a sudden tolerance to volatility depends on the tick of inflation in commodity prices. minimum required funding regime. In We have been a little bit careful in Norway or Denmark you have to cure implementing those strategies, in not your short fall the day before yesterday! over weighting energy, particularly to In the U.S you get to amortize over a the degree that the common indexes few years, its not nearly as draconian. do. We put a little more in hedging You also get to pick your own discount strategies because we knew that too rate, a little bit, in which part of the much in long commodities would mean curve and so on. The balance of growth high volatility in those strategies and and liability hedging assets depends on that would be difficult to stomach. We your risk-reward utility as a sponsor. thought the hedging strategies would take some of the volatility out, whilst

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

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WHAT MACRO-ECONOMIC ISSUES DO INSTITUTIONAL INVESTORS NEED TO BE AWARE OF IN ORDER TO EFFECTIVELY HEDGE INFLATION RISK?
MODERATOR: VIVIANNE RODRIGUES US Capital Markets Reporter Financial Times

PANELLISTS: JULIA CORONADO Chief North American Economist BNP Paribas Corporate & Investment Banking DONALD W. LINDSEY Chief Investment Officer & Professorial Lecturer in Finance The George Washington University Endowment Fund THOMAS CAMMACK Senior Investment Manager Teacher Retirement System of Texas

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: Ill 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 70s and going through to the 90s 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.

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 weve 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

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

WHAT MACRO-ECONOMIC ISSUES DO INSTITUTIONAL INVESTORS NEED TO BE AWARE OF IN ORDER TO EFFECTIVELY HEDGE INFLATION RISK?
binding. Whilst we dont 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. 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 cross road." forces are de leveraging as well as demographics, especially in western countries. The result longer term will be inflation but not inflation in everything. Well 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 havent 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. Thats 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 todays 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. manufacturers 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 Donalds 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 doesnt 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

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 doesnt 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 dont start demanding a higher risk premium and that in fact does limit the Federal Reserves 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 doesnt 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 riskreward for any central banker is to not let the economy tip over on your watch

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

WHAT MACRO-ECONOMIC ISSUES DO INSTITUTIONAL INVESTORS NEED TO BE AWARE OF IN ORDER TO EFFECTIVELY HEDGE INFLATION RISK?
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 cant 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 wont 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. 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: Im looking for a headline of VIVIANNE: It is a big debate, how you around 2.5% and core of around 1.5%. can actually bring interest rates from zero in an economy to a high enough VIVIANNE: Thank-you very much to the level fast enough to fight inflationary panel for your time and we can finish pressures if they really pick up. on that point. I wonder now whether each of you would risk an inflation forecast for 2012, assuming rates will be zero for some time but "..the risk-reward for any central we might see some banker is to not let the economy quantitative easing still around in the tip over on your watch..." U.S.? JULIA: We are estimating both core and headline inflation to be around 2% for the year. We dont 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 weve 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

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

WHITE PAPER

STRUCTURING AN ASSET ALLOCATION STRATEGY FOR CHANGING INFLATION RATE ENVIRONMENTS

DONALD W. LINDSEY, CFA Chief Investment Officer and Professorial Lecturer in Finance The George Washington University Endowment Fund

he 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 Reserves 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

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STRUCTURING AN ASSET ALLOCATION STR ATEGY FOR CHANGING INFLATION R ATE ENVIRONMENTS
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. TIPs 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 TIPs 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.

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.

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his 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. TO READ MORE FREE REPORTS VISIT:

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Clear Path Analysis 2012