Not for profit portfolio considerations in the current inflationary environment
Pricing pressures continue to intensify in the United States as the consumer price index (CPI) skyrocketed 8.5% higher year-over-year in March, representing the highest increase in inflation in 40 years.¹ Not for-profits and long-term investors are far from immune to the tide of inflation seeping into all corners of the economy—indeed, inflation can put pressure on how far donations go and strain a not for-profit's operating model, eroding its purchasing power and, ultimately, the ability to fund its mission. Non-profit organisations are wise to consider the impact of inflation on their organisation, assess their portfolios' sensitivity to inflation and make appropriate adjustments to the portfolio to position themselves for investment success.
Evaluate the spending policy sensitivity to inflation
For those organisations that need to spend at a higher level, the sensitivity to inflation could be higher—the more a not for profit spends, the greater the chance of impairing the asset base in down markets. This makes an evaluation of the spending policy, and the relevant time horizon, even more critical.
If your goal is to exist in perpetuity, then preserving capital and maintaining the purchasing power over time are crucial. In order to do this, your target return must be equal to or greater than the rate of inflation plus spending plus expenses. And choosing the right measure of inflation is key, as not all sectors within the not for profit world experience the same rate of inflation.
For example, certain not for profit asset owners have historically faced an inflation rate that is materially higher than inflation rates in other parts of the economy. The year-over-year tertiary education index in the Consumer Price Index (CPI) rose by 6.4% in the year to March 2022. In comparison, headline CPI rose by 5.1% through the same period2. Overall, this highlights the importance of using an inflation measure that most closely mirrors the inflation in your specific sector, which will allow for a more accurate estimation of your required target return, if one of your goals is to preserve the purchasing power of your assets.
Consider adjusting strategic and tactical asset allocations
Based on the above, not for profits need to consider whether their asset allocation strategy is poised to help them deliver the returns they need to maintain their spending rate. The strategic asset allocation drives the investment program, contributing up to 90% of the variability of the portfolio's returns.
Certain asset classes serve as more effective hedges against inflation than others. For instance, the ownership of real estate and other real, tangible assets can hedge against certain inflation risks, whereas a higher allocation to traditional bonds might be more exposed. Incorporating an inflation hedge is especially important for smaller institutions that generally have lower allocations to real assets and marketable alternatives, which tend to weather inflation well. Value stocks can also serve as an effective hedge against inflation. Historically, these tend to perform better than their expensive growth counterparts in periods of high inflation and rising interest rates when future earnings become less valuable. Lastly, with expected U.S. Federal Reserve interest-rate hikes to combat inflation, fiduciaries should be aware of their portfolio exposures to interest-sensitive assets, such as debt.
Take a nuanced approach and monitor the evolving situation
Inflation expectations remain high in the short term, and the ongoing surge in inflation across the globe is putting increased pressure on central banks to tighten monetary policy—markets are pricing in a significant number of rate hikes this year. We believe the spike in inflation—fueled by supply-chain disruptions, labour shortages and surging consumer demand, and further exacerbated by risks from the Russia-Ukraine conflict and continued pandemic lockdowns in China—will eventually moderate, although it may reach uncomfortably high levels. In Australia, we believe that moderating demand and a rebalancing in demand (from goods to services) should eventually allow inflation rates to come back down to earth.
The bottom line
Not for profits should consider the impact of inflation on spending payout and if changes need to be made in light of shifting capital market expectations. The drivers of inflation should be recognised when making changes to the strategic asset allocation. Finally, remaining flexible is key as inflation and markets evolve, potentially becoming choppier before abating.
¹ As of April 12, 2022.
² Australian Bureau of Statistics