San Jose Police & Fire Department Retirement PlanSan Jose Police & Fire Department Retirement Plan

NEPC, LLCOne Main Street, Cambridge, MA 02142Tel: 617-374-1300 Fax: 617-374-1313

www.nepc.com

CAMBRIDGE I CHARLOTTE I DETROIT LAS VEGAS I SAN FRANCISCO

Registered Investment Advisors

Inflation Linked Assets

September 15, 2009

Allan MartinPartner

Edward J. O’Donnell III, CFAConsultant

Carolyn SmithPartner

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What are Inflation Linked Assets?What are Inflation Linked Assets?

• Assets that have intrinsic value; investors value their inherent utility– This value is less eroded by inflation (unlike paper assets)

• Inflation-sensitive equities: Real Estate, Infrastructure, Energy, Agribusiness

• Commodities

• Inflation-linked bonds (e.g. TIPS)

• Timber

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Why Invest in Inflation LinkedWhy Invest in Inflation Linked Assets?Assets?

• Many hard assets offer real after-inflation return and valuation protection; better inflation-hedge than financial assets

– Help protect purchasing power

• Diversification – Inflation Linked Assets have low correlations… – To traditional asset classes and are counter-cyclical (rise when many others fall); – Among one another; and– Which lowers overall portfolio volatility, providing higher risk-adjusted return

• Important consideration for client portfolios, many are under-exposed

– Liabilities are sensitive to rising inflation

• Inflation can be the highest risk portfolios face– Inflation Linked Assets provide portfolios insurance against inflation– Inflation insurance is currently cheap

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Why Invest in Inflation Linked AssetsWhy Invest in Inflation Linked Assets Now?Now?• Can accomplish long-term strategic objectives while taking

advantage of current pricing opportunity – Access long-term inflation protection and diversification benefits as part of

strategic allocation

– Current short-term, low inflation (or deflationary) expectations run counter to long-term inflationary pressures facing U.S. and global economy

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GSCI S&P 500 10 Yr Treasury

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• Near term - Low inflation likely– Weak overall economic demand– Strong dollar in “flight to safety”– TIPS pricing in very low 5-10

year inflation expectations– Commodities pricing reflects low

expected economic growth

• Medium term - Inflation could rear its ugly head – Stimulus expands money supply– Increased government

borrowing will put pressure on the Dollar

– Commodities prices to rise on growing economic activity

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Inflation-Sensitive Assets – Currently CheapInflation-Sensitive Assets – Currently Cheap

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Strategic Allocation Considerations & RisksStrategic Allocation Considerations & Risks

• How much Inflation Linked exposure is currently in the Fund?– Initial decomposition (strategic vs. tactical)

• What are the liquidity needs and time horizon?– TIPS are most liquid; Timber least

– Distinguish between public & private markets

– Complement public with private strategies; core and opportunistic

• Potential Risks– Volatility of individual investments

– Macroeconomic trends and cyclicality

– Low correlation and market timing

– Improper benchmarking

– Cash collateral

– Manager-specific risks: selection is key

– Auditors’ concerns; AICPA and SFAS 157

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• Inflation can be the highest risk portfolios face– Liabilities are sensitive to rising inflation

• Employee wage and salary increases; cost of living adjustments for retirees

– Inflation Linked Assets provide insurance against inflation• Inflation insurance is currently cheap

• Diversification

– Balance liquid core investments with less liquid satellite investments

• Highly Liquid Exposure– TIPS

• Strategic or tactical allocation• Included in inflation linked assets or fixed income allocation

– Commodities• Long Only as well as Long/Short manager

• Less liquid exposure– Infrastructure– Timber

• Benchmarking can be challenging– Consider creating a “inflation linked assets” category, which would include real estate, commodities, TIPS,

infrastructure, timber– Each individual strategy would have its own return and risk expectations along with its own benchmark

• Include allocation to Inflation Linked Assets in future asset allocation

Summary & TakeawaysSummary & Takeaways

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TIPS

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TIPSTIPS• Treasury Inflation-Protected Securities

– Designed to protect investor purchasing power from rising inflation– Guarantee investors a real rate of return when held to maturity rather than a

nominal one• Structured with fixed coupon rate set at the time of original issuance

– Represents the real rate of return required by investors at that time – Bond’s principal is adjusted upward based on changes to CPI– With fixed coupon rate applied to the growing principal balance, interest payments

rise with inflation– Never adjusted below Original Face

• TIPS are the most direct and pure inflation hedge– Cheap, safe, liquid means of inflation protection– More easily understood by clients than many other inflation-hedge assets

– Risks– Interest rate paid is lower than equivalent treasuries – Lowest expected return among inflation linked assets. The higher your benchmark

for inflation linked assets, the less you can rely on TIPS to meet your objectives.– Interest rate paid is lower than equivalent treasuries – Deflation: if U.S. economy suffers from deflation, these securities won’t be useful– Marketability – not as easy to trade on the open market as non-indexed treasuries.– CPI Calculation - Many Economists, including Greenspan, feel CPI is overstated. If

the government decides to switch to another inflation measure, then the CPI adjustment won't be as valuable.

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TIPS – Current OutlookTIPS – Current Outlook

• Very popular; demand continues to rise despite current low yield (1.3%)– Investors willing to give up yield in exchange for protection

• Best performing asset class in late 2007– Flight to quality during credit crunch and uncertainty favored Treasuries – Rising expectations for future inflation favored TIPS even further

• Now working when other assets are not; a strategic asset worth having – US real rates at the short end are negative. Flight to quality and rise in oil

prices has been dramatic and good for the TIPS. While US rates have led the pack, rates in foreign markets are still relatively high.

• Core inflation rose from its y/y low of 2.1% last summer to 2.5% in January, and latest core report was slightly slower based on discounting in retail activities and auto rebates, offsetting higher shelter costs as rents rise. – To the extent that businesses have been able to pass along their higher

costs, however, this estimate could be too low. – Fed is counting on core inflation remaining low so that they can keep easing

to relieve distress in the financial system, and avoid stagflation.

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TIPS and Implied InflationTIPS and Implied Inflation

TIPS implied inflation breakevens (Treasury yield – TIPS Yield) from the smoothed series that the Federal Reserve puts out

Breakevens today are still below peak levels reached in 2005 and 2006

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CommoditiesCommodities

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Commodities: How They WorkCommodities: How They Work• Three drivers of commodity returns

– Spot price– Roll Yield– Collateral Yield

• Spot price: supply and demand– Supply shocks: real and perceived. Depends upon where you are in the supply chain.

OPEC, Copper strikes in Peru, and green energy on Uranium. – Demand elasticity: at what price of gasoline would you take the bus or buy a Prius?

• Collateral Yield: rising tide floats all boats– Majority of commodity exposure gained via derivatives, especially futures– Investors maintain margin at broker for futures collateral; typically T-Bills– Rising inflation pushes nominal yields higher, enhances commodity returns– LIBOR is cost of financing; many commodity approaches actively manage the collateral

in a LIBOR strategy to offset these costs

• Roll Yield: Backwardation & Contango– Backwardation: upward sloping reinvestment curve; negative roll yield

• Headwind to rolling-forward contracts & maintaining exposure

– Contango: downward sloping reinvestment curve; positive roll yield • Tailwind to rolling-forward contracts & maintaining exposure

– Passive investment experiences these & is powerless; only holds near-term issues

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• Implementation is simple, inexpensive, and liquid

• Commodities are a strong portfolio diversifier– Returns are negatively correlated with equity and bonds; asset

class return drivers are very different – Reduce overall portfolio risk

– Correlation of returns among commodity sectors is also low– High 0.24 industrial to precious metals; low 0.07 metals to agriculture

– Commodity returns are positively correlated with inflation– Especially when unanticipated (e.g. supply shocks)

– Provide protection & diversification when needed most– Headwinds to equities & bonds are tailwinds to commodities

Benefits of Commodities InvestingBenefits of Commodities Investing

Correlations Equities Bonds

GSCI ER Index -0.20 -0.36

DJ-AIG ER Index -0.19 -0.1014 years ended December 31, 2004 (1.0 is perfectly positively correlated, -1.0 is perfectly negatively correlated)

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Commodities: Major SectorsCommodities: Major Sectors• Energy• Metals—industrial and precious• Agriculture—hards, softs, and livestock• Low correlation among and within sectors

– Diversification benefit can dampen volatility if actively managed – Yet some inter-dependence—e.g. energy costs & aluminum

production

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GSCI and DJAIG Commodity Index Sector ComponentsGSCI and DJAIG Commodity Index Sector Components

Source: Commonfund

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InflationInflation

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Inflation Point/Counterpoint: The US FedInflation Point/Counterpoint: The US Fed

• Printing money: Fed is increasing the monetary base to fund various stimulus packages; greater money supply makes the USD worth less. The “soft landing” is likely impossible – policy makers face a fielder’s choice between high unemployment and high inflation.

• Stimulus policy: current fiscal and monetary policy are geared towards spurring economic growth out of recession, not towards containing inflation

• Risky assets: Fed has more higher-risk assets on its balance sheet than ever before (e.g. significant ownership in faltering banks, auto, mortgage, health-care, and insurance companies). This potentially alters the yield investors require for holding US Treasuries. It also undermines investor confidence in the US.

• Underfunded liabilities: Social Security, Medicaid, Medicare, PBGC, and Military Benefits to name a few

• There is growing unease with regard to CPI as a viable inflation measure and TIPS as an effective inflation hedge

• The Bernanke buffet: the smorgasbord of measures offered up by the Fed (e.g. quantitative easing; buying up investment banks and mortgages) is difficult to take away, once corporations and consumers get used to it. Stopping the stimulus party could prove to be a politically unpopular move.

• Bernanke has not learned the lessons of 1990s Japan, and is walking the US down the same sorry path

Inflation Will Rise• The Fed is competent. It will control money

supply appropriately, by withdrawing reserves at the appropriate time; not too slowly (causing higher inflation) nor too quickly (stunting recovery and leading to deflation) i.e. it will stick the soft landing.

• The Fed is aware of the exit problem. It will start the process of exiting excess supply when the economy is below full employment and inflation is below the (2%) target. If the Fed misses the bulls-eye, we may see inflation greater than the 2% target--say 3 or 4%, but not hyper-inflation.

• Excess reserves on bank balance sheets will lead to credit expansion; greater velocity of capital will reduce the need for greater supply

• Market measures of inflation (e.g. CPI) and forecasts for inflation (e.g. TIPS implied inflation) both speak to a very low-to-moderate inflation environment going forward  

• Bernanke savant: Ben is an astute scholar of the great depression, one who is determined to avoid repeating its policy mistakes

Inflation Will Fall

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Inflation Point/Counterpoint: Other Central BanksInflation Point/Counterpoint: Other Central Banks

• Russian and Chinese bankers are suggesting a new global reserve currency through IMF SDRs or a market-basket, possibly including gold

• China is likely to continue selling US Treasuries, or at a minimum, temper future purchases; increasing price pressure and USD supply.

• Asian central banks diversifying away from US Treasuries • China is on a commodity buying spree. China continues to

diversify its portfolio away from being a major currency manager to owning and operating inflation linked assets (e.g. buying up oil fields and copper mines) as well as focusing on encouraging domestic consumption.

Inflation Will Rise Inflation Will Fall• IMF forced selling of gold will help maintain

value of all fiat currencies is competent.

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Inflation Point/Counterpoint: The US DollarInflation Point/Counterpoint: The US Dollar

• US dollar is likely to resume its long-term secular decline in value.

• We are in unchartered waters relative to Europe and Japan with our bank nationalizations, auto buyouts and national healthcare - hard to say we are any different.

• The current dollar rally is being buoyed by a "flight to quality", a misnomer if there ever was one

• All signs point to a US dollar that is less attractive to global investors:

– Fed funds rate near 0%– Unemployment near 10%;– Negative to low GDP growth – High % of GDP in debt– Explosion of risky assets on Fed balance sheet

• Emerging markets' debt is becoming more local in nature, and less USD-based. Emerging markets balance sheets are strong relative to their developed world counterparts; emerging markets have gone from being borrowers to lenders.

• China is definitely trying to decouple from US consumer dependence and move towards a mixed consumer/export economy

Inflation Will Rise• Currency is a relative value game; US is looking

better able to recover from this crisis than most developed nations

• If Treasury yields rise, USD will become more attractive

• Lower USD value also makes US goods cheaper - stimulating exports (and economic growth), if USD declines more rapidly than other currencies. Demand for USD will rise, elevating currency value to new price point equilibrium.

• Much of emerging markets' debt is USD-based; they are not likely to repatriate this any time soon

• China and US are in symbiosis with regards to borrowing and lending; we need each other to grow our economies

Inflation Will Fall

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Inflation Point/Counterpoint: CommoditiesInflation Point/Counterpoint: Commodities

• If global stimulus packages are successful, they will ultimately lead to greater demand for natural resources; after a period of lower global inventories, higher commodity prices are sure to come…

• Supply destruction: – Global inventories are lower– Lower commodity prices are causing significant cost-

cutting measures—e.g. Capex is down significantly – Global supplies are insufficient to meet long-term

population growth and industrialization needs – The current state of supply destruction is setting up the

next, inevitable commodity price rally

• Demand: long-term, sustainable demand for global natural resources is likely to improve as credit markets recover, lending standards widen, and companies begin to spend and produce more materials. Emerging markets are undergoing an industrial revolution and rapid urbanization; these powerful forces move global demand for natural resources.

• Dollar effect on commodity prices: – Commodities trade & price in USD– Weakening USD will be bullish for commodities as

marginal global investors will demand more commodities.

– Emerging market currencies become more valuable and increase incremental demand for commodities.

• Commodities have rallied year-to-date, in large part due to speculation that longer-term inflation risks are rising; in part due to a decoupling of emerging markets from the developed world consumer

Inflation Will Rise• Current commodity prices properly reflect a

global economic slowdown • Supply: current inventories are sufficient to

meet lower demand in slow growth environment; consumers and companies not spending

• Demand: near-term demand for commodities is declining on the global economic slowdown and a lower investor risk appetite

• The year-to-date rally is purely speculative in nature; in reality, the fundamental balance between supply and demand has reached a new (and lower) equilibrium price point

Inflation Will Fall

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Inflation Point/Counterpoint: The ConsumerInflation Point/Counterpoint: The Consumer

• Developed world: once credit markets recover and lending standards improve, consumers will borrow more and spend again---increasing demand for essential resources *

• Leverage (on personal and corporate balance sheets) is an essential component to moving the wheels of capitalism; it will come back *

• Ultimately rising home prices would certainly boost consumer confidence and spending; home equity will once again become income to spend *

• Rising unemployment rates are unsustainable; jobs will recover and companies will resume growing and spending. Unemployment is a lagging economic indicator.

• Emerging world: consumer preferences are changing; with rising wealth comes rising demand for global natural resources

– Food: increased demand for more protein-based diet is highly correlated to GDP growth

– Energy: increasing demand for fuel from factories and cars

– Infrastructure: building roads, airports, and bridges at a very rapid pace; rampant industrialization and urbanization requires energy, power, and transportation--and lots of industrial metals

– Precious metals: new wealth eager to display its shiny status

* None of these have materially happened in Japan

Inflation Will Rise• Developed world: the need to increase savings

rate is an important lesson learned from this financial crisis

• Corporations face higher cost of borrowing; rising capital costs make earnings expectations and profit margins lower

• Consumer no longer 2/3 of US GDP; government spending likely to rise, but not enough to offset more conservative consumers

• Political momentum towards climate change makes traditional energy sources unattractive in a carbon-sensitive marketplace; consumer preferences changing  

• Emerging world: though the emerging consumer may drive demand for global natural resources, the trading partners are different (they are decoupled from us)

• Emerging markets are focusing on more domestically-oriented sectors; becoming less and less dependent on export-driven sales to the developed world consumer.

• Markets like Brazil and China trading more goods and natural resources with each other; taking other markets out of the supply/demand equation

• Emerging markets are beginning to solve domestic demand needs with domestic inventories; importing less; decreasing global demand measured on market exchanges

Inflation Will Fall

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AppendixAppendix

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Stocks and Bonds Underperform in Periods of Rising InflationStocks and Bonds Underperform in Periods of Rising Inflation

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Countercyclical Nature of Inflation Linked AssetsCountercyclical Nature of Inflation Linked Assets

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Countercyclical Nature of Inflation Linked AssetsCountercyclical Nature of Inflation Linked Assets

Correlation of S&P Index with Commodities, Bonds & Other Equities

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Inflation Linked Assets: Supportive Tactical Momentum Inflation Linked Assets: Supportive Tactical Momentum

• Several global trends are in place that may favor inflation linked assets– Robust demand

• China, India and the rest of emerging markets (e.g. Brazil, Emerging Europe) are growing rapidly. As these regions industrialize, capex on inflation linked assets increases, as does global trade (as very few produce the materials they need to grow).

– Limited supply• Volatile price history, long lead times, political instability, and significant capital

requirements have constrained investment

– Shifting asset preferences• Commodities emerging from a 20-year bear market• Inflation increasing• Global demographics• Commodity supplies• Investors seek uncorrelated return streams during uncertainty and volatility in

traditional capital markets

– Inflation is on the rise

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Real Return – Inflation Linked StrategiesReal Return – Inflation Linked Strategies

TIPS

Energy

Commodities

Infrastructure

Real Estate

Liquid

TIPS

Energy

Commodities

Infrastructure

Real Estate

Hedge Funds

Energy

Commodities

Infrastructure

Real Estate

Timber

Energy

Commodities

Infrastructure

Real Estate

Timber

Private

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Vehicles for Inflation Linked Exposure (not including GAA) Vehicles for Inflation Linked Exposure (not including GAA) TIPS

a) Within Core Bonds

– commingled pools or separate a/c

b) Exchange Traded Funds (ETFs)

c) Direct, dedicated investment

d) Some hedge funds

Energy (Oil and Gas)

a) Public Energy Funds

b) Exchange Traded Funds (ETFs)

c) Private Energy Partnerships

Real Estate, Infrastructure, Timber

a) Direct Purchase – Separate a/c

b) Public Equities

c) Private Partnerships

Commodities

a) Direct Physical Investment

b) Portfolio of Commodity-Related Stocks

c) Commodity Futures – Enhanced Index

d) Private Partnerships