Rethinking inflation risk and protection for nonprofit institutions | Economy Track

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Nonprofit institutions face an increasing set of operational challenges, from declining participation and demand to loss of donors and outside funding. In navigating these constraints, increased importance is being placed on endowments and foundations as a source of funds.

The operational challenges of nonprofits are compounded by the risk of inflation, which can increase costs and deteriorate the purchasing power of endowment and foundation dollars relied upon to support spending on vital services. The rapid price increases of the COVID era offer a stark reminder of the destructive influence that an inflation shock can impart.

While the pace of overall price increases has largely moderated, a return to the ultra-low inflation environment that prevailed between the Great Financial Crisis and the pandemic seems unlikely. As such, institutions are under pressure to develop a clearer understanding of what inflation risk means to them and how they can strategically protect against it in investment portfolios.

The particular inflation predicament of nonprofit institutions

Endowments and foundations are often established to provide a perpetual source of funding for nonprofit institutions, meaning the philosophical investment horizon tends to be long term. But in practice, institutions tend to rely on endowments and foundations to fund ongoing spending needs, which creates acute near-term investment considerations as well.

Institutional investment committees are intimately familiar with the fiduciary challenge of balancing the needs of today with those of tomorrow. Prudent management of institutional funds leads nonprofit institutions to adopt policies that align ongoing spending from endowments or foundations to a certain percentage of investment assets to ensure sustainability with this challenge in mind. It also leads institutions to diversify across many asset classes to account for a broad array of investment risks, the loss of purchasing power from inflation being one.

A diversified portfolio with a healthy allocation to risk assets such as stocks has tended to outpace inflation over extended periods of time, satisfying long-term spending sustainability under such policies as described above. But over shorter periods of time, the volatility of stocks makes them an unreliable inflation hedge. It can be the case that an inflation spike coincides with falling stock prices, such as in 2022.

If costs suddenly surge without a comparable increase in asset values, an institution’s policy could potentially constrain spending to a level that falls short of adequately providing for the near-term needs expected to be funded by endowments or foundations. Institutions recognize this risk, and conventional thinking often leads them to protect against it by incorporating an allocation to what are often considered traditional inflation hedges, such as currencies, commodities and real estate.

But a recent analysis published by The Wharton School at the University of Pennsylvania uses statistical methods that go beyond conventional thinking to shed new light on inflation risk and protecting against it. The authors reveal two significant takeaways: (1) the different underlying components of inflation pose different near-term risks, and (2) an asset’s effectiveness as protection against inflation depends on the underlying component driving the inflation at hand.

Getting to the core: Updating conventional thinking on inflation risk

The most popular measure of inflation is the “headline” Consumer Price Index (CPI), which broadly approximates the overall price level in the economy. Headline CPI is often tracked by institutions as a way to plan for expected shifts in costs. But headline inflation is comprised of distinct components with different characteristics, so economists tend to separate “non-core” (food and energy) prices from “core” (all other goods and services) to get a more nuanced view.

In decomposing headline inflation into these components, research reveals that core and non-core inflation (particularly energy inflation) have sharply different statistical and economic properties. Core prices comprise the bulk of the headline measure, but core inflation has historically been much more stable and persistent than energy inflation. So the relatively smaller, more volatile, less persistent energy component is often what drives observed fluctuations in headline inflation.

If an institution’s primary inflation concern is its cost of services suddenly outpacing its ability to draw on investment funds, understanding which of the distinct components of inflation most directly impacts those services is crucial. Higher core prices such as the cost of a professor, a nurse, a vehicle, or IT equipment are likely to have a more direct and lasting impact on those costs than an energy product like gasoline. While shifts in energy prices may be significant, these fluctuations are less persistent — an increase in the price at the pump is often quickly offset in part by a subsequent decrease. Conversely, the cost of a professor or nurse tends not to go down often or by much, nor do the prices of vehicles or IT equipment. If core inflation experiences a sudden surge, institutions ought to be prepared for an immediate and significant increase in costs.

Concentrating only on the broad measure of headline inflation conflates the distinct underlying components in a way that can obscure the different risks posed by each component. Focusing on the headline measure instead of core inflation may lead volatile shifts in energy prices to cloud an institution’s view of the core costs that are most directly related to the services they provide. Moreover, the different properties of the underlying components have implications for the effectiveness of investment assets as protection against inflation.

Assets as inflation protection: Getting to what works

Understanding the economic differences between the underlying components of inflation adds a new dimension to evaluating the statistical effectiveness of various assets as inflation hedges. Essentially, traditional views on what “works” as protection against headline inflation may be unintentionally capturing a relationship that stands with only one of the distinct components.

Orthodox portfolio management practice holds that diversification among assets with varying levels of statistical correlation is an effective way to mitigate risk. Since higher inflation is a downside risk to institutions, dedicating some portion of a portfolio to assets that are positively correlated to inflation would serve as a hedge against the risk of a near-term inflation shock.

When the two distinct underlying components of inflation are separated, the research shows stark differences in the effectiveness of various assets as inflation protection. During bouts of energy inflation, traditional views of inflation protection seem to be confirmed: traditional bonds lack inflation hedging properties, while currencies, commodities, and real estate (in the form of Real Estate Investment Trusts, or “REITs”) all provide some near-term protection against energy inflation.

But during episodes of core inflation, currencies, commodities, and real estate all fail to effectively hedge against inflation. Bonds remain largely ineffective as well, except for an often-overlooked asset specifically designed to hedge against inflation: Treasury Inflation Protected Securities (TIPS).

TIPS are U.S. Treasury bonds with a twist. They pay a lower interest rate than traditional Treasurys, but as CPI increases, the investor also receives additional shares of the bond (technically an adjustment to the face value). The adjustment provides an extra element of inflation protection that traditional Treasurys lack, which explains their effectiveness as a hedge against surging core prices.

Though TIPS stand out as a strong statistical near-term hedge against core inflation, this does not mean other assets lack any inflation protection value. For example, stocks may be an effective inflation hedge over long time horizons simply because they tend to outperform inflation over extended periods of time. But this outperformance has less to do with near-term inflation correlation and more to do with long-term returns associated with the risk of equity ownership.

Prudent management of institutional funds leads to endowment and foundation portfolios that are broadly diversified among many asset classes to account for an array of risks. Fighting inflation risk requires a diversified set of tools, and TIPS can play an important role that is missing from stocks and traditional bonds. For empirically supported near-term protection against the acute risk that a spike in core inflation poses, institutions would be wise to consider an allocation to TIPS within a diversified portfolio.

The takeaways for institutions

Inflation presents a challenge to nonprofit institutions that rely on endowments and foundations to help fund vital spending needs now and in the future. Inflation protection is best achieved by decomposing inflation into its underlying components and structuring a portfolio based on what satisfies both near-term and long-term considerations.

Eric Morris, Ed.D., Portfolio Manager & Staff Economist for Alesco Advisors, is responsible for managing client portfolios and helping clients make practical sense of complex issues using economic insights.

The content in this article is provided for informational purposes only, and should not be construed as personalized investment advice. The data and information used in the preparation of the article are obtained from third-party sources believed to be reliable, but Alesco Advisors does not guarantee the accuracy, completeness, or timeliness of the data and information.