CalSTRS plans for inflation, defends against recession.

Central banks’ massive efforts to stimulate economies and save banks from spiraling into bankruptcy are bound to fuel inflation when economies stabilize, but another unexpected knock could also send the U.S. economy back into recession.

That’s the conundrum faced by the $120 billion-asset California State Teachers’ Retirement System (CalSTRS) alongside a list of other risks, said Chief Investment Officer Christopher J. Ailman in a presentation to the pension fund’s board in November.

The U.S.’s Troubled Asset Relief Program (TARP) and the bank rescue package now being worked out in Europe shift leverage from those banks to the governments, and that’s almost certainly going to result in inflation, Ailman said, adding, “And that’s why we want to build an inflation-sensitive portfolio.”

But even though inflation is “primed, ” he said, the lack of consumer purchasing power and GDP growth will keep it at bay for the foreseeable future.

“What we’re trying to do with the portfolio is navigate this economic uncertainty,” Ailman said, noting that “anemic is the key word” describing the U.S. economy.

Although the economy is growing at less than 2%, he said, exposure to equities will be necessary when inflation becomes more broad-based than recent short-term inflationary pops, such as the run up in commodity prices earlier this year. “But we also know that one slight kick and the U.S. economy will slip back into recession,” Ailman said.

The fund is currently underweight global equities, with an interim target of 49% of the portfolio. “Our underweight to equities helps us when the market is negative but hurts us when it rallies,” Ailman said.

The recession kick could come from across the pond, if Europe’s sovereign debt crisis ends up sending those economies into a downward spiral and curtails exports to the U.S.’s biggest trading partner. That would affect a broad swathe of CalSTRS’s investments.

“We’re still digging ourselves out of a hole,” Ailman said, noting the fund is down more than 3% for the year. He added that CalSTRS portfolio is purposely underweight global equities and maintains 1% to 2% in liquid, short-term cash that can quickly be invested opportunistically.

A potentially more immediate impact could come from the inter-relatedness of financial institutions that own the sovereign debt of countries threatening default—Greece but even more importantly Italy and Spain—as well as one another’s debt.

“What we’ve tried to do in the portfolio is not just look at first hand exposure and second hand, but third derivative and fourth derivative,” Ailman said. “Do we invest with people in the U.S. who invest with people in Europe, who have invested in European banks who own the [sovereign debt] debt. You have to worry about how far that wave reaches potentially.”

Another big concern is the market’s volatility. Ailman said CalSTRS’portfolio was up or down $1 billion in value on 35 out of 65 trading days, and up or down $3 billion on several days during the period between August and October.

Ailman attributed the volatility to the economic uncertainty in Europe and the U.S. as well as the advent of high-frequency trading and dark pools.

Ailman also pointed to concerns about the Chinese real estate market bubble and whether it is manageable. He noted that there’s less interconnectedness among Chinese banks, reducing fears about a broader financial-market collapse, but there is also very little transparency into the health of the Chinese financial system.  He said CalSTRS has very little direct exposure to Chinese real estate, and only about 1.5% of the portfolio is exposed directly to Chinese companies, with more indirect exposures stemming from investments in multinationals such as General Electric and IBM.

Ailman said his discussions with other fund managers that have been in the business for 20 years or more have echoed his own concerns about the financial market’s increasing complexity and interrelatedness. Today, he said, it’s more difficult than ever before to discern what the market will do with any specific piece of news.

“In the old days, you would know exactly how to trade and make money from a piece of news. Nowadays I’m not sure you would know how to trade it,” Ailman says.