Inflation Report: Pension funds riding the wave

The debate over the nature of the current inflation wave is far from over. This year, as the global economy recovered from last year’s pandemic-induced recession, inflation has continued to beat expectations. The price of raw materials, consumer goods and housing has been rising, to different extents, both in the US and the euro-zone, reversing a multi-year trend of low inflation. Is this a transitory phenomenon or the sign of a regime change, and how should institutional portfolios be adjusted as a result?

It will take some time before the answer to that question becomes clear. Meanwhile, investors have started to take inflation seriously. 

Edith Siermann, head of fixed income solutions and specialised fixed income at NN Investment Partners, says: “For the first time in many years, there is a distinct possibility that inflation in the euro-zone might be significantly higher over the next 10 years than it was in the last decade. This is currently not our main view but it certainly has become a possibility.”

For that reason, Siermann sees long-term inflation as a potential driver of portfolio allocation over the coming years. However, the company expects that euro-zone rates will continue to be low and that both country and credit spreads will remain tight. 

“European fixed-income markets will continue to be dominated by the European Central Bank’s monetary policy. Our view on ECB policy will therefore be another important driver of portfolio allocation. Without unforeseen crises, we expect volatility to be low. We are currently not planning significant strategic changes in our fixed-income portfolios,” she says.

GIAM: new sources of diversification 
Bruno Servant, CEO of Generali Insurance Asset Management (GIAM), expects overall euro-zone inflation to be 1.9% in 2021 and 1.4% in 2022, well below the ECB’s target. “This is a true headache for the ECB, which has just unveiled a more dovish forward guidance,” says Servant.

For liability-driven investors such as GIAM’s clients, the duration gap remains a significant concern. As such, the priority continues to be finding new sources of diversification. 

Servant says: “Solving the challenge within capital requirements will become harder. In particular, the current stretched valuations and record-low real yields will reduce the stock-bond diversification benefits in the future. Liability-driven portfolios will need to understand and onboard more currency risk, more credit exposures across different rating and seniority levels. Adding more private assets would also improve their profile. This wider and more flexible allocation of risk, within the regulatory capital framework, will be key in the years to come.”

However, in the event that inflation became a more urgent issue, Servant advises to tackle it with a diversified approach.

He says: “We look at a mix of inflation-protected government bonds, high-yield bonds and equities. While linkers provide with direct inflation compensation, they are also exposed to real yields rise and we therefore like to add selected high-yield issuers, whose reactivity to yields is lower. On top of that, there are equity sectors that are positively correlated to inflationary pressures, directly or indirectly, including chemical, banks, oil and gas, and small caps in general. Real assets also tend to offer good inflation-hedging characteristics.” 

Investors would welcome some definitive evidence supporting one side of the debate or the other. But the lack of clarity on the current situation is forcing them to keep an open mind on the near term and a steadfast focus on the long-term drivers of portfolio allocation. 

APG: three mega trends 
At Dutch pension asset manager APG, the recent rise in inflation, after decades of unusually low price growth, has forced a rethink of the modelling approach. APG’s chief economist Thijs Knaap says: “Over the past 30 years, there have not been any significant inflationary shocks. For that reason, when evaluating how assets perform in an inflationary environment, stochastic modelling provides unreliable results. In the past year we have added a number of deterministic scenarios.”

The institution has, for instance, evaluated the performance of different asset classes in the event of a shock that would cause a stagflation scenario. Knaap says: “Think of a scenario where climate change causes a productivity or cost shock, due to the effects of floods, fires or taxes on carbon emissions.

“There is another hypothetical scenario where trouble in the euro-zone causes the ECB to lose control of monetary policy. This is a scenario where debt is too large to manage and high inflation causes significant problems.”

In both scenarios, says Knaap, the only asset classes that perform in a satisfactory manner are index-linked bonds and commodities. “You would think that real assets would perform well in an inflationary environment, but that does not seem to be the case. Real estate, for instance, would benefit from higher income streams but valuations would fall.”

Constructing the portfolio based on these results is undoubtedly difficult. Furthermore, Knaap tends to agree with those who see inflation return to the level of the past decade in both the US and Europe. 

There are three ‘mega-trends’ that Knaap considers to be materially significant to APG’s portfolio. One is climate change, which already drives most of the institution’s investment decisions. The legacy of COVID-19 and the tensions between the US and China are the other two, but these are harder to translate into portfolio allocations, because of their unpredictable nature. 

“Nevertheless,” Knaap says, “we have to take inflation into account, due to the long-term horizon of our investments. Our clients have historically seen inflation as a significant risk and limited their exposure to it because of the damage it can do to pension benefits.” 

AP4: continued low returns 
Marcus Svedberg, investment strategist at Fjärde AP-fonden (AP4), the SEK 489.8bn (€48.2bn) Swedish buffer fund, also makes the case that inflation will pull back in the medium term.

“The signs point towards a more pronounced global reflation phenomenon. But this is temporary, in our opinion, and our model suggests that US inflation will come back to slightly below 2% in the medium term. That is, unless the US economy undergoes a structural change,” he says. 

Svedberg tracks three structural trends – technology, globalisation and the climate transition – which could alter the picture. 

He says: “If we saw further advances in automation within industry, we could see economic growth accelerate. Similarly, significant investment into green infrastructure, as announced by the US government, would be growth-friendly. And if governments resist the urge to curb globalisation, growth would benefit. If all those three trends pushed in the same direction, that would increase our trend-growth assumption. But we would need to see stronger signs of that.” 

Stronger growth over the next few years is almost a sure fact, thanks to the huge fiscal and monetary stimulus that is being implemented to combat the consequences of COVID-19, says Svedberg. But in his view, the long-term picture is not that different from the pre-COVID world.

“Perhaps surprisingly, when we put our 10-year glasses on, we come to a very similar conclusion as we did prior to the pandemic. Interest rates are likely to rise over the next decade, but will be stuck at relatively low levels, and the global economy is not growing all that fast. That means we have to realistically adjust our assumptions on returns from financial markets,” Svedberg says. 

He argues that returns will be lower in the future, despite the excellent results of the past few years. 

“Whatever one assumes is the neutral rate of interest, and I notice that different people use very different assumptions, it is extraordinarily low, for both Europe and the US. That means the returns from a mixed portfolio will be fairly low from a historical perspective,” Svedberg says.

“However, in this scenario of low growth and relatively low rates, you are still rewarded for taking risk, so equities are a favourite asset class, despite being already expensive. As an investor, we are also very active in real assets, we certainly are not alone.”

Over the next decade, the priority will be finding value within equity portfolios and real assets and the sources of value could change rapidly over time. “It is going to be a grind,” he says.

A series of fundamental macroeconomic questions should never be put aside, according to Svedgberg. 

He says: “What will central banks do about their enormous balance sheets? Market participants should not be surprised to see the Federal Reserve start tapering and eventually reduce their balance sheet, slowly or quickly, depending on how fast the economy is growing. 

“But what if central banks have no time or willingness, for whatever reason, to shrink balance sheets? Assuming interest rates will rise to an extent, we are then left with a key question of what levels of debt-to-GDP are sustainable.”