Pension funds are riding the wave

Key points

  • Inflation in the United States and the euro zone has continued to exceed expectations this year
  • The transient nature of the phenomenon has been called into question
  • Investors see inflation rising in the medium term
  • Drivers of portfolio allocation are more or less unchanged from the pre-COVID era

The debate over the nature of the current wave of inflation is far from over. This year, as the global economy recovered from last year’s pandemic-induced recession, inflation continued to beat expectations. The price of raw materials, consumer goods and housing increased, to varying degrees, both in the United States and in the euro zone, reversing a multi-year trend of low inflation. Is this a transitory phenomenon or a sign of a regime change, and how can institutional portfolios be adapted accordingly?

It will take some time before the answer to this question becomes clear. Meanwhile, investors began to take inflation seriously.

Edith Siermann, Head of Fixed Income and Specialty Fixed Income Solutions at NN Investment Partners, said: “For the first time in many years, there is a real possibility that inflation in the Eurozone will be significantly higher over the next 10 years. that was in the last decade. This is currently not our primary view, but it has certainly become a possibility.

For this reason, Siermann sees long-term inflation as a potential driver of portfolio allocation over the next few years. However, the company expects Eurozone rates to remain low and domestic and credit spreads to remain tight.

“European fixed income markets will continue to be dominated by the monetary policy of the European Central Bank. Our view on ECB policy will therefore be another important driver of portfolio allocation. Without unexpected crises, we expect volatility to be low. We don’t currently anticipate any significant strategic changes to our fixed income portfolios,” she says.

GIAM: new sources of diversification
Bruno Servant, CEO of Generali Insurance Asset Management (GIAM), expects headline eurozone inflation to be 1.9% in 2021 and 1.4% in 2022, well below the ECB objective. “It’s a real headache for the ECB, which has just unveiled a more accommodating forward guidance,” Servant said.

For liability-focused investors such as GIAM’s clients, the duration gap remains a significant concern. Thus, the priority remains to find new sources of diversification.

Servant says, “Solving the challenge within the limits of capital requirements will become more difficult. In particular, the current stretched valuations and record real yields will reduce the benefits of equity-bond diversification going forward. Liability-focused portfolios will need to understand and incorporate more currency risk, more credit exposures across different rating levels and seniority. Adding private assets would also raise their profile. This wider and more flexible distribution of risk, within the framework of regulatory capital, will be essential in the years to come. »

However, in case inflation becomes a more pressing issue, Servant advises tackling it with a diversified approach.

He says: “We are looking at a mix of inflation-protected government bonds, high yield bonds and equities. Although linkers provide direct inflation compensation, they are also exposed to rising real yields and so we like to add selected high yield issuers, which have lower responsiveness to returns. On top of that, there are equity sectors that are positively correlated to inflationary pressures, either directly or indirectly, including chemicals, banks, oil and gas, and small caps in general. Real assets also tend to offer good inflation hedging characteristics.

Investors would appreciate definitive evidence supporting one side of the debate or the other. But the lack of clarity on the current situation forces them to keep an open mind on the short term and 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 exceptionally weak price growth, has forced a rethink of the modeling approach. APG’s chief economist, Thijs Knaap, says: “Over the past 30 years, there have been no significant inflationary shocks. For this reason, when evaluating the performance of assets in an inflationary environment, stochastic modeling provides unreliable results. Over the past year, we’ve added a number of deterministic scenarios.

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

“There is another hypothetical scenario where unrest in the Eurozone causes the ECB to lose control of monetary policy. This is a scenario where the debt is too big to handle and high inflation causes significant problems. »

In both scenarios, Knaap says, the only asset classes that perform well are indexed bonds and commodities. “You would think that real assets would perform well in an inflationary environment, but that doesn’t seem to be the case. Real estate, for example, would benefit from higher income streams, but valuations would fall.

Building the portfolio on the basis of these results is undoubtedly difficult. Additionally, Knaap tends to agree with those who see inflation returning to decade-old levels in the United States and Europe.

There are three “mega-trends” that Knaap considers significant for APG’s portfolio. One is climate change, which is already driving most of the institution’s investment decisions. The legacy of COVID-19 and the tensions between the United States and China are the other two, but these are more difficult to translate into portfolio allocations, due to their unpredictable nature.

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

AP4: still low yields
Marcus Svedberg, investment strategist at Fjärde AP-fonden (AP4), Sweden’s SEK 489.8 billion (€48.2 billion) buffer fund, also says inflation will come down in the medium term.

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

Thijs Knaap

Svedberg tracks three structural trends — technology, globalization, and climate transition — that could be game-changing.

He says, “If we see further advances in automation within the industry, we could see economic growth accelerate. Similarly, significant investments in green infrastructure, as announced by the US government, would be favorable to growth. And if governments resist the urge to rein in globalization, growth will benefit. If these three trends were pushing in the same direction, it would increase our trend growth hypothesis. But we would need to see stronger signs of that.

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

Marcus Svedberg

“Perhaps surprisingly, when we put on our 10-year-old glasses, we come to a very similar conclusion to what we had before the pandemic. Interest rates are likely to rise over the next decade, but will remain stuck at relatively low levels, and the global economy is not growing so fast. That means we need to realistically adjust our assumptions about financial market returns,” Svedberg says.

He maintains that returns will be lower in the future, despite the excellent results of recent years.

“Whatever one assumes to be the neutral interest rate, and I notice that different people use very different assumptions, it is extraordinarily low, both for Europe and the United States. This means that the yields of a mixed portfolio will be quite low from a historical perspective,” says Svedberg.

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

Over the next decade, the focus will be on finding value in equity portfolios and real assets, and the sources of value could change rapidly over time. “It’s going to be a chore,” he said.

Bruno Servant

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

He says, “What will central banks do with their huge balance sheets? Market participants should not be surprised to see the Federal Reserve begin to shrink and eventually shrink its balance sheet, slowly or quickly, depending on how fast the economy is growing.

“But what if central banks don’t have the time or the will, for whatever reason, to shrink balance sheets? Assuming that interest rates will rise to some extent, we find ourselves so with a key question of what levels of debt to GDP are sustainable.