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Pension funds face the perfect stagflationary storm

While hopes of a ‘soft landing’ abound, global pension funds are a little more cynical. A stagflationary environment is not just possible, but likely, and hedging against it will be a herculean task.

“Extreme pragmatism” will guide asset allocation as pension funds prepare for a stagflationary environment, according to a survey of 152 global pension funds managing AUD$3trilion by CREATE-Research and the Amundi Institute (headed up by Monica Defend, photo at top).

The survey found that 50 per cent of respondents subscribe to a stagflationary scenario for the post-pandemic economy – too hot in terms of inflation, too cold in terms of growth – with Western governments obliged to keep running large deficits to fund post-pandemic reconstruction and energy security.

“The challenge is immense because the recent revival of inflation is believed to be structural, not cyclical,” says the survey report, titled Pension funds: reorienting asset allocation in an inflation-fuelled world. “In part, it also reflects deep-seated supply side vulnerabilities that were metastasising under the surface in a prolonged era of ultra-loose monetary policies.”

“The key vulnerability relates to the shift in the manufacturing centre of gravity from the West to the East over the past four decades in pursuit of cost efficiency. The recent reversal towards ‘reshoring’ is vital but also expensive.”

While the push into private markets continues at pace, the majority of respondents (62 per cent_ believe high-quality equities will provide them the most inflation protection. On a three-year forward view, the “gravitational pull” in return-seeking assets will favour global equities (cited by 70 per cent of respondents), US equities (58 per cent, European equities (47 per cent), and Chinese equities (40 per cent).

Real estate comes in at a distant second to high-quality equities (49 per cent) , tied with infrastructure. Overt inflation hedges based on swaps was favoured by 46 per cent of respondents.

But the recent reset in asset valuations isn’t yet complete. Equity market valuations remain above the levels reached during the Covid-led selloff in early 2020. Each new rally will “eat its own tail” as central bankers continue their rate hike blitz, and the deeply ingrained belief that the Fed will always intervene if markets tumble no longer holds water.

“With every big slide since the start of the ‘Greenspan put’ in 1987, policymakers’ efforts to reboot markets were welcomed with open arms,” the report says. “But this was only possible when low inflation was a constant. That is now a Herculean task. Hence, central banks will lose their potency in influencing market prices: 40 per cent agree and 18% per cent disagree, with 42 per cent saying maybe.”

Around 60 per cent of respondents believe that inflation will have a negative impact on their portfolio, while 11 per cent believe it will be positive (on the basis that easy monetary policy has had a distortive effect on asset prices, and the reversal means that markets are more likely to be “rational and value oriented”. But there’s still the possibility of financial accidents throwing an already uncertain future into total disarray.

“The big market rally in July 2022 was driven by the belief that July inflation data in the US marked a turning point and the Fed would start cutting rates early in 2023,” one Swedish pension plan told the survey. “ Alas, this blind faith was shattered by August inflation data. This is hardly surprising. We are truly on a voyage into the unknown where mega forces now drive asset choices more than monthly data.

“… we don’t rule out the possibility that central bankers will wimp out if rate hikes cause a deep recession and a debt trap where borrowers borrow more to service their debt. As they strive to tackle inflation, policy errors are inevitable, if history is any guide.”

Respondents also believe that a return to fundamentals will create an opportunity for thematic investing, and are intensifying their search for a “thematic premium” from predictable sources of value creation.

“In the post-pandemic era, the spotlight has turned on megatrends that are driving disruptive innovations, reshaping business models and moulding public and corporate policies,” the report says. “These changes are unfolding at a nonlinear pace. As a result, 60 per cent expect to increase their allocations and four per cent to decrease it.”

“So far, allocations have remained small because the toolkit of thematic investing is emerging gradually. The key constraint is the absence of a widely recognised classification system that is essential for activities such as portfolio construction, manager selection and peer benchmarking. Another constraint is the relatively limited universe of ‘pure play’ companies that seek to capitalise on key growth points in the global economy. These constraints are expected to ease as interest in thematic investing intensifies.”

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