Stagflation is the economic scenario that many pension funds fear the most but are perhaps least prepared for. Its heady combination of accelerating prices and meagre growth remains an economic rarity through history. However, this is an unusual moment, and it would be understandable if investors were worried that central bank efforts to control inflation while limiting recessionary risks could lead to missteps that make stagflation a genuine danger in developed markets.
Over the summer, US and European central banks confirmed that they do not expect to end the current interest rate hike cycle soon. Headline inflation is rolling over and core is expected to follow soon, but it is not a given (or even likely) that core prices, which strip out more volatile elements, will fall as rapidly as the headline numbers.
Monetary policy in Europe is still loose, global fiscal spending is stimulative, labour markets are tight, and growth in developed markets is better than feared but still subdued. Our own expectation is for global GDP growth to slow to 2.7 per cent in 2023 from 3.4 per cent in 2022 and to 0.4 per cent from 3.6 per cent in the eurozone – and it is currently unclear if recessions can be avoided while attempting to kill inflation.
So, how can pension schemes protect themselves against stagflation risks while still remaining sensitive to the current uncertainties?
Assessing your vulnerability to stagflation risks
High price rises and slowing growth are a double-edged sword for pension funds. Scheme liabilities will immediately increase with inflation through indexation mechanisms afforded to members. Typically, this leads to an immediate decline of the funding ratio – a scheme’s balance between available assets and liabilities. However, this time around, the inflation is accompanied by higher interest rates, which on balance should be supportive for the funding ratio.
Over the longer term, slower growth will deliver impacts through lower profit margins and lower equity prices and would have the effect of depressing funding ratios. Therefore, if the current environment develops into a stagflation scenario, with a wage-price spiral and declining profit margins, then the funding ratios of pension funds will be hit hard – but the spending power of retirees will be hit even harder.
How to deal with these uncertainties is partly dependent on a fund’s current position – for example, its funding ratio level; its ability to raise pension contributions; whether inflation indexation is capped or not, and so on. All funds should take a closer look at their ability to protect themselves against inflation strategically, but the right course of action will vary individually according to their own strengths and weaknesses within these parameters.
Where to seek protection
Protecting against inflation is partly possible by reducing the scale of any interest rate hedging strategy to avoid further losses if interest rates increase further. Over the long run, underhedged liabilities make funds less vulnerable to increasing inflation, and the same goes for rates.
In the near term, we do expect further rate hikes by central banks and have a relative preference for long-duration bonds. In that spectrum, high-quality bonds, selected investment-grade corporate bonds and sovereign, supranational and agency bonds are preferable over higher-yielding bonds, which may be more sensitive to an economic downturn.
Inflation-linked bonds have shown a relative high correlation with unexpected inflation in the past but potentially look expensive now. However, we would highlight that real rates are at historically high levels and therefore are more likely to decline going forward. It is not yet clear if we will see recession in developed markets, or how deep it might be, but the possibility brings the risk of spread widening at higher interest rate levels.
In this uncertain environment, it is understandable that riskier and illiquid assets are not currently in favour with pension schemes. Managing liquidity is key, as became clear during the UK gilts crisis in October last year. Pension funds are generally still over-allocated to illiquid assets, and we expect this will continue well into 2024 given the difficult task of exiting such strategies.
Thoughtfulness over haste
All things considered, we think that investment-grade credits look more attractive compared to high yielding bonds, and long-duration might hold some appeal, while Inflation-linked bonds have become a trickier call.
Trustees should acquaint themselves with all of the above as viable and potentially valuable weapons in their asset allocation arsenal. Nevertheless, this is a fragile moment that is likely to reward schemes for thoughtfulness over haste. The key is being primed and ready to act, as and when the macro trajectory becomes less uncertain.
