- Inflation will remain structurally higher in the new regime
- Central banks are walking a tight rope between recession and inflation
- Central banks will lose their potency in boosting market returns
- The spectre of ‘stagflation’ implies an environment of low returns
After a prolonged era of cheap money and double-digit returns, the sharp spike in inflation to its 40-year high in 2022 in the West was a game changer.
That the Goldilocks scenario of moderate growth and low inflation has been rudely interrupted is not in doubt, nor is central banks’ resolve to tame the inflationary spiral.
The rich world is now walking a perilous tight rope, after virtually abolishing risk pricing in capital markets over the past 12 years. The scope for policy missteps is enormous, as central banks seek to pull off the highly desirable ‘soft landing’ that minimises both inflation and recession risk at the same time.
Our 2022 Amundi–CREATE institutional survey aims to shed light on how pension plans are responding as their portfolios are hit by the market impact of the latest surge in inflation in the key Western economies.
The survey is based on responses from 152 pension plans from 17 jurisdictions, managing €1.98trn of assets.
A regime shift
Titled ‘Pension funds: reorienting asset allocation in an inflation-fuelled world’, the report finds that the current monetary regime faces big upheavals. Tremors from two seismic events – the COVID-19 pandemic and the war in Ukraine – will reshape global capitalism for years to come.
Various shifts are already evident (figure 1). Some focus on capital markets, others on systemic forces that affect markets as well as wider society. History shows that such transformational shifts follow a nonlinear pattern, often causing big market impacts over extended periods from their ‘second order’ multiplier effects. For now, the emerging economic order displays three key changes.
First, the globalisation of the past is being diluted by ‘reshoring’ – producing more stuff at home or trading with friendly nations to ensure national security and avoiding supply-chain disruptions. Global trade is giving way to self-reliance.
Second, the current ‘cost-of-living crisis’ requires governments to play a much greater role in ensuring self-sufficiency and also tackling the economic inequalities within countries that have long built up as the side effects of globalisation.
Case study of a US pension plan
“After the end of the Bretton Woods exchange rate system in 1973, the US Federal Reserve was no longer obliged to maintain a fixed rate between gold and the dollar. It was free to extend business cycles by issuing fiat money at will.
“The resulting decrease in the number of recessions meant that the US economy was unable to weed out ‘zombie’ companies that could barely pay the interest on their borrowing. The misallocation of capital, low productivity, rising inequality and the hollowing out of the manufacturing base was all too evident as the Fed also put more emphasis on price rises in the real economy than on asset inflation in the finance sector.
“Asset prices increasingly became addicted to central bank largesse. They were moved more by the utterances of central bankers than by fundamentals in the real economy. Much of the wealth creation during the longest bull market in history was illusory. It could not heal the secular stagnation in the real economy. Instead, it worsened economic inequalities.
“Now, having prioritised a hawkish rate hike to tackle the raging inflation it saw as temporary, the Fed also risks huge reputational damage, having enticed investors of all shades up the risk curve.
“Before the big correction in June 2022, markets had reached nosebleed levels. Historically, credit booms have always ended in tears. The current one will be no different, as rate hikes in 2022 will tip the US economy into recession. We cannot rely on the Fed to prop up the markets.”
Third, governments in all the key economies are committing huge investment to their net-zero climate goals. This much is evident from the two landmark supply-side initiatives in the US last summer – the Inflation Reduction Act to tackle climate change and the CHIPS and Science Act to pour billions into private sector investments.
As a result, key economies will continue to run big budget deficits, requiring the continuation of financial repression – low interest rates to keep debt manageable and higher inflation to vaporise it. This leaves central banks to perform a near-impossible balancing act – fighting inflation and supporting national policies. Such trade-offs will vary across the globe, causing desynchronisation between economic regions.
But one thing is certain: central banks will no longer be able to calm markets when they become ultra-volatile, as policymakers have done over the past 35 years (see case study).
The days of double-digit returns from a prolonged asset bubble are over, as inflation has roared back to life. The low interest rates and high equity returns of the post-2008 era were only possible when inflation was low.
To bring inflation down towards the policy goal of around 2%, the terminal federal fund rate in the US needs to rise steeply into the 5-5.5% range. If not, inflation expectations will become de-anchored, as the cost-of-living crisis in the West continues to intensify. There are already signs of a self-fuelling wage–price spiral in Europe.
The challenge is immense because the recent revival of inflation is believed to be structural, not cyclical. In part, it also reflects supply-side vulnerabilities that were developing in a prolonged era of ultra-loose monetary policies since the 2008 financial crisis.
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 reversal towards ‘reshoring’ is vital but also expensive.
The second set of problems relates to anaemic productivity growth in the West. They include: underinvestment in physical capital in ‘old’ industrial sectors despite their big weight in every modern economy; underinvestment in education and training for the skills of tomorrow, as artificial intelligence becomes the new heartland technology in every sector of the economy; and overinvestment in the glamorous large internet platforms with few job opportunities for workers displaced by globalisation. This sector has benefited hugely from low discount rates that have magnified the present value of its future earnings.
The third set of problems relates to the over-financialisation of capital markets, decoupling them from the real economy. The role of equity markets has morphed from a source of raising capital for growing companies to a vehicle for cash distribution and balance sheet management. The real returns on total financial assets exceeded GDP growth, as central banks worried more about price inflation than asset inflation.
Spectre of secular stagnation
Figure 2 shows that 50% of survey participants subscribe to a stagflation scenario for the post-pandemic global economy – too hot in terms of inflation and too cold in terms of growth. It assumes that, with their bloated balance sheets, central banks will find it hard to do ‘whatever it takes’. Inflation expectations may thus become de-anchored as workers intensify wage demands and companies strive to maintain profit margins.
The ‘secular stagnation’ scenario, in which price pressures from the supply side ease, alongside falls in aggregate demand from rate rises, is cited by 38% of survey respondents.
It envisages a return to the hole we were in before the pandemic – low growth, low inflation, low physical investment, rampant inequalities and stagnant wages. Its key assumption is that the US Federal Reserve will do enough without breaking the global economy.
The ‘roaring twenties’ scenario – reminiscent of the big economic bounce after the Spanish flu pandemic of the 1910s – is cited by 12%. In it, price pressures from the supply bottlenecks ease notably alongside robust growth, driven by productivity gains from innovation that also keeps inflation low.
The question is not whether inflation will decline from its recent high of 8-10% on the current policy path in the West. It is whether inflation will come down to an acceptable level. Historically, high inflation has been self-limiting because it creates dynamics that can slow future inflation as real incomes and consumption decline and the immediate cause of the spike fades.
However, history also shows that once inflation is this high, it is also prone to rise further and become more volatile, unless central banks resort to former Fed president Paul Volcker’s ‘shock and awe’ playbook of the 1980s, which triggered two recessions. That would mean the Fed’s fund rate moving towards the 5% to 5.5% range. The risks of a hard landing are rising, as are those of a tumble in corporate earnings.
Future asset returns will be a lot lower than in the past decade. Each rally will eat its own tail while the rate-hike blitz continues. The deeply ingrained belief that the Fed will intervene if markets tumble may fall by the wayside. With every big slide, markets have welcomed back their sugar daddy with open arms. However, this was only possible when low inflation was a constant. That is now a Herculean task. Central banks will lose their potency in boosting asset prices, as they embark on quantitative tightening in earnest. Assessing what constitutes fair value for asset classes remains the biggest challenge after a prolonged period of frothy markets and damaging bubbles.
Unsurprisingly, only 11% of survey participants believe that the impact of inflation on their investment portfolio will be positive, while 59% say it will be negative (figure 3).
Rising correlation a game changer
Bonds and stocks have suffered major sell-offs in lockstep in 2022 – as they did during the Great Stagflation between 1978 and 1982. Bonds’ role as an income generator and a diversifier has been weakening. It was only strong when central banks could influence inflation expectations. Now, with rising interest rates, the income role is coming back. Asset allocation is therefore being reoriented towards the following: real assets in private markets in search of inflation protection; dynamic investing in an agnostic search for decent returns; regional dispersion, as key markets become desynchronised; value investing, as central bank support melts away and asset prices revert to fundamentals; and passive funds, as cost becomes vital in a low nominal return era. In the process, asset allocation now has three buckets, each with its own goal.
The first goal seeks decent total returns via high-quality equities that are seen as the portfolio’s key growth engine, so long as inflation does not persist above 5% for long. The second goal is inflation protection via assets that are seen as having a built-in mechanism to keep up or keep ahead of inflation. The third goal is capital conservation via bonds that serve to hedge risky assets.
However, future-proofing a pension portfolio is hard. First, the rising correlation has been limiting the scope for diversification. Equities and bonds are the two biggest asset classes. Unless they are negatively correlated, meaningful diversification is difficult.
Second, there is a limited capacity of inflation-protected assets that limits their universe and their illiquidity and reduces portfolio flexibility. In fact, such assets are already a crowded trade, as indicated by rising dry powder.
Third, sovereign bonds are no longer a safe haven. The extreme volatility in the UK Gilts market in September showed how policy mis-steps can cause havoc. Worse still, it also shows the perils and pitfalls that central banks have to navigate.
On the upside, tighter monetary policy will make markets more rational and value oriented. The long winter for value investing is coming to an end. It will also intensify the search for better returns as periodic market ructions create bargains in underpriced distressed assets. Inflation-protected assets in illiquid private markets – such as infrastructure and real estate – hold special appeal if policymakers become more tolerant of inflation. Most importantly, higher rates will reduce the present value of future pension liabilities and reduce pressure on funding ratios from choppy markets.
Journey into the unknown
Pension investors find themselves on a voyage into the unknown. Many expect the current rate-hiking cycle to extend into 2023, if central banks are to meet their policy targets. Rate hikes operate with long time lags, so things will worsen before they get better.
The clean-up of some past excesses in the markets will help pension investors to rebuild their portfolios on a more solid basis. A pivot in central bank action at some point to avoid a severe recession will create entry points into risk assets with more decent valuations.
Monica Defend is head of Amundi Institute and Amin Rajan is CEO of CREATE-Research and a member of The 300 Club