American economist Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon” — implying that it can only arise when central banks increase the supply of money.
Thijs Knaap, chief economist for APG Asset Management, believes Friedman is correct in the long term, but not about the inflation Europe is experiencing now.
“Inflation in the euro zone is what we call ‘cost push,’ meaning that actual goods and services have become harder to obtain because of things that happened in the world, not at the central bank,” Knaap told AsianInvestor.
In the view of the chief economist for the Dutch pension fund with around $662 billion in assets under management, the dislocations from Covid-19 — the disease as well as the policy responses to it — and the Russian invasion of Ukraine are the two main disruptors of the economy at the moment.
“Both the supply of commodities and the steady stream of imports that Europe has come to expect from Asia were disrupted by both these factors, which has made price increases an inevitable result. That is behind most of the current inflation in the euro zone,” said Knaap.
Once the price of energy, food and imports becomes more expensive, a market will typically experience “second round effects” where local producers increase their prices to make up the cost increase and workers start demanding higher wages, and then inflation feeds on itself, according to Knaap.
“At that point Friedman is right again, it takes an accommodative central bank to sustain this process in the long run,” he said
The European Central Bank (ECB) has been accommodative for a long time, keeping inflation at less than 2% in the euro zone, but this is changing said Knaap.
“The ECB is still on the back foot but rapidly getting less accommodative,” he said. “Other central banks have already started tightening and this has driven up interest rates from their very low starting levels. We track the 20-year euro swap rate, an important variable for our funds. It went from 0.5% at the start of the year to 2.4% currently, a very steep increase.”
While Knaap expects the worldwide disruptions to supply chains will dissipate in the next year, he says this is not guaranteed.
“China is not done with Covid and we are one mutation away from another worldwide outbreak,” he said. “Who knows what will happen in Ukraine, which the Russians seem intent on destroying. There may be more shocks ahead.”
“Higher interest rates take their time working through the economy, and the increases we saw the first half of the year will start having an effect on behaviour in another 12 months or so,” said Knaap.
However, the decline in asset prices since the start of this year shows that financial markets respond quicker than this. Much will depend on how much tighter central banks will need to get, and whether financial markets can stomach these tighter policies, said Knaap.
“Central banks are facing their biggest test since the 1970s and it appears they will continue to tighten without much regard for financial markets. At some point this will start leading to problems, with overextended parties in financial markets or in the real economy,” he said.
APG’s analysts expect to see inflation peak at around 7.5% in 2022 in the euro zone, but barring further shocks expect it to decline to around 4% in 2023 and be back around the 2% target the year after.
“Investors will need to be very careful about what risks they are exposed to, and whether they can handle them,” said Knaap.
“We do worry about inflation, which is terrible for pensioners, but because of this a lot of our investment policy is geared towards real assets.”
PROTECTING THE PENSION
Pension funds typically move slowly due to their size and their long-term outlook. To protect against the current levels of inflation they should have adjusted their portfolios some time ago, said Knaap.
“Our clients were aware of the risks and bought positions in commodities and real assets such as infrastructure and real estate, and alternatives such as hedge funds and private equity. Also, they are short duration because higher interest rates make their liabilities smaller. All of these elements are working well so far, funding ratios are up for the year,” he said.
APG’s investment team has a long horizon and over $600 billion in assets, which allows the pension fund to access illiquid, real assets that are harder to access for other investors.
“Should inflation continue, we are confident that the current asset mix will provide a good buffer against further shocks,” said Knaap.
“So far, commodities have done best in the current regime. Our clients allocate between 0 to 8% to strategies that follow the GSCI [S&P Goldman Sachs Commodities Index] or to illiquid commodity investments. For those who do not have a commodities allocation, we find hedge funds do well in these times of high volatility.”