The US consumer price index has soared by 6.2% since October 2020, the fastest annual pace since 1990, according to data release on Nov.10 by the U.S. Bureau of Labor Statistic, confirming investor fears that high inflation will be a distinguishing characteristic of pandemic recovery.
In a survey conducted by Asset Owner Insights, AsianInvestor's proprietary data platform, more than 30% of the 70 asset owners who participated said that rising rates and inflation were the biggest portfolio risks over the next six months.
For any pension fund looking to offer price-indexed benefits, inflation is a perennial concern according to Thijs Knaap and Charles Kalshoven, chief economists at Dutch pension fund APG which manages over $705 billion in assets.
“We operate large funds and cannot turn on a dime, so any action we take on inflation will be part of our long term-strategy, i.e., we have already taken it a long time ago.
"When determining our asset mix we take into account many different scenarios, of which high inflation paths are definitely part,” Knapp and Kalshoven told AsianInvestor in emailed comments.
“An important way that our clients are positioned for inflation is by not hedging their interest rate risk 100%. When inflation and interest rates go up, their funding ratios will tend to improve,” they said.
On the asset side, APG invests in real assets on behalf of its clients that the economists explained should move with the price level in the long term.
“Our largest client ABP has 17.5 % of their assets in real estate, infrastructure and commodities combined. For some assets there is a direct link with inflation in the valuation – index-linked bonds, inflation swaps,” said APG’s economists.
“For other assets the revenue streams are often directly linked to inflation, like rental income.”
Knapp and Kalshoven asserted that in the long run, it is not just assets that have a high correlation with inflation that are worth having, “it is also about earning risk premiums that are high enough to be able to pay out inflation. From that perspective equity is interesting.”
Hedging against inflation
Over 2021, risks of rising inflation have been a key focus for asset owners on portfolio positioning according to Andrew Zurawski, associate director of investments in Asia at leading global advisory Willis Towers Watson.
“Our central forecast is for inflation to peak in advanced economies in early 2022 before easing to be largely in line with central bank targets later in the year,” Zurawski told AsianInvestor.
“However, upside risks to inflation are much higher relative to the pre-Covid period. The most recent data suggests broader inflationary pressures to be higher than we anticipated earlier in the year.”
In some economies, central banks have already begun lifting policy rates, and Zurawski expects the US to follow suit and enter a tightening cycle next year.
“These trends have been less pronounced in Asian economies where inflation has generally remained low, although recent energy shortages in China and Europe can prolong supply chain blockages and lead to higher global inflation,” he said. “Longer-term, the shift in China’s climate policy could also impact the volatility of commodity prices.”
Against this background, Zurawski said that investors should consider assets that can provide an implicit or explicit inflation hedge.
“Historically, assets such as prime real estate, infrastructure and commodities have performed well during inflationary periods, although the performance can vary quite substantially from one inflation episode to the next, while implementation of commodity exposure can be difficult.”
More traditional assets such as equities and nominal bonds usually perform poorly when inflation is unexpectedly high and yields spike. However, earnings growth can support equity returns in a high growth environment, said Zurawski.
“A key risk to equities is a growing expectation of higher-than-expected discounts rates over the medium term. Inflation-linked bonds offer inflation protection but they can generate loses if real yields increase from their current very low rates,” he said. “Our preference is to build exposure to a mix of real assets, both listed and unlisted, with a medium to long-term perspective.”
“We are seeing increasing asset allocation to cash by underlying investors. In countries with flexible pension schemes this is creating an investment/asset allocation challenge for the asset owner as they have limited options to place cash on a short-term basis,” said Franck Dubois, head of Asia Pacific for BNP Paribas Securities Services.
A general lack of investment opportunity is a particular challenge across the Apac region, Dubois told AsianInvestor .
“Looking at the majority of our clients they have funds sitting long whilst they are over invested in Australian, US, UK or G10 equities; they have no return from government debt which used to be a safe haven option and they are struggling to find well-priced private equity and real estate assets,” said Dubois.
“There was also a slow down or stop in IPO activity in 2020 that has started again in 2021 but this is at different stages market by market,” he added.
While rates continue to remain low, the continued search for yield is driving an increased appetite for private capital investments, said Dubois.
“The current opportunities for renewable energy for example is more attractive than ever before with the launch of many new solar and wind projects deals in recent months and with more to come to meet increasing demand for sustainable investments,” he said.
“We are seeing a higher number of traditional asset owners and managers entering into the private capital asset class, in addition to the usual specialists clients like the institutional investors, private equity and private debt investors.”
The survey was conducted by Asset Owner Insights, AsianInvestor's proprietary data platform.