Inflation fears could see schemes move to lock in equity gains

For example, the MSCI World Index delivered annualised, gross returns of 22.35 per cent in the three years to December 2021 — with reasonably low levels of risk, given the index’s relatively high Sharpe ratio of 1.2.

But there are many uncertainties in markets and the global economy. Chief among them, at least for pension trustees, are high inflation, rising interest rates and the potential global economic impact from the conflict in Ukraine.

Central banks are already indicating a desire to ‘normalise’ monetary policy. This will, in turn, reduce the space that governments have available to them to finance deficit spending.

Bouts of inflation typically end with aggressive monetary tightening and a shock to economic growth. With that risk in mind, the ability of global equities to deliver the kind of earnings growth seen since 2019 needs to be questioned

Equity markets have responded by correcting anything up to 20 per cent from their cyclical highs. It is typical that price earnings multiples fall as a monetary tightening cycle begins. A weaker growth outlook from the impact of higher energy prices has also contributed.

However, equity price levels remain high relative to recent years. In such an environment, perhaps now is the time to think about locking in recent gains from global equities and reallocating assets towards more sustainable equities or debt instruments.

Taming inflation with interest rates

Not so long ago, benign levels of inflation seemed the norm. Only in extremis did, say, UK prices rise at more than the Bank of England’s target of 2 per cent a year.

But, since early 2020, it has become clear that production, distribution and many parts of the services sector have been hobbled by bottlenecks, supply shortages and staff shortages. These have created a rapid increase in inflation.

UK inflation now sits at 4.9 per cent, a level not seen since the dark days of September 2008. Other economic regions offer a similar story: the OECD average is 5.21 per cent, forecast to fall to a more manageable 3 per cent not until early 2023.

As such, monetary policy is set to become tighter. The Federal Reserve and BoE have raised interest rates already.

The market believes that the Fed’s message is more hawkish, and the BoE’s is more dovish. Hence market pricing at the moment is for another six or seven 25 basis point hikes from the Fed this year and just under five additional 25bp hikes from the Bank.

This is not all. Central banks are withdrawing from asset purchases. This could affect liquidity in bond markets, nudging real yields higher and corporate credit spreads wider. If we add in inflation, then the result will be higher bond yields across the maturity spectrum.

Rising yields

This could be good news for pension fund trustees.

They face the opportunity to invest in fixed income at higher yields over the coming months — something they may well fund through an asset allocation shift, from global equities into credit, as they look to lock in equity gains.

In making such a switch, pension funds seek a diversified portfolio of good credit quality bonds, often to match their cash flow liabilities.

US corporate bonds offer an attractive yield relative to sterling and euros, and having some hedged exposure to the US market — to improve diversification — could be an attractive option.

Inflation-linked bonds look a particularly good fit for many schemes. This asset class within fixed income was one of the best performers in 2021. It could continue to lead the way in 2022.

The market is pricing that UK inflation stays just below 4 per cent over the medium term, which would be higher than the BoE’s inflation target. However, while inflation is perceived as a risk, bonds linked to inflation indices issued by governments are still a valid option.

Central banks have been buying bonds for a decade. As recently as last September the European Central Bank said, “our asset purchases… will remain crucial in the time to come, paving the way out of the pandemic and towards reaching our inflation target”.

But that was then, and this is now. Once central banks stop buying bonds and start delivering rate hikes, our central outlook for this year is for higher real and nominal bond yields reflecting the shift to a tighter global monetary stance and higher inflation expectations.

Moreover, a year ago the big challenge was fighting the pandemic. Today, the risk of new variants of the Covid-19 virus remain a worry — but central banks now also have to contend with inflation. This is likely to persist even beyond a hoped-for early end to the war in Ukraine.

Bouts of inflation typically end with aggressive monetary tightening and a shock to economic growth. With that risk in mind, the ability of global equities to deliver the kind of earnings growth seen since 2019 needs to be questioned.

At the same time, higher bond yields shift the relative valuation between equities and bonds and could potentially require some derating in equity markets.

This year could therefore see some significant asset allocation shifts.

Chris Iggo is chief investment officer for core investments at AXA Investment Managers