How pension schemes should view stagflation risks

Key points: 

• Stagflation is a rare but troubling phenomenon which pension schemes will be closely watching given central bank efforts to tame inflation without damaging growth
• The current environment provides several potential implications for funding ratios and hedging strategies
• We would suggest considering high-quality and long duration bonds as the interest rate cycle continues and urge schemes to keep a keen eye on liquidity risks

There is an economic scenario that pension funds perhaps fear the most, but for which most are probably least prepared: Stagflation. Most schemes have a strategic asset allocation based on a relatively optimistic “goldilocks” scenario. Rightly so, you could argue, as stagflation’s heady combination of accelerating prices and meagre growth remains an economic rarity through history.

This is an unusual moment, however, and it would be understandable if investors 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 past month central banks in the US and Europe have confirmed that they do not expect to end the current cycle of interest rate hikes as they battle to address stubbornly high core inflation. 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 and labour markets are tight. AXA IM’s central scenario is for global GDP growth to slow to 2.7% in 2023 from 3.4% in 2022 and to 0.4% from 3.6% in the Eurozone – and it is currently unclear if recessions can be avoided while attempting to kill inflation.

Seeking protection

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. This leads to an immediate decline of the funding ratio – a scheme’s balance between available assets and liabilities. However, this time round, it is accompanied by higher interest rates, which on the 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 too. 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. It is a scenario schemes might to protect themselves against, but not at all costs.

How to deal with these uncertainties is partly dependent on a fund’s current position i.e., the funding ratio level; the ability to raise pension contributions; whether inflation indexation is capped or not, and so on.¹ Nevertheless, pension funds should take a closer look at their ability to protect themselves against inflation strategically.

Liquidity a factor

This 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 interest rates. Unless, of course, you think we are at a peak in rate levels now, in that case you could keep your hedge in place. 

In the near term, however, we do expect more 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. We would however highlight that real rates are in positive territory, in fact at historically high levels, and therefore are more likely to decline going forward. It is not yet clear if we might 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 plans. Managing liquidity is key, as became clear with the so-called ‘LDI crisis’ in the UK last year in October.² Pension fund 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.

Here is where we stand. Core inflation is falling slowly as labour markets remain tight. Growth is better than feared but subdued in developed markets. Longer-term rates will rise as short-term policy rate views grow more hawkish and spreads could widen further as we lock in higher interest rate levels.

All things considered we think that investment-grade credits look more attractive compared to high yielding bonds, and long-duration might hold some appeal. Inflation-linked bonds have become a trickier call, even if it may still be sensible to build in more protection against inflation in strategic asset allocation – but this is a fragile moment likely to reward thoughtfulness over haste.