The great comeback?
The outlook for inflation and the implications for pension funds
- The massive fiscal and monetary response to the Covid-19 crisis has triggered widespread speculation that inflation, which has been missing in action for so long, could be about to make a comeback.
- We believe, on balance, that any revival of inflation will be modest. While there may be some upward pressure on inflation in the medium to long term as a result of the crisis response, structural headwinds look set to cap any rise, and may even lead to continued low inflation.
- For pension funds, the impact of inflation on funding goals will depend on the nature of the inflation linkage within their liabilities, their asset mix, and whether liability valuations are marked to markets.
- Overall, our analysis of three inflation scenarios points to the need to build robust and well-diversified risk asset portfolios as a key pillar to achieving funding goals, and to the particularly important role of real assets in providing protection against inflation risks.
What is driving inflation?
Could inflation be about to make a comeback, after a long period on the sidelines? Given fiscal stimulus is one of the most important drivers of inflation, the massive government spending programmes we’ve seen announced since the Covid-19 crisis could be expected to lead to higher inflation further down the line.
However, things aren’t quite that simple. It’s important to recognise that there are many other macroeconomic trends that can influence inflation. For example, ageing demographics and new advances in technology continue to have a significant disinflationary effect. Over the last decade these trends, as well as many others, have all pushed down on inflation (Exhibit 1).
On balance, our long-term expectation for inflation1 has remained broadly stable at 2.2% per annum for the global developed economy. Over the coming years, however, we think we could see a wider distribution of inflation outcomes as some inflation drivers wane and others push inflation higher. In the near-term, the Covid crisis has delivered a strong deflationary hit to the economy, and we do not expect to see much upward pressure on inflation or, correspondingly, in bond yields in the next five years. Beyond that, however, inflation outcomes could go either way.
Exhibit 1: Inflation drivers
Three inflation scenarios
To see what could happen to inflation in the medium to long term, and to see how pension funds could be affected, we consider three global scenarios: Lowflation; Managed Inflation; and Highflation.
- Managed Inflation
In the “ lowflation” scenario, inflation remains subdued and below central bank targets across the world. Inflation dynamics remain very similar to the post-financial crisis era, as policy measures struggle to push up inflation expectations.
In this scenario, fiscal policy is not used aggressively to stimulate growth or inflation. As a result, nominal bond yields remain near current depressed levels and yield curves are flat as central banks continue asset purchases. Bond markets are also less sensitive to growth data, with real yields anchored in deeply negative territory. In this regime, we’d expect inflation to remain low everywhere, but particularly so in Europe.
For pension funds that mark liabilities to market, a lowflation scenario will provide no relief in the form of rising yields pushing liability valuations down. Improvements in funding levels will instead require either capital injections, or strong risk asset returns.
For pension funds that do not mark to market, lowflation will, on the face of it, be more benign as any inflation-linked liabilities are kept in check. However, many of these pension funds have a greater reliance on risk assets to deliver strong long-term returns for funding purposes—for example, the Local Government Pension Schemes (LGPS) in the UK or funds in the Netherlands seeking to make the transition to the “New Deal”.
Asset returns have, of course, been strong since the global financial crisis, but whether such returns can be sustained from elevated valuations and in a continued low growth environment is moot. We would expect risk assets to be challenged in this scenario.
In the “Managed Inflation” scenario, inflation gradually returns to target and is then managed and does not overshoot. In this scenario, both fiscal and monetary policy are stimulative well into the economic recovery. Central banks successfully use their altered framework, which targets average inflation, to raise inflation expectations, but once realised inflation returns to target, policymakers move to a less easy stance and fiscal policy turns neutral.
Nominal bond yields will rise gradually and yield curves will steepen. The majority of the rise in yields is generated by a move higher in inflation breakevens, while real yields are kept in negative territory by extremely accommodative monetary policy.
The rise in yields will come as a welcome relief for pension funds with nominal guarantees that mark their liabilities to market, and may permit the resumption of discretionary pension increases. In an environment where inflation is well managed, increasing liabilities in line with inflation in a discretionary manner is likely to be more achievable. Managed Inflation is also likely to be friendlier to risk asset markets, with rising asset prices driving the returns required to enable increases to be granted.
While risk assets may do reasonably well, returns from bonds will be disappointing in the Managed Inflation scenario. Therefore, the impact on pension funds that do not mark to market will depend very much on their asset mix and the returns generated.
The biggest challenge may be faced by pension funds with guaranteed or statutory inflation linkage that mark to index-linked bonds. In this scenario, we expect real yields to remain anchored, so these pension funds will get little funding relief from rising real yields and will continue to depend on risk asset returns.
Overall, a critical dependency for pension funds will again be the performance of risk assets—either to support discretionary indexation once the balance sheet is repaired, or to drive funding level repairs where funding levels remain depressed due to low real yields.
In the case of “Highflation”, easy monetary and fiscal policy stimulate higher inflation expectations, and eventually these expectations lead to runaway inflation. This scenario is, in our view, the least likely outcome as it is hard to see an economic environment where the secular forces depressing inflation (demographics, low wage bargaining power) are no longer present. Having said that, in the Highflation scenario bond yields will move sharply higher, nominal yield curves would steepen, and breakeven inflation rates and real yields would both rise.
Highflation will be a particularly difficult scenario for most pension funds. While there may be some relief in the form of rising bond yields, both real and nominal, this scenario is most likely to be associated with more challenged and volatile returns from risk assets. Depending on asset mix and the approach to valuation and funding, the risk asset experience may well come to dominate overall pension fund balance sheets.
Clearly, mark-to-market pension funds that have fully hedged and closed down exposures to risks will be less affected by market volatility. There are certainly a number of closed and mature corporate funds across Europe that are in this position. However, for the many pension funds that continue to rely to some degree on risk asset returns, Highflation—although the least likely of our scenarios—would be highly problematic. Other than exiting risk assets altogether, the principal tool to manage this risk will be diversification.
Exhibit 2 summarises these three scenarios.
Exhibit 2: Impact of different inflation regimes on pension funding
How can pension funds respond?
Our expectation is that Managed Inflation is the most likely scenario. However, we see risks on both the upside and particularly the downside that cannot easily be dismissed. Upside risks have increased as a result of the post-Covid policy response, but the balance of inflation risks remain to the downside. At least in the short term, we don’t expect to see much inflation at all, and neither does the market (Exhibit 3). A full discussion of our inflation analysis and expectations can be found in our 2021 Long-Term Capital Market Assumptions publication.
Exhibit 3: Five-year/five-year forward inflation and spot 5 year breakeven inflation
Whatever inflation scenario eventually transpires, those pension funds that continue to rely on returns from risk assets will need to ensure a robust and well-diversified risk asset portfolio. Elevated valuations in listed equities in particular can be expected to put a cap on performance, which means investors will need to work their portfolios harder to eke out return.
Our long-term expected return for global developed equities, consistent with our managed inflation scenario, is just 4.1% to sterling investors and 3.5% to euro investors (the gap reflects currency differentials). The worst outcome would be higher inflation without productivity, which would hit earnings and margins, putting pressure on equities. Pension funds will therefore need to be mindful to protect against the Highflation scenario, even while trying to increase overall returns.
Given the challenges that lie ahead, pension funds may need to look to opportunities beyond equities and bonds to keep their funding goals on track. We believe real assets—with the attractive yields and inflation protection that they offer—could form part of the solution.
1 J.P. Morgan Asset Management 2021 Long-Term Capital Market Assumptions