European investors preparing for inflation rise

European institutional investors are adding protection to shield portfolios against medium-term inflation risk even though the short-term impact of COVID-19 crisis has been deflationary.

That's because the pandemic has accelerated the prospect of increases in production costs and prices of goods due to disruptions in supply chains. Investors are expecting that these developments will diminish the purchasing power of assets in the medium term. Added to that, investors believe central bank stimulus programs will last longer than they did in the aftermath of the global financial crisis.

"Central banks are faced with considerable uncertainty over the possibility of the second wave (of infections), and they will have to keep their policies very easy. We would expect quantitative easing (to continue) all through this year and next year," Stuart Thomson, senior strategist at Manulife Investment Management in London, said in a telephone interview.

Mr. Thomson said the stimulus that followed the global financial crisis helped banks get their balance sheets in order but did not bring back pre-crisis lending to the real economy.

European pension fund executives and money managers agree that the recent economic shock caused by the coronavirus has been prompted by a government-inspired lockdown of the economy rather than a banking crisis. They said they are now preparing for the return of inflationary pressure as early as in the middle of next year by adding inflation protection.

While economic downturns are usually credit-induced, the COVID-19 slowdown was caused by the shutdown of the economy and it forced incomes to fall, said Daniel Booth, CIO of the £45 billion ($56.4 billion) Border to Coast Pensions Partnership, Leeds, England, a pool of U.K. local authority pension funds. Therefore, rates are less efficient as tools to help with the recovery, he added. Instead, central banks are financing deficits to stimulate the economy, which at some stage causes inflation, he said.On the other hand, lower gross domestic product forecasts foreshadow lower inflation in 2020. The International Monetary Fund said June 24 that the global GDP will shrink 4.9% this year. For 2021, the fund sees growth of 5.4%.

Sources said pension fund executives have greater flexibility to manage inflation risk in the U.S. where fewer plans have inflation-linked liabilities unlike their European counterparts.

"It doesn't appear U.S. investors are highly concerned about inflation over the next three to five years," said Matthew Maleri, principal at consultant Rocaton Investment Advisors LLC in Norwalk, Conn.

Still, Mr. Maleri said the coronavirus impact is evolving rapidly. "You may see inflation pick up while the supply is constrained. If you get demand suddenly, that creates an inflationary scenario," he said.

Mr. Maleri added that inflation could pick up while unemployment is still high. "In that scenario, central banks will be reluctant to raise interest rates and reluctant to slow down their stimulus program," he said.

But inflows to global inflation-protected bond funds exceeded $2 billion in the week ended June 24, a weekly record according to data platform EPFR. In addition, gold funds also pulled in more than $1 billion in the same period, the 11th time in the past 14 weeks, EPFR data showed.

Tapan Datta, head of global asset allocation at Aon PLC in London, thinks it is very possible that in a year's time markets will flip to worrying about higher inflation. "It is very much the case that you want to be protecting yourself against inflation risk," he said.

Some European executives are taking action now. For example, Luc Vanbriel, CIO of the €2 billion ($2.2 billion) defined benefit Pensioenfonds KBC, Brussels, said real assets could help protect against inflation. That's why KBC is looking for additional unlisted real estate and infrastructure investments such as railways, regulated utilities and monopoly investments that will have inflation-linked cash flows. The fund's private assets investments are currently 3.5 percentage points below its target asset allocation of 15%. "We are very cautious about inflation. In Belgium, salaries are linked to inflation. If inflation increases, salaries increase and so do pension liabilities," he said.

"Buying a protection against inflation at the moment is very cheap. And if you can close that risk and it doesn't cost you, we try to close that risk," he added.

Another European fund, Collective Investment Vehicle for London Local Authorities Pension Funds, a £16.7 billion pool of local authority pension funds, recently hired Aviva Investors for a £107 million inflation-linked real estate investment. Aviva will invest in long-income real estate, including long-lease and ground rent investments as well as infrastructure debt and real estate debt on behalf of the fund.

But sources said that real assets such as real estate are not the most effective inflation hedges out there for investors with short-term investment horizons. U.K. investors with short-term needs have been adding inflation-linked bonds, gold and derivatives instead.

Chris Jeffery, head of rates and inflation strategy at Legal & General Investment Management in London, said European and U.S. inflation protection doesn't look especially expensive.

For Mr. Jeffery, U.S. Treasury inflation-protected securities are a good insurance against the upcoming inflationary pressure as investors can pick up 10-year inflation protection in the U.S. at about 160 basis points below the Federal Reserve's target and in Europe at 70 or 80 basis points below the European Central Bank's target, he said.

"We want to hedge against inflation because it's about the real purchasing power of people's assets. If this perception is right, then at some point the correlation between equities and inflation turns around, then inflation at some point can become a source of a concern to the equity market," he added.

Jos Vermeulen, head of solution design at Insight Investment Management Ltd. in London, said that short-term negative inflation, or deflation, can affect U.K. pension plans by increasing deficits due to a reduction in the value assets linked to inflation while pension benefit payments cannot be reduced.

But he said: "If pension funds have started to believe (the risk is long-term) deflation, they would have reduced their hedges. They haven't done that. Pension funds have done the opposite. They have been buying more inflation," he said.

Manulife's Mr. Thomson added: "We are seeing disinflationary forces, which are very strong. There is a considerable output gap, which is disinflationary, but markets have discounted that and are looking for central banks to cover the pandemic hole and to stimulate beyond the pandemic into the recovery. We expect a boost to cyclical inflation in the middle of next year."

Manulife added inflation protection to its investors' portfolio too. Mr. Thomson said: "We have been attracted to inflation-linked (products across the G-10). We look at curve steepening trades to benefit from the cyclical recovery."

Multiasset portfolio managers also bought inflation-protection positions through derivative exposures and gold. Mark Robertson, head of multistrategy funds at Aviva Investors in London, said the firm since March has added a U.S. inflation swap position in the firm's £5 billion target-return portfolio. Aviva's portfolio runs assets for U.K., European and Australian institutional investors.

Colin Harte, senior strategist and portfolio manager at BNP Paribas Asset Management in London, said that since the crisis the firm boosted its gold exposure in the multiasset portfolios, which manage €65 billion in assets on behalf of European and global investors. In addition to between 7% and 8% allocated to inflation swaps, BNP Paribas' portfolios now have an exposure of between 4% and 5% to gold, up from about 2% before the crisis. "There is no perfect inflation hedge," Mr. Harte said, adding that derivatives are more straightforward protection, while inflation-linked bonds expose investors to interest rate risk.