We stick to long term plan
Although we try not to pay too much attention to short-term developments and instead focus on long-term trends, part of our job is to reflect on hot topics, including inflation. The problem is that if we ask 10 different academics about inflation, we will get 10 different answers.
However, to sum up our view, we broadly expect inflation to be transitory, particularly in Europe, as it appears to be driven primarily by the transitory effects of Covid and energy prices.
The picture is slightly different and more complicated in the United States. There is some disconnect between equity markets, which seem to be anticipating three Federal Reserve rate hikes next year, while Treasury markets seem to suggest otherwise. But we still believe in the ability of the Fed to manage inflation expectations.
The medium-term outlook is complicated, but we still see long-term trends in demographics and technology acting as a headwind to inflation.
Regarding our asset allocation, we remain on a long-term trajectory of shifting our allocation from fixed income to real assets. This is a strategic decision that we made a few years ago.
This simply encourages us to slightly increase the pace at which we move from fixed income to real assets. We’re not the biggest pension fund, but we’re big enough that we have to adapt when selling fixed income assets and buying real assets.
Regarding our equity portfolio, we are pleasantly surprised by the ability of the companies in which we invest to pass on inflationary pressures to clients. They are managing this inflationary environment well and are seeing tremendous earnings growth.
Economic growth will most likely fluctuate as the pandemic continues, but we see no significant danger of stagflation.
Therefore, in the current environment, equities could also be winners, but a portfolio of private assets protects us from the likely bouts of volatility in the stock markets.
In other developments, this year we plan to take a closer look at investments that could benefit from the climate transition. We have intensified our ESG efforts across the portfolio and believe that climate change represents a challenge as well as an opportunity.
Cautiously optimistic, but Omicron a concern
Our program is growing rapidly, with inflows of around £5 billion (€5.9 billion) per year currently, which will increase to £6 billion per year in 2023. This means we can take advantage illiquidity premium. We have invested heavily in private markets lately, including private debt and real estate debt, and are growing in private equity.
Before the Omicron variant of the coronavirus rattled markets, we were cautiously bullish on equities and rebalanced our bond allocation from overweight to neutral. In December, we were still slightly overweight in high yield, but overall we diversified and invested with a cautiously positive outlook. Recently, we have also increased our allocation to UK property, which has generated good returns.
The spread of the Omicron variant requires us to be vigilant, but we have increased our ability to react. In particular, we have implemented a program of derivatives based on futures contracts, which helps us to rebalance when necessary or when an opportunity arises. Thanks to a separate derivatives account, we can rebalance quickly and efficiently using liquid instruments. Managing a derivatives program raises questions from an ESG perspective, but we are working on it.
In terms of inflation, we benefit from an allocation to commodities that we built before the Covid-19 pandemic. In 2019, we felt we had to invest in this asset class and started to add to our exposure, despite opinions that this was premature. We are now well placed to offset the impact of rising inflation on the markets.
Almost everything is expensive
It is a very difficult time to invest as most asset classes are very expensive, from low risk sovereign fixed income securities to the riskiest asset classes. It is also difficult to have a clear view on many issues, from the outcome of monetary policy decisions to inflation, which is why, to some extent, investors like us have to work on a scenario basis.
However, it is possible to make clear decisions – for example, on government bonds. They are super expensive and should be avoided where regulations permit. Investment grade credit is not as expensive, but this should also be avoided.
In my opinion, growth stocks are also very expensive, after the positive performance they have enjoyed thanks to the fall in interest rates. While the medium-term outlook for growth and productivity is more or less unchanged, despite the pandemic, being exposed to growth stocks implies high exposure to duration. However, growth stocks can do the job to some extent, particularly if duration exposure is offset by shorting long-term rates.
On the positive side, I think it pays to be overweight value stocks. There are several markets where cheap stocks can be found, including parts of Europe, the UK and Japan.
The focus should be on less liquid markets, for example mezzanine debt and infrastructure. I also see value in venture capital as opposed to leveraged buyouts. In Europe, in particular, investing in venture capital is cheaper than in the United States.