Inflation looms over investors in Europe as they navigate uncertain year

While inflation remains at the top of the list of preoccupations for pension fund and money management executives in Europe this year, the return of volatility and being ready to jump on opportunities afforded by challenging markets are also moving up the agenda.

The return of diversification in its more mainstream form — with equities and bonds poised to reverse the correlation trend of 2022 — also is a focus, as are opportunities from the green transition.

For APG Asset Management, the firm gained diversification last year from commodities and other alternatives, said Thijs Knaap, chief economist in Amsterdam at APG Asset Management, the €524 billion ($560.6 billion) manager running the assets of the €480 billion Stichting Pensioenfonds ABP, Heerlen, Netherlands.

For 2023, "diversification between equities and bonds looks useful once again now that yields have come up. In the recession/inflation dilemma, the combination of equities and bonds should shield you from the worst. We will continue to diversify with alternatives as well," Mr. Knapp said.

However, geopolitical tensions and ESG-related demands are making it harder to diversify between regions and geography, so Mr. Knaap added that diversifying between asset classes can, partly, substitute.

Executives at the Pension Protection Fund, London, are anticipating buying opportunities in the markets, just as they saw in September when some U.K. pension funds got caught up in the liability-driven investment crisis after an announcement of unfunded tax cuts — which were later walked back by a new government — caused gilt yields to surge and prices to drop in a matter of weeks. That led to a liquidity crunch among some pension funds as they faced huge collateral calls on hedges in LDI portfolios.

"I don't think any CIO would be here today thinking it's not a challenging moment trying to make money. It's just how you go and do that," said Barry Kenneth, CIO at the lifeboat fund for the pension plans of insolvent U.K. companies. The PPF has £39 billion ($47.1 billion) in assets.

"We are positioning the fund to have enough dry powder all the time to be opportunistic for when markets have some issues. And I think markets will continue to have issues."

During the September LDI crisis, the PPF picked up "some of that slack" from U.K. funds that were forced to burn through assets to meet collateral demands. The PPF bought about £1 billion in mostly short-end credit and even some long-term credit on an asset-swap basis in order to get duration of credit spreads — not the interest rate component, Mr. Kenneth said.

The PPF investment team will also continue to look at natural resources — including timberland, farmland, agriculture — which give attractive risk-adjusted returns, without the ESG component, and executives think there is also scope to increase expected returns in these asset classes. From a financial perspective, the team sees "ESG as the cherry on the top" on these investments as they stand on their own two feet without it, Mr. Kenneth added.

In terms of asset allocation, the PPF's cash holding is sitting at about 7% or 8% — both for liquidity and opportunity purposes. "As much as we want to keep cash for collateral purposes … we still have a pool of capital in order to look at new opportunities or opportunities when the market gives us the chance. But I suspect '23 is going to be extremely volatile and present opportunities when markets can dry up a little bit."

One source of volatility will be geopolitical tensions, which will remain a major consideration for managers — both from an investment and client perspective.

"Navigating geopolitical tensions has increasingly become an occupational hazard for investors," said Sandro Pierri, CEO of BNP Paribas Asset Management in Paris. "The conflict in Ukraine has had a profound impact on global commodity prices, amplifying inflation, and forcing Europe to rethink its energy policies. This will have major implications for industry structure and living standards for years to come," Mr. Pierri said.

There's "no doubt (that) 2023 will bring fresh sources of volatility. But that volatility should be seen as an opportunity for an active manager. It is our job to make sense of the evolving macroeconomic landscape, position accordingly, and translate the market moves into strong performance for our clients," Mr. Pierri said, adding that the firm sees opportunities in the shift to green hydrogen, the restoration of natural capital and building green infrastructure.

BNP Paribas AM has €605 billion in assets under management and advisement.

Geopolitics also has an impact in terms of money managers' businesses. "As we continue to expand our footprint and horizons, we will need to be mindful of dealing with markets and investors in different parts of the world," said Paul Williams, London-based head of international business development at Polen Capital Management LLC, which had $57 billion in assets under management as of September.

And geopolitical tensions will also play into the overwhelming theme for asset owners and money managers in 2023: inflation.

While pension funds being "famously sensitive to interest rates and geopolitics is an important factor in how we got to our current situation, I can only choose inflation as the top external focus" for 2023, Mr. Knaap said. "This is because it affects us directly," since increased prices of goods affect participants as consumers, "and it seems like it is the most uncertain element in the economic/financial mix today."

U.S. inflation was up 7.1% year over year in November, eurozone inflation was 10.1% and the U.K. has been dealing with double-digit inflation, too, with November's number coming in at 10.7%.

"The biggest challenge in global markets just now is what's happening with inflation and interest rates," Mr. Kenneth agreed. "One view is about what happens to fixed-income allocations, but the biggest concern I actually have is what the impact is on our other asset classes. If you've got real estate, infrastructure, long-term debt, even equities to a certain extent, they all have a linkage into interest rates in terms of the valuation."

PPF executives hedge liabilities against interest rate and inflation risks, so thinking about the impacts are purely from the asset side, he said.

"The key question is for the Fed (U.S. Federal Reserve) and what economic cost are they willing to pay to get inflation down," Mr. Kenneth said. "Because that determines everything here. And I don't think it's just in the U.S., I think (it's) across the board. It feels to me that we're going to keep on going in terms of interest-rate hikes, probably beyond where the market is currently pricing it."

He suspects that there will continue to be "a reset in asset prices" this year due to continued high inflation and interest-rate increases. "And some assets are going to be more exposed to that than others. And geopolitics … puts even more pressure on" repricing due to deglobalization's inflationary nature. Plus, the conflict in Ukraine has led to a lot of commodity-linked exposures continuing to price higher — adding to inflation pressures, Mr. Kenneth added.

Asset managers agreed that inflation is the top concern.

"Inflation is and will remain the mother of all decision-making and market moves," said Bjoern Jesch, global CIO at DWS Group in Zurich. The manager has €833 billion in assets under management.

Last year, central bankers cited spiraling inflation as the main driver for interest-rate hikes across the U.S., eurozone and the U.K.

Although inflation rates remain high, they have tapered slightly.

"Moving into 2023, debate has now shifted to the inevitable fall in inflation from elevated levels," said Stephanie Butcher, CIO at Invesco Ltd., which has $1.44 trillion in assets under management. Ms. Butcher is based in Henley-on-Thames, England. "In the eyes of many commentators, this would signal a peak in U.S. interest rates, allowing the Fed to pivot away from tightening and firing the starting gun for an aggressive risk-on rally."

However, added into the mix is the ongoing effects of the COVID-19 pandemic and Russia's invasion of Ukraine, which will "ensure that fiscal spending (by governments) will focus on ensuring security in its widest sense — covering energy supply, defense spending and supply-chain resilience," Ms. Butcher said. That will likely drive a capital-expenditure cycle, which will be made all the more urgent by a supply-demand imbalance with regards to energy and raw materials. And on top of that, China's release from its zero-COVID policy "orthodoxy" will intensify that imbalance, she added.

"As a result, while we believe the market (consensus) is right to expect a pause in the rate-hiking cycle, we're wary of expecting a fast pivot because we believe there are more structural drivers of inflation in the system," Ms. Butcher said.