With supply chain disruption, inflation pressure on raw materials and worker shortages all taking their toll, the conversation has increasingly centred on the possibility of stagflation. What do pension schemes need to look out for to avoid the worst?

Stagflation is far from a desirable outcome. It would represent a failure of both of the Bank of England’s objectives: keeping to its inflation target and supporting economic growth.  

Simeon Willis, chief investment officer at XPS Investment, says for this reason stagflation isn’t the “central scenario” but adds: “It does represent a threat, and we’ve got some fairly significant drivers that take us in that direction if they’re not managed in some way.”

Economist Frank Eich says that now we’re coming to the end of the base effect and entering a new phase, it will cause more concern. “I think that’s why people are starting to get even more nervous,” he says. “[If] this is potentially something more long term, then it becomes a problem.”

Shortages of supply and the increasing price for raw materials has made it difficult to manage inflation in a constructive way. One way to control this is to bring interest rates up. A month ago, markets were not expecting rates to go up until summer 2022, but are now pricing in a rise in the Bank of England base rate from 0.1% to 0.25% in December, with another expected move to 0.5% by March.  

If inflation rates go up and is not being driven by demand but by underlying costs, Willis says it can slow the economic growth down more than the impact on the underlying cost increases. Eich adds: “If there’s a supply problem you can’t really do a lot about that, [schemes] just have to accept it’s something they can’t really control.”

There are also a large number of political factors that the UK is facing at the moment, like the departure from the EU. “It’s a thing where there’s lots of trip hazards here,” says Willis. “It has to be managed pretty carefully to avoid a number of those things causing a problem down the line that leads to this stagflation environment.”

According to XPS’s recent quarterly update, the funding level progression for a typical scheme fell by 1.7%. This is not a huge drop, but the greater significance for pension schemes is that the environment we find ourselves in now can put pressure on scheme funding going forward.

Willis says the reason for funding levels dropping is that pension schemes aren’t fully hedged against inflation or interest rates. “The risk that pension schemes are exposed to are situations where they’re not hedged fully on inflation,” says Willis. “There’s a potential that inflation creates an environment that’s not very good for business growth, and that hits the nominal value of assets as well, which could potentially be a double whammy.”

With the potential for stagflation creating a difficult economic environment, it is important to navigate through this current environment carefully to keep inflation within reasonable levels. “Inflation is one of those things where just the right amount is fine for everyone, and if it is too high or too low, both of those are an undesirable situation for different reasons,” says Willis. “It’s an interesting balancing act and there are lots of factors that could potentially have a significant effect on where we end up. It’s choppy waters.”

There is an expectation that once the world economy recovers from Covid, these issues will go away. Eich says that hopefully pension schemes can see through this: “It depends obviously what assets pension schemes hold. But, from the economy perspective I think people expect the world will start growing again once these problems have sorted out. Let’s just hope that will happen during 2022.”

The focus in the past during the global financial crisis and now at the start of the Covid pandemic was demand, but now the problem lies with supply. Eich says this is quite a different problem: “Inflation is really supply driven, not demand driven. The focus has been so much fixated on the demand side over the past 10 years, so we need to switch our mindset.”