Inflation Fears Mount Among Fund Managers

The effect of inflation on pension plans should be monitored, as inflation could translate to higher pension fund payments, Merrill Lynch said in a release.

Fears of Inflation

Fund managers were slightly less negative in their expectations for economic growth and corporate earnings than last month, Merrill Lynch said. Fewer respondents (18%) believe the world has already entered recession, down from 24% in April. The number expecting recession within a year fell to 29% from 40%.

Instead, investors are focusing on inflation. A quarter of respondents expect global core inflation to rise in the coming 12 months, compared with just 7% in April, the release said. This is prompting predictions of higher bonds yields, with 80% of investors expecting long-term rates to be higher a year from now. In contrast, fewer respondents are predicting higher short-term rates.

“Evidence is pointing to a possible sell off in bonds as inflation worries mount,’ said David Bowers, independent consultant to Merrill Lynch, in the release. “A sharp rise in bond yields could help convert this financial crisis into an economic crisis.’

Threat to Pensions

The threat of stagflation is bad news for company pension plans, the release said. Indexation means a rising cash-call at a time when profits are moderating for many.

Developments in the U.K. are being watched. The U.K. Pensions Regulator has the power to ensure pension contributions rank ahead of dividends, and these powers have strengthened since April 14, which investors might not appreciate, Merrill Lynch noted. Investors should be paying close attention to the unfolding story of the extent to which higher inflation translates to higher pension fund payments for corporate, monitoring the investment strategy that plan sponsors are using, Merrill Lynch said. The gap in performance between those corporate pension plan sponsors using and not using LDI could increase markedly as stagflation takes hold.

“Plan sponsors using LDI have the advantage of a hedge against higher inflation and sharp changes in interest rates,’ said Gordon Latter, Pensions and Endowments Strategist at Merrill Lynch. “Those pension plans that remain unhedged leave themselves at the whim of the market.’

Inflated Earnings

Despite expressing a lower risk of recession, the panel still worries that earnings estimates are detached from reality, according to the release. More than three quarters of investors (77%) said that consensus estimates for global corporate earnings are too high (in response to a new question on the survey).

Moreover, fewer investors see value in equities. The number of investors who believe that equities are undervalued fell to a net 15% in May, which is down from a net 26% in April. Fears of overvaluation are also apparent in commodities. In response to more new questions, a net 52% of asset allocators said that they thought oil is overvalued, and a net 29% of asset allocators thought gold to be trading above fundamentals.

Turning to Oil

Oil, gas, and basic resources benefit from one of the few clear growth stories.Fuelled by growing inflation fears, Eurozone investors have rediscovered their enthusiasm for the commodity trade, the release said. Oil and gas, seen as inflation-proof, has extended its position as Europe’s favorite sector with 41% of investors overweight, compared with 29% in April. A net 11% of investors expect inflation to rise in the coming year (2% in April).

“In a slowdown, earnings momentum drives out-performance—not value,’ said Karen Olney, Chief European Equities Strategist at Merrill Lynch. “The relentless need for food and infrastructure in developing markets means that commodities, and not labor, are the scarce resources in this cycle, and this scarcity means pricing power. Banks, on the contrary, are being penalized for earnings decay. While still unloved, this month they are no longer seen as cheap as they move from value-trap, implying upside, to trap status.’

One month ago nearly a quarter of Eurozone and U.K. investors said banks were undervalued, and that number has now fallen to zero, the release said.

A total of 191 fund managers participated in the global survey from May 2 to 8. The survey was conducted with market research company Taylor Nelson Sofres (TNS).