European challenges inflate allocation concerns

Investors’ increasing expectation of inflation risk in Europe, coupled with monetary policy implementation challenges at the European Central Bank, is an argument for a greater allocation to strategies that perform well in inflationary markets, according to a research note by AQR Capital Management.

“Given current Eurozone inflation uncertainty, we urge investors to examine their asset allocations in light of changing inflation risks and to consider the potential effects on their overall portfolios,” the paper says.

Data from the European Union’s statistics office for year on year inflation for March, revealed the fourth consecutive month the headline inflation printed above 2 per cent, the upper bound of the European Central Bank’s target range.

This is having the effect of increasing market uncertainty and shifting expectations towards higher levels of future inflation.

The AQR paper says that while the ECB has traditionally been diligent in guiding monetary policy to achieve its inflation objective it faces three implementation challenges: economic divergence among Eurozone countries; persistent fiscal imbalances in peripheral Europe; and a vulnerable private banking sector.

It argues these three challenges mean investors should be asking whether the ECB is in a position to tighten monetary conditions.

“While the Eurozone inflation outlook remains uncertain, it is important to note that traditional institutional portfolios resemble a bet on low and stable inflation, since they tend to fare poorly in inflationary periods on a relative basis,” the paper says.

The paper can be accessed below

Eurozone Inflation Update – Will ECB Actions Match Its Rhetoric