LHV Pensionifond S

The year started powerfully on the securities markets: the MSCI World index rose by 5.2% measured in euros in January. The S&P 500 index, which tracks the shares of 500 large US companies, added 4.7% to its value, and the Nasdaq index, which reflects the US technology sector, rose as much as 9.1% after last year’s big decline. The Japanese Nikkei index and the Euro Stoxx 50 index also increased by 3.9% and 9.9%, respectively.

Central banks still have a long way to go and headwinds are strong

Stock markets have been in an upward trend since last October. Investors seem to believe that, by mid-2023, central banks will be able to break the backbone of inflation and return to the old pattern of behaviour, where every setback in the economy and markets was treated by cutting interest rates.

I, too, believe that the rate of inflation peaked in the second half of last year for this economic cycle, and that the rate of price growth will decline to 4% or 5% by mid-2023. However, central banks aim to achieve price stability, which is defined as 2% price growth.

This is not an easy task, as politics have become more populist around the world. In economic policy, this is manifest in, for example, often fighting inflation with measures that actually accelerate inflation.

An excellent example of this is the Inflation Reduction Act pushed through last year by Joe Biden’s administration in the US. Economists with different worldviews have an unprecedented consensus that the new law is likely to lead to exactly the opposite. These kinds of legal regulations and measures do not make it any easier for central banks to fight inflation. Instead, they force interest rates to be raised more than would be necessary without government intervention.

We all remember the extraordinary measures central bankers were willing to use over the past 14 years to push up inflation when it fell 0.1% or 0.2% below the 2% target. I am sure that central banks will also show a fighting spirit now that there is a need to bring inflation down.

Several inflationary trends are currently apparent, including increasing government intervention, rising (likely permanently) higher defence expenditure, the transition to greener energy, and the restructuring of supply chains for greater resilience. These trends work against central banks’ efforts to curb price growth. Therefore, it is difficult to calibrate monetary policy and there is a risk that central banks can overtighten the monetary policy screw.

Investors expect interest rates to drop in the second half of the year

Bond markets are already expressing investors’ faith that central banks will beat the inflation rate. Ten-year German government bonds offered a yield of 2.56% at the start of January, which shrunk to 2.29% by the end of the month. At the same time, the 6-month Euribor rose from 2.73% at the beginning of January to 2.988% at the end of the month.

The European Central Bank deposit interest rate remained at 2% throughout January. Investors expect that after raising the interest rate by 50 basis points at the 2 February meeting, it will be raised again by 0.5 percentage points in March. The interest rate will then reach 3%.

Short-term interest rates are, therefore, already higher – and in an upward trend at that – than long-term interest rates, which are in a downward trend. The inverted yield curve, as it is known, has almost always indicated an imminent deterioration of the economic environment.

It must be admitted that central banks have become the largest investors in the last couple of decades by acting very aggressively in the money markets. Bond prices do not reflect as much information about investor expectations as they did in the past, but an inverted yield curve still sends a message.

As mentioned, the stock markets have been in an uptrend since October. After all, many investors expect that, in the second half of the year, central banks will be forced to lower interest rates because the economic environment will cool down and also bring down the pace of inflation.

The excessively long a period of cheap money has now lead to a situation where investors are more interested in the monetary policy of central banks than in the economic results of companies. When the economic environment deteriorates, investors often cheer, as the positive impact of lower interest rates on stocks and real estate outweighs the negative impact of lower profits and rents. Such an attitude is perverse and unproductive. It encourages speculation with existing assets and discourages investment in the future and the creation of new value.

I suspect the recession will be more severe than many investors think. Should inflation remain well above the target set by the central banks, they will not care how much the markets fall this time, but will raise interest rates until they reach the target set by law.

In our investing decisions, LHV pension funds have always prioritised the profit and cash flow to be earned by companies and projects in the future. We have always looked for projects that are intrinsically sound, do not use borrowed money too aggressively, and can do without government support. The projects must be viable even if interest rates rise above the historical average and remain at that level for a longer period of time.

Estonia has become a big spender and borrower

Estonia’s debt burden has been one of the smallest in Europe, and this has been one of the reasons why we at LHV have liked Estonia as an investment environment. However, for some time now, Estonia has been one of the biggest spenders in Europe. There are politicians who would like to loosen the purse strings even more, support everyone, and spread the myth that all other countries disburse subsidies even more generously. Unfortunately, the reality is different: in the last five years, Estonia’s debt burden has grown rapidly, at a time when interest rates have been on an upward trend. It is true that Estonia’s debt burden is still small, but this does not mean that we should finance current expenses with loans.

I recently noted an analysis of the development of the Greek economic environment, which included the graph below. By the way, the rating of Greek government bonds has risen significantly in recent years, and the performance of the Greek stock market was at the forefront in Europe last year.

Figure 1. Change in government debt-to-GDP ratio since 2019 (percentage points). Source: DG ECFIN, AMECO

A high debt burden amplifies the risks. At difficult times, risks should be mitigated rather than increased. This means that all expenses need to be critically reviewed, and if something can be cancelled or postponed it should be seriously considered.