LHV Pensionifond XS

After a surprisingly substantial rise in July, the world’s largest stock markets were in decline again in August. The S&P 500 index, which tracks the value of the largest US companies, lost 2.9% of its value measured in euros last month, while the Japanese Nikkei index fell by 1.5%.

After rising 7.4% in July, the Stoxx 50 index, which represents some of the largest companies in Europe, lost 5.1% of its value in August. The performance of Baltic stock exchanges was mixed: while the Tallinn and Vilnius stock markets grew by 2.4% and 1.9%, respectively, the Riga stock market declined by 4.5%.

The European economy is in an extremely challenging situation, with the war in Ukraine contributing to extensive increases in energy expenditure. This is a huge blow, as Europe can only cover just over 40% of the energy it consumes, while the rest has to be imported.

Chart: Total energy imports and oil price in the Eurozone

In the past, the majority of the energy imports to Europe came from Russia, but after Russia began to wage war in Ukraine, Europe must look for alternatives to the energy bought from the aggressor state. Rising energy costs directly impact the prices of all goods and services that are produced using this energy. The rule of thumb is that if the price of natural gas rises by 100 euros per MWh, the rate of inflation will accelerate by 2%.

However, rising inflation cannot be attributed solely to the increase in energy prices. For too long, monetary policies throughout the developed world were extremely loose, with central banks keeping interest rates too low and pumping out more and more liquidity. The deposit interest rate of the European Central Bank has been 0% since 2012 and has even turned negative in recent years.

When the signs of inflation first emerged in spring 2021, central bank models predicted this would be temporary. After delaying for too long, they only responded to the inflation this spring. The European Central Bank continued to buy up bonds and pump money into the system, even until as late as the end of June 2022. Only when inflation in the Eurozone accelerated to 8.6% in July did the European Central Bank finally discard the policy of negative interest rates.

Aid packages introduced by governments during the COVID crisis were another factor contributing to the rapid growth of inflation. Although these kept the economy more or less going during difficult times, they were simply too universal in hindsight. Everyone was offered support, regardless of whether they actually needed it. When COVID restrictions were slowly lifted in the second half of 2021, the economies of developed countries began to overheat.

Seizing good opportunities

A high rate of inflation complicates the process of making investment decisions for companies, as it becomes difficult to estimate the behaviour of input prices, i.e. the price of labour and raw materials. In addition, a higher inflation rate also means rising interest rates and a higher cost of capital. With the future uncertain, companies are cautious in launching new projects and hiring employees.

In an inflationary environment, investors use higher risk premiums when evaluating companies, and they discount cash flows from future periods to their present value at higher interest rates. Rapid price growth may bring better turnover and profits for the company in the future, but if the present value of these cash flows is determined at a higher discount rate, the company’s value may still drop. The same logic applies to salaries: even if salaries increase by 10%, with 20% inflation, real salaries actually fall by 10%.

Because the real economy is harmed, few assets can hold real value during high inflation. Asset prices may rise in nominal terms, but adjusting these to the high inflation rate may still reveal that the real value of the assets has dropped. The companies that succeed in an inflationary environment are those with a unique, strong market position and the ability to price their products and services as the environment changes.

Inflation feeds risk into the investment environment, which is reflected in a greater fluctuation in securities prices. However, the biggest risk is that people give up on investing in the future. Both as businesses and as individuals. Keeping money in a bank account is not the wisest choice in an inflationary environment, where rising prices diminish the purchasing power of money with each passing day. The only thing worse than that, and a sure way of having empty pockets, is to spend money mindlessly.

I believe that, in the longer term, Estonia’s nominal economic growth will be around 5 or 6%. Projects with moderate risk that offer a higher return than this would therefore make a worthwhile investment today. Of course, higher-risk projects should include an additional risk premium, because not every investment may go as expected.

In the management of pension funds, we at LHV have always made our first goal to protect clients’ assets, even in difficult circumstances, then to overcome the rate of inflation in the long term, and finally, to offer a better return than our competitors.