March was another great month for stock markets. The US stock market rose 7.2% in euros and the stocks of European companies rose 6.1% during the month. Asian stock markets were less optimistic: The Chinese stock market lost 3.7% of its value in euros during the month.

While European countries are fighting the third wave of the coronavirus, the mood in the United States is brighter. It is hoped that restrictions can be lifted quickly thanks to vaccinations and that people will soon be able to enjoy life to the fullest again. The US government nevertheless plans to boost the economy with both short-term subsidies and long-term loan-financed infrastructure investment programmes.

Like last year, the US central government budget deficit is expected to reach 15% of GDP this year, although the economic downturn of 2020 (−3.5%) is beginning to turn into decent expected growth (+4.2%). The longer-term investments are expected to be covered from a growing tax burden in the future.

By the end of last year, US government debt had risen to 27.7 trillion dollars, equal to 129% of GDP. This is more than it was after World War II in 1946, when the ratio was 118%.

If the government deficit projected for 2021 is added to this, the US debt burden will exceed 130% of GDP by the end of 2021. This is higher than the relative debt burden of Portugal and Spain, but still below that of Greece and Italy.

Will government deficits turn out to be inflationary?

While the levers of economic recovery were mainly in the hands of central banks in the year following the financial crisis of 2008, in the current coronavirus crisis, politicians have taken control and central banks have receded into the role of government finance providers. Until now, central bank independence has been seen as an important factor in keeping inflation under control, but in recent years the US has taken the view that the central bank is just a department of the government sector.

Inflation has long been below the targets set by central banks (around 2%) in most countries around the world. Therefore, a slight acceleration in inflation may even be good news at first, as it gives hope of growing out of the debt burden.

However, it is unclear whether the potential price rises can be controlled and how in a situation where central banks are essentially unable to raise interest rates. After all, the debt burden of both governments and the private sector is already so high that the servicing of loans may be endangered and rising interest rates may put pressure on asset prices.

While 2% to 3.5% inflation has historically been a favourable environment for equity and real estate investors, a faster inflation rate has not provided a very pleasant experience for asset owners.

The first signals of the acceleration of inflation should come from the labour market and food prices. As long as unemployment remains above optimal and wages do not rise, it is unlikely that prices will accelerate regardless of how much central banks buy government bonds.

The good news is that during the coronavirus crisis, companies have increased investment in the digitalisation of business processes, which should contribute to future productivity growth and thus also support wage growth.

However, with support from the debt burden, the rise in asset prices has considerable exceeded economic development over the past decade, which is why the gap between the financial and real spheres is wider than ever. At the same time, bond markets are larger than stock markets. As interest rates rise (as inflation accelerates), bond prices will fall. The year 2018 clearly showed how painfully the stock markets reacted to the rise in interest rates.

Investment strategy of LHV pension funds

By the end of March, it became clear how many clients and how much money would leave the second pillar pension funds. Due to political instability over the past 18 months, LHV pension funds maintained higher liquidity compared to the optimal investment strategy and refrained from investing in somewhat less liquid domestic assets. Now that the situation is clearer, we can continue to implement our investment strategy.

LHV Asset Management aims to achieve an annual return of at least 6% in actively managed, higher-risk pension funds, which is expected to exceed both the nominal growth of the Estonian economy and wage growth. To attain this goal, we prefer to invest money in local companies and real estate if the expected yield justifies it.

I believe that the value of an investment is primarily determined by the (expected) cash flows. I also consider it important that the company or project be viable even in a changing economic environment, where the availability of capital is limited.

Most of LHV’s pension fund portfolio is invested conservatively. Our goal is to ensure the preservation of pension assets even in more complex conditions and maintain sufficient liquidity to invest when others are selling and the price level is more favourable than at present.

We have invested a small part of LHV’s pension fund portfolio in venture capital funds managed from Estonia. Estonia’s emerging technology sector has offered many success stories that have brought international attention and laid the groundwork for the further development of the sector. LHV pension funds have been among the anchor investors in almost all venture capital funds operating in Estonia (Karma Ventures, Superangels, Trind Ventures and Tera Ventures). We consider the sector to be highly promising in the long term and we will continue to seek to partake in its growth.

The present time is somewhat schizophrenic for investors. Inflation is expected to accelerate on the one hand, but interest rates are expected to remain very low for a long time on the other. Time will tell whether central banks will be able to keep interest rates and inflation under control (despite the growing debt burden of governments and the private sector) or whether market forces will eventually re-emerge and investors will once again experience the cyclical nature of economies and securities markets.