In this year of uncertainty and challenges, October offered investors some hope and consolation: the MSCI World Index, which reflects international stock markets, rose by 6.2% measured in euros. At the same time, the S&P 500 and Stoxx 50, which track the value of the largest US and European companies, rose by 6.9% and 9.1%, respectively, while the value of the largest companies in emerging markets (as per the MSCI Emerging Markets Index) decreased by 4.1%.

Despite a decent rise in October, stock indices are in the red all over the world this year. Compared to the beginning of the year, the MSCI World Index has lost 8% of its value in euros, and the S&P 500 and Stoxx 50 have lost 6.4% and 13.8%, respectively.

While the stock markets still have some companies and even entire economic sectors whose value has increased in 2022, the bond markets have seen losses on a greater scale. As interest rates have risen rapidly around the world, bond prices have fallen. For example, the Eurozone Bond Index lost 16.1% of its value in the first ten months of the year. The price movements of bonds, which are usually considered safe, have been even greater this year than the changes in stock prices.

The fact that bonds have lost more value than stocks inevitably raises the question of whether bond markets have overreacted or whether stock markets have underreacted in their downward trend. Although there is reason to expect stock markets to produce a higher yield than the bond market in the long term, bonds may produce an even better result at the current yield level in the next few years.

At the beginning of October, the Estonian state issued one billion euros worth of ten-year bonds, which offer a 4% annual interest. LHV’s conservative pension funds also subscribed to these bonds. I believe this was an interesting deal from an investor’s perspective, and the bond yields reflect both the very high rate of inflation and the very low liquidity of the bond markets.

Are central banks moving from one extreme to the other?

This year’s inflation rate in the eurozone will probably reach 10%. Nevertheless, there are already signs that the European economy is starting to cool down, and as the demand for goods and services shrinks, price growth will also slow down – provided that the supply does not shrink even faster.

I predict that in 2023, inflation in the eurozone will remain at around 5%. In the long run, it is even possible that instead of inflation, we will be worrying about deflation and its negative impact on the economy and society.

I believe that in our current debt-burdened society, it is possible to get the rate of inflation under control by sharply raising interest rates to reduce both consumption and investment. However, this will be a painful process, because no one can predict when this remedy will start to work and what the side effects of the treatment will be.

I suspect that the probability of achieving a ‘soft landing’ is close to zero. Those who have prepared a sufficient financial cushion and therefore have more options for coping with difficult circumstances will come out of this increasingly complicated situation having suffered the least harm.

Investment opportunities in the financial sector

For me, the biggest shock in October was the Swedish central bank’s decision to award the Nobel Prize to former US central bank president Ben Bernanke. In my view, Bernanke is one of the chief architects of both the 2008 financial crisis and the current monetary chaos. Fortunately, his award was not for his contribution to the 2008 financial crisis nor for the ‘Bernanke doctrine’, but instead for his earlier research on how to make the banking sector more crisis-proof.

Regulated banks are probably safer now than ever before, but the price of this is the rapid growth of shadow banking: no one knows exactly what the risks of shadow banking are and where they are hidden. In my view, banking sector regulations should be a desirable quality assurance and not a punishment to be avoided.

Year after year, regulations have been tightened on traditional banks, which is why part of the business has moved to the less regulated or completely unregulated area of shadow banking (alternative financial service providers, specialised funds, payment intermediaries), while traditional banks have lost market share and significantly underperformed in yields compared to stock indices. I believe that this trend will reverse in the near future.

For some time already, we have been gradually increasing the proportion of financial sector shares and bonds in LHV’s pension funds. I believe that moderately positive interest rates tend to have a positive effect on the economic environment, encouraging competition and real innovation. Negative interest rates may work in theory, but in real life they have proved to be a failed experiment and a drag on the economy. Here you can find an interesting interview with Ben Bernanke’s one-time colleague, former head of the Bank of England, Lord Mervyn King, who shares his analysis on what has gone wrong in monetary policy in the last twenty years and what to expect from the future.

The current economic environment and geopolitical situation are undeniably difficult. However, the positive is that there is finally talk about the risks associated with endless borrowing, as there are no longer any illusions that you can take out a loan for free. Money is finally starting to have a price, and no one knows exactly how high that value will rise. The price of money, or the interest rate, is the most important price in the economy, which affects the prices of all other assets and goods. If the price of money changes significantly, then there is a reason to recalculate all financial plans and revise budgets.

Hope is not a good investment strategy. Those who are ready to adapt and align their costs and investments with reality will do better in a changing environment than those who wait until they have no choice.