The performance of stock markets this year has exceeded expectations and the S&P 500 Index, which tracks the biggest US companies, reached another record level in November. The index is up 25% year to date, thereby supporting the rise of the global stock market by nearly 22%, following the correction in the fourth quarter of last year.
At the same time, growth in corporate profits has slowed down world-wide or even declined. This means that the abatement of the trade war and recovery of the economy – something that is not at all certain, considering the previous political trends – have been factored into the prices.
The cycle has reached its late phase
The growth phase of the current economic cycle has lasted for more than ten years, owing to which corporate profits have increased sharply. In particular this concerns earnings per share, the growth of which has been supported by buy-back programmes worth trillions of dollars. It is difficult to believe in continued rapid growth if unemployment in the US has dropped below 4%. In theory, we should have seen salary growth and the resulting acceleration of the inflation rate a long time ago.
Despite the predominant monetary policy, consumer price index growth still remains below the 2% target set by central banks in several parts of the world. This is really one of the reasons why the central banks have once again turned on the money taps. In November, the European Central Bank began to release fresh money into circulation, buying bonds worth a total of EUR 20 billion in a single month, and will continue to do so as long as this is needed. Also, the balance sheet of the Federal Reserve has increased by several hundred billion dollars after a decline lasting for nearly five years.
The condition of the global economy is not as good as international stock markets are indicating. President Donal Trump’s trade war has created a great deal of confusion everywhere and forced a downward adjustment to the world’s economic growth forecasts. Weaker than expected economic growth has, in turn, given the central banks a reason to intervene more actively in money markets. On the other hand, there are suspicions that monetary policy could also be used as a key in the hidden and quiet currency war, to create further stimulus for their country or an economic region through competitive advantage.
We have reached a period of time when, following even the slightest setback in the economy, the focus is immediately shifted towards central banks. Perhaps it will be possible to sustain the growth cycle for some time; however, the central bankers themselves have stated that the efficiency of monetary policy is decreasing, and in order to have an effect the governments grappling with already high loan burdens must increase their expenditures.
More personal connection with investments
LHV’s pension funds have, for an extended period of time, focused more on protecting assets, as I have considered the price level of large international stock and bond markets to be too high. As I expected a fast downward correction from the financial markets, we have made notable changes to LHV’s investment strategy over the last couple of years.
We are increasingly looking for alternative investment opportunities to public stock exchanges. It is more complicated to build a private equity and real estate portfolio than to invest in liquid shares and bonds; yet, the long-term rate of return may be better – in particular, if we weigh the return against the risk.
While infrastructure exists for stock indices and investment funds, which makes them easily accessible to retail investors, and small amounts can also be invested simply and quite efficiently, then systematic investing in private equity, venture capital and even the real estate sector presumes a rather large and very long-term investment portfolio. The volume of single investments in it reaches into the millions of euros, and the time-horizon is generally more than five years. Even for Estonian pension funds this world was almost unreachable just a few years ago due to our small volume.
This year, LHV pension funds have invested in the private equity funds of Novalpina, Blackstone, Investindustrial and Quilvest. The first two have a certain connection with Estonia: Novalpina bought and delisted Olympic, and Blackstone has invested in Luminor.
When buying shares from a stock exchange, a couple of clicks is all that is necessary, with the shares appearing in your account. Investing in a private equity fund, however, is like participating in a planned large-scale project: the parties get to know each other and consider how well long-term cooperation might go.
While an investment fund (be it active or passive) still takes a passive interest in a company, then a private equity fund invests in a company only if it can gain control over it and implement changes within. When buying shares from a stock exchange, the capital is not directed into the company, but instead to the investor that sells the shares – I, however, am interested primarily in investments where capital can be used to support growth.
Pension funds play an important role on the capital markets of developed countries and in the wider economy. Besides hands and brains, economic growth also requires capital. Capital, in essence, means savings, which in turn means that society spends less than it earns and puts the extra capital to work productively – investing in tools. Banks do offer loans, but not capital. Capital is your own equity that has to be paid into the new project before the bank is ready to grant a loan. Accordingly, capital is born only when someone spends less than it earns.
The more you save, the more capital you have. The more capital there is, the bigger the projects you can undertake and the higher the income you may earn. The more you earn, the more you can save, and so on. Wealth is created only thanks to saving and not consuming.
Rich countries have large, internationally operating companies and big capital markets. We still have to fight for our place on international markets and create and grow our companies. For this, we need capital, and that means local savings. If we invest in our own companies, it will be that much easier to also involve international capital.
The performance of stock markets this year has exceeded expectations and the S&P 500 Index, which tracks the biggest US companies, reached another record level in November. The index is up 25% year to date, thereby supporting the rise of the global stock market by nearly 22%, following the correction in the fourth quarter of last year.
