Share prices continued to increase in June. The Euro Stoxx 50 Index, which follows the value of European companies, added 6.4% when taking into account dividends and the S&P 500 Index, which unites the largest US companies, grew by 0.7% in euros. The rapid rebound of equity markets from the March low has been unexpected and impressive: at the end of June these two indices were only down by 12.4% and 3.2% respectively since the start of the year. The increase has not been dampened by the fact that the recovery speed and scope of the world economy is still unclear.
Securities markets have been supported by unprecedented stimulus packages and support programmes initiated by central banks and governments. These have helped to sustain companies and economies and ensured a certain level of normality.
Despite extensive support measures, the IMF estimates that the world economy is to lose 11 trillion euros this year and the next due to the virus. According to the latest forecasts, the GDP will decrease globally by around 4.9% this year (3% according to April forecast). Economic recession in the eurozone will thus likely reach over 10% and the US GDP will decrease by around 8%.
Stimulus comes at a price
The money funnelling is designed to help companies and consumers back on their feet faster, but it is not a free lunch. At the beginning of 2020, the US Department of Treasury estimated a budget deficit of 1 trillion dollars (around 5% of the GDP), but by the end of June it seemed that this year’s deficit will amount to 3.7 trillion dollars (around 18% of the GDP) instead.
The European Commission estimates that the government deficits of eurozone countries will reach to 8.5% this year. This increases the public sector’s debt-to-GDP ratio from 86% in 2019 to around 103% by the end of 2020.
This inevitably leads to the question of how long central banks and governments will have firepower and the effect of greater debt obligations to economic growth in the future. Debt burden was very high almost everywhere in the world even before the Covid-19 pandemic and not just in the government sector. One may think that this is currently not the most burning question due to low interest rates, but despite lax monetary policy more and more companies have difficulty servicing their debts.
Companies who use their whole profit to pay interest are called zombie companies. The so-called zombies formed less than 5% of US companies at the beginning of this century, but their share has grown year by year and is currently reaching almost 20% – this in a situation where risk-free interest rates have decreased to almost zero even in the US.
If central banks want to avoid a great wave of bankruptcies, increasing interest rates becomes a highly complicated task. On the other hand, keeping struggling companies afloat may result in inefficient distribution of resources and lower increase of productivity in the economy.
How to invest in such a situation
As mentioned, central banks are currently putting trillions of dollars into circulation, buying up both government and corporate bonds (of increasing risk levels) and even corporate shares. Fair prices on securities markets are no longer determined by purchasers and sellers who appreciate corporate profits and their increase, but central banks’ monetary policy. This drives up the price of existing assets regardless of the cash flow they offer.
If the interest rates of risk-free bonds are negative, even a zombie company becomes valuable despite it not earning a profit or the lack of guarantee that it will do so in the future. This environment is perfect for profiteers and ignoramuses and the market is shaped by greed and the fear of missing the boat.
The March slump was a great opportunity for LHV pension funds to once again invest in equity markets at a reasonable price. We also seized this opportunity quite aggressively. By now, companies’ profit ratios have once again increased to over 20 on larger markets, which means less than 5% return if the companies do not increase their profits.
In such a situation, we prefer to invest in over-the-counter assets that offer somewhat greater return or involve a smaller risk. For instance, in June, LHV pension funds laid the foundation stone for two new rental apartment buildings in Uus-Mustamäe because we believe in Estonia’s growth perspective. The 127 rental apartments in the Manufaktuuri Quarter have been on the market for over a year now and have successfully managed to earn profit for pension fund shareholders.
The first wave of the pandemic may be over for now, but the economic impact and consequences of the crisis will continue to affect us for a long time. In LHV, we choose investments, above all, on the basis of the estimated cash flow of companies and projects. The hope of reselling the investment in the future at a higher price alone is not sufficient for analysing the investment and making a purchase decision.
An investment whose value increases quickly only due to a simple but promising story may lose its value just as rapidly. There are plenty of examples of this from the past. Investing is more like a marathon than a sprint.
Share prices continued to increase in June. The Euro Stoxx 50 Index, which follows the value of European companies, added 6.4% when taking into account dividends and the S&P 500 Index, which unites the largest US companies, grew by 0.7% in euros. The rapid rebound of equity markets from the March low has been unexpected and impressive: at the end of June these two indices were only down by 12.4% and 3.2% respectively since the start of the year. The increase has not been dampened by the fact that the recovery speed and scope of the world economy is still unclear.
