The year 2022 was pivotal for securities markets. In early January, several of the world’s largest and most important stock indexes were at all-time highs, and global bond markets held more than 10 trillion dollars worth of low-risk bonds that investors were willing to pay to hold.
Just one year earlier, the volume of bonds with a negative annual yield was even larger at 18 trillion dollars. Although inflation rates had been on an upward trend throughout 2021, central banks insisted this was temporary: several of them continued to buy up bonds and pump money into circulation until mid-2022.
The value of the S&P 500 index, which tracks the world’s largest and most important stock market, fell by around 20% last year, despite a mere 5% decline in corporate profits. The price-to-earnings (P/E) ratio of the index was 27 times the earnings for the past 12 months in early 2022 but dropped to 19 by the end of the year.
Although, at the start of 2022, the US stock market was overvalued in terms of almost every historical standard, stocks still looked cheap relative to the bond market, where the ten-year US government bond offered an annual yield of 1.63%.
In early 2022, the US Federal Reserve offered an interest rate of 0.25% on overnight deposits. Over the next 12 months, the Federal Reserve raised interest rates seven times to an eventual 4.5%.
The adjustment may not be over
The interest rate is the price of money. When the price of money was close to zero, all assets, regardless of quality, appeared cheap. Over the past year, interest rates rose significantly, meaning that money once again had a price.
While just a year ago, due to negative interest rates, 100 euros in your wallet was worth less than a 100 euro note you would receive in 10 years (yes, absurd!) then, with the reversal of interest rates, we returned to a world where the 100 euros in your bank account today is worth more than a 100 euro note you would receive in ten years. At a 4% price of money, the current value of a future 100 euros 10 years from now is a little less than 68 euros.
A rise in interest rates has a negative impact on asset prices, as the value of future profits and rents falls. Furthermore, why risk buying shares in a company that only offers a 1.5% dividend when essentially risk-free government bonds offer an annual yield of 4%?
I suspect that if interest rates rise further, the values of ventures and projects with higher risks and longer time horizons may fall further.
In 2022, bond markets fell even more than stock markets, which leaves unanswered the question of whether bond markets overreacted or whether stocks still have room to fall. Bonds are generally lower-risk investments than stocks.
Thirty-year US government bonds lost more than half their value to rising interest rates last year. It is true that after 30 years, the investors will get their entire investment back, but the value of the bond that will be redeemed after 30 years is currently only half of that. While there is a direct mathematical relationship between the bond price and the interest rate, expectations about companies’ future profits also come into play in the case of stock prices.
The price level of stocks depends not only on interest rates but also on the financial performance of companies. Companies’ profit ratios decreased significantly last year, but still remain somewhat above the historical average. The financial performance of companies was stronger than expected last year, even despite the accelerating rate of inflation, rising interest rates, and disruptions in supply chains. If the growth of the largest economies were to turn negative in 2023 and corporate profits fall, this would put stock markets under new pressure.
However, this does not mean that all companies would face equal difficulties. I believe that, in the coming years, a company’s debt load and the ease or difficulty of refinancing existing debts or attracting new capital will count more than the sector in which it operates.
For the past 20 years, and especially during the past ten, interest rates have been historically very low. In July 2012, the European Central Bank lowered the interest rate on its standing deposit facility to zero, and in June 2014 it went negative for the first time. This meant that commercial banks had to start paying for depositing their funds in the central bank. The US Federal Reserve refrained from setting negative interest rates but kept them close to zero for a long time.
Now that the US Federal Reserve pays banks 4.25% for their deposits and the European Central Bank pays 2%, interest rates have merely normalised. Those who hope and expect a return to the monetary policy regime of a few years ago, where the price of money was essentially 0%, are likely to be disappointed. You can find a 200-year history of US dollar interest rates here.
The economy is cyclical
For years, I have noted the absurdity of the monetary policy of developed countries. It is necessary to support the economy during a crisis, but more than ten years of continuous support can develop into a dangerous addiction.
In a recent interview, Jeffrey Gundlach, who was crowned the king of the bond markets after Bill Gross, compared a 0% monetary policy to an adrenaline injection: it is necessary in a life-threatening situation, but it is neither healthy nor reasonable to have an adrenaline shot every morning.
LHV pension funds pursue a very long-term investment strategy. We have always considered the possibility that the economy and securities markets are cyclical, and that both interest rates and stock market ratios fluctuate around their historical averages. The investment portfolios of our pension funds have been designed based on this knowledge.
Owing to conservative investment strategy, we did not make a maximum gain on the phenomenal rise of the stock markets in 2021, when the world’s largest economies were almost locked down, while the policy of zero interest rates and the generosity of governments boosted the value of all companies and projects. But thanks to our conservative investment strategy, we also managed to avoid investing in companies with a high debt burden, whose value was based on nothing but lofty promises and who have been in free fall over the past year.
PS!
In an earlier newsletter, I wrote about the growing importance of stories and narratives, which have even surpassed the ability of companies in certain lines of business to offer real products and services. Several speculative bubbles burst last year. Some were caused by the greed and naivety of the investors themselves, while others were deliberately and maliciously created illusions. The lawsuit between the scandalous medical diagnostics startup Theranos and its founder Elizabeth Holmes was settled last year.
I would like to hope that the events of the past year point to the importance of independent critical thinking, and that we, as citizens and investors, will be better able to tell between illusions and reality in the future.
By the way, Merriam Webster, the oldest publisher of dictionaries and reference books in the United States, chose gaslighting as the word of the year for 2022. It means creating a false narrative that causes a victim of fraud to question the validity of their own thoughts.
