November started in a cheerful mood in the stock markets, which helped reach a new record high in both the European and US stock markets in the middle of the month. In the last weeks of the month, the mood changed and the stock markets reversed, leaving the MSCI World Index for November at 0.6% in euros. One reason for this was the spread of a new coronavirus variant that could lead to renewed restrictions on economic activities, which had almost revived in the meantime.
It cannot be said that the new wave of the pandemic was the only fear: another important risk factor is the rise in consumer prices almost everywhere. Until recently, central bankers and economists have confirmed in unison that rising prices are only a temporary phenomenon caused by upset supply chains. But these should be fixed soon or optimised to fit the new circumstances.
Faster inflation > rising interest rates > higher taxes?
Using complex economic models, researchers predict that price growth will slow down on its own, despite central banks continuing to buy bonds from the markets and real interest rates remaining 4% and more than 5% below zero in Europe and the US, respectively. On the other hand, all those who live real life and do real business feel the effects of the prices of almost all goods rising from month to month.
With the support of central banks’ monetary policy, stock and real estate prices have been recovering faster for a long time than their dividend or rental income would justify. Nevertheless, the rise in asset prices has been welcomed, as those who own some form of real estate or a small investment portfolio have felt richer as a result.
Even though wages, which have stagnated for some time in the US and many parts of Europe, have started to rise faster, the prices of goods are rising even faster, and people’s purchasing power may even decline despite higher wages.
While in March, the prices of goods and services in the US rose by 2.6% year on year, the inflation rate in November was 6.8% year on year. In the euro area, consumer prices rose by 4.9% in November, which is slower than in the US but more than two times higher than the target set by the European Central Bank.
For a long time, central bankers have been trying to drive inflation through low interest rates and buying bonds to help reduce and alleviate the debt burden that has grown fast over the past 30 years.
The cost of servicing loans was thus reduced. Still, those with collateral increased their debt burden, as the price of money was unprecedentedly low and additional loans helped leverage existing investments, the returns on which declined as prices rose. As mentioned, those who had property felt increasingly rich, even though they had unprecedented loans on their necks.
Suppose reality forces central bankers and researchers to adjust their models and recognise inflation as not being temporary. In that case, there will be no other means to curb inflation than to stop buying bonds and start raising interest rates.
If investors are no longer willing to pay for government borrowing but start demanding interest rates that exceed inflation, rising interest costs may significantly increase budget deficits in many major economies. This, in turn, can lead to higher taxes.
We consider both inflation risk and the risk of rising interest rates
Perhaps I am being unfair when I accuse central bankers of stubbornly sticking to their models and ignoring reality. I, too, have been true to my views, the model of how I think the economy works, and how value is created.
As I have repeatedly emphasised, I value cash flow and profits highly. While a high debt burden can help leverage profits, I consider it a risk in the first place. I understand that, in theory, the interest rate can be any positive or negative figure. Still, I think it is dangerous to expect that interest rates will remain below inflation in the future. I suspect that central banks will ultimately have to choose whether to control inflation or interest rates.
Central banks are likely to delay raising interest rates as long as possible, as this could prove very difficult politically: higher lending rates would negatively impact the prices of almost all assets and hamper investments in development. At the same time, let’s not forget that achieving price stability is one of the main tasks of central banks, and in many countries, it’s their only task.
Therefore, higher interest rates are quite certain to arrive; the only question is how long the difficult decision will be postponed. Delaying increases risks because if inflation expectations get out of control and start feeding inflation, interest rates will have to be raised even more in the future.
Higher interest rates would have a devastating effect on the bond market. If interest rates were to rise by 2%, for example, the price of a ten-year ‘risk-free’ bond would fall by around 20%. Highly leveraged companies and projects would also be at risk.
Higher interest rates would also adversely affect companies and projects whose income (and profits) come in the very long run. Much of the technology sector, which invests in growth and has postponed making a profit to the distant future, has low leverage levels but is still vulnerable to rising interest rates. In the second half of November, when stock markets began to decline, companies in the technology sector were among the biggest losers.
The LHV pension funds have prioritised maintaining the real value of assets, considering both the inflation risk and the risk of rising interest rates. Therefore, we avoid long-term bonds and hold short-term, low-risk bonds only for hedging and liquidity management purposes. We try to earn income from investments and projects whose cash flows are perceptible and which justify the price level of these assets.
November started in a cheerful mood in the stock markets, which helped reach a new record high in both the European and US stock markets in the middle of the month. In the last weeks of the month, the mood changed and the stock markets reversed, leaving the MSCI World Index for November at 0.6% in euros. One reason for this was the spread of a new coronavirus variant that could lead to renewed restrictions on economic activities, which had almost revived in the meantime.
