LHV Pensionifond S

June was generally a positive month for international stock markets. The S&P 500, which tracks the value of major US companies, rose by 3.5%. The MSCI World Index, which assesses the performance of emerging markets, also increased by 3.6% over the month, driven by the growth in the stock markets of Taiwan, South Korea, and India.

European stock markets, on the other hand, experienced a downward trend in June: the Eurostoxx 50 depreciated by 1.7% over the month. This was largely due to French President Emmanuel Macron’s decision to hold snap parliamentary elections in France following the European Parliament elections. This decision will likely create at least short-term political instability and increase the risk that France’s public finances may not be brought under control anytime soon. This could, in turn, escalate into a problem for the eurozone.

The rise in the US stock market was mainly driven by the increase in the value of major technology sector companies there.

Figure 1. Since the beginning of 2023, the stocks of the seven largest technology companies have surged by 149% (green), while the remaining 493 companies in the S&P 500 index have shown much more modest movement (blue). Sources: Apollo Research, Bloomberg.

The value of companies within the S&P 500 index has increased by $5.8 billion this year. Of this growth, 31% (equivalent to $1.8 billion) can be attributed solely to the rise in NVIDIA’s stock price. Although large technology companies have earned decent profits in historical comparison, the majority of their value growth can be attributed to the expansion of profit multiples, indicating investor optimism.

Figure 2. Investor optimism about future company earnings: indicator for the top 10 most profitable companies (green) and indicator for the top 10 companies by market capitalisation (blue). Sources: Apollo Research, Bloomberg.

Furthermore, compared with the first dot-com bubble in 2000, the value of current leading technology stocks is even higher, and the overall market is relatively more expensive.

Figure 3. S&P 500 companies’ 12-month forward price-to-earnings ratio (beige), forward price-to-earnings ratio for the top 10 companies (green) and price-to-earnings ratio for the S&P 500 index without the top 10 companies (blue). Sources: Apollo Research, Bloomberg.

Artificial intelligence holds great promise

Artificial intelligence could be a world-changing technology that has been fantasised about for decades. However, in the past couple of years, progress has primarily been driven by exponential growth in computing power and a novel approach that could turn what used to be science fiction into reality.

Paradoxically, economic growth in developed countries has been progressively anaemic for the past couple of decades, despite the rapid advancement of technology, and debt has increased much faster than the economy almost everywhere. In this predicament, there has been hope for a positive technological shock that would ultimately add momentum to economic growth and help solve the monumental challenges facing humanity, such as global warming.

Nevertheless, it would be naive to expect that any scientific or technological breakthrough, no matter how significant, could change the world on its own. Tasting results first requires extensive investment. This, in turn, implies prioritising our activities and likely tightening belts in less productive areas in order to create investment opportunities in areas where results are achievable.

The fact that technology giants have a lot of money to invest and little debt works in their favour. Unfortunately, the overwhelming majority of the rest of the economy is currently burdened by higher debt than ever before. This could significantly hinder development and create additional social tensions.

Risks should be managed and diversified during times of change

The LHV Asset Management team is positive about technological development but less optimistic about the valuation levels of companies in the technology sector. Currently, our focus is more on the energy and commodities sector as we anticipate that technological advancements will require new investments in both energy and distribution networks. We also have high expectations for the banking sector, which is considerably undervalued despite healthy profits.

In the long run, technological development is deflationary, meaning that production becomes more efficient and cheaper. However, in the short term, when investments are still being made and the economy is being restructured, price growth can actually accelerate as demand for resources exceeds supply.

At LHV, we believe that while central banks’ tighter monetary policies have significantly slowed consumer price growth, the financial environment is still too loose, due to the ever-increasing government spending, to achieve a definitive victory over inflation.

In a challenging and uncertain economic environment, it is wise to diversify risks across different asset classes. In recent years, gold and the stocks of companies mining precious metals have played a significant role in LHV pension funds’ portfolios. We began investing in gold at a time when the yields on long-term risk-free bonds were negative, seeking alternatives to government bonds.

We believed that gold could provide a better outcome than a guaranteed loss. As a result of this choice, we were able to largely avoid losses in the bond market, where government bonds, previously considered almost risk-free, became one of the riskiest asset classes as inflation accelerated. In recent years, however, the price of gold has provided returns almost comparable to stock markets.

I suspect that diversifying risks solely among different stocks, or within one asset class, may not be sufficient in today’s complex economic and geopolitical environment. To mitigate risks, it pays to look at the investment landscape more broadly and not restrict oneself to listed stocks and bonds.