III pillar

October was a good month for stock markets, up 5.8% on the MSCI World Index. The S&P 500 index, which represents the shares of the largest US companies, rose by as much as 7.2%, reaching a new record level by the end of the month. The Stoxx 50 index, which tracks the shares of large European companies, rose by 5.1%. The value of emerging market companies also increased, but to a lesser extent: 1.2%.

On the other hand, bond markets have been on a downward trend since the summer of 2020, as the governments of large countries have made major changes to their fiscal policies to combat the virus. The United States are increasingly embracing the principles of modern monetary policy, which means that maintaining a balanced national budget has become secondary, and politicians are spending and investing as much as they like.

Although economic growth has accelerated significantly since the pandemic crisis and employers are finding it increasingly difficult to find workers, central banks continue to buy bonds, which is essentially equivalent to financing government spending. This involves a danger that financial discipline will be difficult to re-establish if politicians get used to distributing money loosely.

Unbridled increase in prices

From month to month, the growth of the consumer price index has accelerated. In October, for example, annualised inflation in the United States rose to 6.2%, the most significant jump in 30 years. At the same time, the (nominal) interest rate on 10-year government bonds was only 1.58%, suggesting that the US dollar had a real interest rate of –4.62%.

In October, annualised inflation in the eurozone reached 4.1%, exceeding the European Central Bank’s price growth target by more than 2 percentage points. Nevertheless, the European Central Bank is continuing its bond-buying programme at an unchanged pace. Both US and European central bankers seem to believe that the price increase is temporary and only reflects the fall in prices during the coronavirus crisis. This appears to align with the view that the economic environment is not strong enough to withstand interest rates above 0%.

Milton Friedman argued in 1956 that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.

However, the experience of recent decades has shown that increase in the quantity of money alone will not accelerate price growth if consumers do not believe in it. However, this may mean that if the rise in consumer prices finally gains momentum, even central banks with their monetary policy levers will not be able to control it easily.

In addition, I am beginning to feel that the days when central bankers were superstars are a thing of the past. If Alan Greenspan or Mario Draghi were able to influence investors’ future expectations with a few words, now the utterances of a star tech entrepreneur may have more weight than the statements or persuasions of Jerome Powell or Christine Lagarde.

Although I would like to believe that economics is based, even just a little, on reality (actual profits and cash flows) and not just on dreams and expectations, it is dangerous to underestimate the impact of virally spread narratives. If the increase in consumer prices does not slow down over the next twelve months, central banks will be faced with a dilemma. They either take decisive action to control inflation or support the economy and risk even faster price increases in the future, which will start to eat away at the economy.

Investing in an inflationary environment

It is widely believed that stocks offer good protection against inflation. However, history has shown that stock yields are higher when inflation is slow, and when price and wage growth accelerates, stock yields fall.

Real estate, raw materials and precious metals have historically provided better protection against inflation than stocks. Therefore, in the case of LHV’s higher-risk pension fund investments, there has been an increased focus on these three asset classes.

The average annual yields of the five asset classes in the US, taking into account the inflationary environment from 1871 to 2021. Source: Citi Research.

In the case of real estate, however, the fact that most investors finance their investments in this asset class with bank loans and bonds is something to keep in mind. In this case, there is a huge difference between whether the debt is taken out with a variable or a fixed interest rate. Should consumer prices continue to rise at the current rate, which is twice the target set by the European Central Bank, it is naive to assume that interest rates will remain at current levels as well.

Historically, interest rates have generally been higher than the inflation rate. The current situation, where real interest rates (nominal interest rate minus inflation) are negative, is more likely an anomaly. As long as real interest rates are –3%, real estate prices will continue to rise rapidly. However, should real interest rates turn positive, rapid growth could turn into a rapid decline.

As far as Estonian commercial real estate is concerned, it has struck me that although rental prices for commercial real estate are mostly indexed under contracts, they have actually grown at a much slower pace than consumer prices – if at all. The rise in Estonian commercial real estate prices has been mainly due to lower interest rates and increased leverage. Furthermore, in an environment of falling interest rates, investors have been willing to pay ever-higher prices for the same flow of rental payments.

We are living in an increasingly financialised world, which means that almost every investment and transaction is made with the help of a loan or leverage. While loan-free real estate is a relatively low-risk investment, real estate acquired with a low-own contribution is anything but risk-free. In this case, more may be lost than was put into the equity transaction.

Source: Bloomberg.

The above chart compares the annual yield on 10-year US government bonds with the country’s annual inflation rate. US real interest rates have only been negative for a very short time in the past.

As I see the economic environment being simply too fragile for it, I have not yet personally believed that the future will necessarily be inflationary. However, this chart made me think that it is not impossible for inflation expectations to start behaving independently. In this case, curbing them will require a truly radical monetary policy and strongly impact all asset classes.