LHV Pensionifond S

The year 2024 turned out to be unexpectedly strong for financial markets, with the MSCI World Index, which tracks the performance of developed country stock markets, gaining 19.2%. This was primarily driven by an extraordinarily powerful rise in US stocks. Since the share of US companies in the World Index is nearly 74%, it is understandable why the global stock market index performed so well.

The S&P 500 Index, which tracks the largest companies in the United States, rose by 23% last year in dollar terms. Notably, a third of this index consists of the shares of seven technology giants (the “magnificent seven”), whose market values rose between 20% and 177%.

Investor optimism and heightened risk appetite reflected in the cryptocurrency markets. The price of Bitcoin soared to $93,714 in 2024, marking a 120% increase.

Figure 1. Returns of different asset classes in dollars in 2024

Outside the United States, stock markets also delivered respectable returns. The MSCI Europe Index rose by 5.8% in euro terms (or 2.4% in dollar terms), but its performance still lagged significantly behind the soaring US stock markets.

Figure 2. The performance gap between the MSCI Europe Index (excluding the United Kingdom) and the MSCI USA Index in percentage points

Mysterious interest rates

While mainstream media may give the impression that interest rates are broadly declining worldwide, the reality is far more nuanced.

In June 2024, the European Central Bank lowered interest rates for the first time in a long while, prompted by a downward trend in inflation and the need to support sluggish eurozone economic growth. However, it is premature to declare victory over inflation. Prices in the euro area continue to rise faster than the central bank’s target, and by year-end, the inflation rate had even accelerated slightly.

For long-term investments, international companies focus on long-term bond yields rather than short-term rates like Euribor, and in Europe, these yields remained steady throughout last year. Germany’s ten-year government bond yield ended 2024 at 2.4%, the same level as at the start of the year.

In the United States, inflation has been easing since the summer of 2022 but remains stubbornly high, driven by unchecked government spending. In September 2024, the US Federal Reserve cut short-term interest rates by 0.5 percentage points for the first time in years, followed by reductions of 0.25 percentage points in both November and December. Yet, long-term bond yields moved higher, rising from 3.95% to 4.58% over the course of the year.

Evaluating US economic growth in the context of the government’s budget deficit

It is perplexing to see discussions about the strength of the US economy when the moderate growth is largely propped up by the government’s unprecedentedly high spending. Just as nominal economic growth is adjusted for inflation to calculate real growth, the government’s budget deficit should be factored in when assessing the overall economic environment. Spending borrowed money makes it easy to create an illusion of success and prosperity.

For example, if the government borrows $100 and spends it, private sector revenues –corporate profits and wages – will rise by roughly the same amount.

Currently, US corporate profits are exceptionally high relative to the size of the economy. Profit margins remain elevated, and valuation multiples such as price-to-earnings (P/E) ratios are at near record levels.

Figure 3. Average valuation metrics of US companies compared to historical averages

The rise in asset prices fuels investor optimism and bolsters the economy

The US stock markets delivered exceptionally high returns in 2023, and at the start of 2024, few hoped a repeat of such remarkable success. Over the past two years, the S&P 500 has surged by more than 50%, marking the second-largest two-year percentage increase in the history of US stock markets. The most significant two-year growth occurred in the late 1990s, just before the dot-com bubble burst.

Figure 4. S&P 500 returns from 1928 to 2024

Traditionally, the economic environment determines the value of companies, but following the financial crisis of 2008, central banks and governments reversed this dynamic with loose monetary and fiscal policies.

Now the so-called wealth effect is what influences the economy and not the other way around: when stock prices go up, consumers open their wallets and the economy grows. The assumption is, of course, that loose monetary and fiscal policies will continue.

In stock markets today, price trends have become a key metric. Growth in profits and revenue has taken a backseat to movements in stock prices. While it is difficult to predict how long this reversed dependency will persist, unsustainable processes inevitably come to an end.

The role of pension funds is to preserve and grow clients’ assets over the long term. The second pension pillar’s success should be evaluated relative to the first pension pillar, making nominal wage growth the ultimate benchmark for pension funds over time.

At LHV, we believe that the goal of pension funds is not to maximise risk at all costs but to balance risk and return carefully while considering the broader economic environment and market conditions. In our view, the role of fund managers – if the fund is actively managed – is to carefully evaluate the risk and expected return of each investment and to avoid both market-driven euphoria and panic.