LHV Pensionifond XL

Both European and US stock markets saw solid gains in May, recouping losses from the previous month. The Euro Stoxx 50 index, which tracks Europe’s 50 largest companies, rose by 2.1% in May, while the S&P 500 index, which follows the value of the top 500 US companies, increased by 4.8%.

Behind the rise in the US stock market since late October lies strong performance from technology companies and expectations that the central bank will swiftly cut interest rates. While the US central bank hinted at three rate cuts in 2024, by the end of 2023, markets seemed to expect four or even five cuts.

However, given the robust US economic environment and supportive fiscal policy due to a large federal budget deficit, it is unsurprising that the inflation rate remains persistently higher than the central bank’s target of 2%. In March, US annual inflation accelerated to 3.5%, holding steady at 3.4% in April and 3.3% in May. Consequently, few believe the Federal Reserve will cut rates more than once this year.

In Europe, where the economic environment is weaker and governments more conservative, inflation has slowed more rapidly, prompting rate cuts. In March, the Swiss central bank reduced rates from 1.75% to 1.5%, with the country’s inflation at 1% year on year. Similarly, the Swedish central bank cut rates by 0.25 percentage points to 3.75% on 8 May. Despite Eurozone inflation accelerating to 2.6% in May, the European Central Bank also reduced its deposit interest rate to 3.75% at its most recent meeting.

Few doubt that the primary driver of the sharply accelerated inflation was the prolonged period of low interest rates. While extremely generous government aid packages during the COVID-19 crisis sparked a sudden surge in consumer prices, more than a decade of quantitative easing created a conducive environment for price explosions. Central banks delayed rate hikes, relying more on their models than on real-life events. Now, central bank models predict inflation will soon retreat to 2%. However, one would hope that decisions going forward will be based on real-life developments rather than models.

Figure 1. The inflation forecasts of the European Central Bank, Swedish Central Bank, Bank of England and Swiss Central Bank, 2018–2026. Source: Gavekal

Even if the economic environment cools, it does not automatically mean slower price growth, given structural changes in the global economy in recent years.

I recently came across a brief analysis from Gavekal discussing the conditions under which inflation could slow to 2% in the Eurozone. The analysis divided consumer prices into three groups:

1. Service prices, which heavily rely on local wage levels and typically make up 40% of the consumer basket in Europe
2. Prices of industrial products, which remain relatively stable due to rigorous international competition and account for approximately 30% of the consumer basket
3. Prices of energy and industrial and agricultural commodities, making up 30% of the consumer basket and historically showing more volatility than the first two categories

Over the decade preceding the COVID-19 pandemic, service prices in Europe rose by an average of 2%, industrial product prices by 0.4%, and energy and commodity prices by 2.6%. This led to a 1.7% average annual growth in consumer prices.

Currently, wages are growing at a much faster pace than 2% across Europe. Given Europe’s participation in the US-initiated trade war, which promises to drive up industrial product prices, it is difficult to see how inflation could slow to 2% within the next 12 months, even if commodity prices do not rise. It is more likely that we will experience a slight acceleration in price growth this year.

Price stability is the primary and often sole objective of central banks. The runaway inflation at the end of the COVID-19 crisis dealt a severe blow to central banks’ credibility. Therefore, it is difficult to believe they would repeat the same mistake and cut interest rates quickly and extensively before inflation stabilises at 2%.

This means expecting rapid successive interest rate cuts this year would be naive: perhaps they will be lowered by 0.25 percentage points a couple more times, but likely not more than that. If the inflation rate does not decrease rapidly, it is unlikely that interest rates will decline significantly, even if the economic environment cools.

However, long-term interest rates are likely to rise, leading to a decline in the prices of long-term bonds. Short-term interest rates in Europe are currently much higher than those of long-term bonds: the six-month Euribor is 3.735%, while the yield on Germany’s ten-year government bond is 2.36%.

As large companies typically secure long-term fixed-rate funding for their long-term projects, long-term interest rates affect the performance of publicly traded companies more than short-term interest rates do.

Profit margins for companies, especially US technology firms, are currently relatively high compared with historical levels.

Figure 2. The profit margins of companies in the US, emerging markets and developed markets (excluding the US).

Figure 3. Profit margins of technology companies versus other firms in the US (%).

Companies’ price-to-earnings (P/E) ratios are also elevated:

Figure 4. The Shiller P/E ratio for US companies, including long-term average and standard deviations.

Therefore, LHV pension funds are currently adopting a slightly cautious approach in the stock markets. I am not predicting a crash, but I also do not expect to see significant stock price growth from today’s levels. We prefer sectors such as banks and mining companies, as we believe commodity prices could rise further due to geopolitical tensions. We are prepared for moderate price growth to continue for some time and have positioned our pension fund portfolios accordingly.