To The Moon

The risk this year is more in bonds than equities.

Currently, euro-denominated bonds, based on the Vanguard Global Bond Index Fund, are down 5.1 percent, while equities, according to the MSCI ACWI IMI index, are showing a modest loss of 4.2 percent in euros.

Since the Russian invasion of Ukraine, shares have actually risen on balance. The reason that equities are lower this year is mainly due to rising interest rates. Investors are very cautious and cash positions are high. The chances are increasing that in the rest of the year, equities can provide much better returns than bonds. When investors realize this, the large rotation from bonds to equities that started last year could continue.

Inflation leaves investors with a choice

There are many implications of the war in Ukraine, but everyone agrees that inflation will continue to rise as a result of the war. The war is again causing disruptions in production chains and energy and food prices in particular are rising sharply. Inflation is the big enemy of bond investors, while the equity asset class is perfectly positioned to compensate for higher inflation. This is first of all because the cash flows when buying a bond are fixed.

If inflation turns out better than expected, the bondholder is in the driver's seat, while higher inflation is immediately detrimental to the real return. With equities, cash flows are variable. Many companies are perfectly capable of passing on higher prices. An appeal to corona and the war in Ukraine provides the licence to do so. Moreover, wage increases are lagging behind, good for profit margins.

Nevertheless, consumers are still in a good position and feel rich after two years of corona. It is that corona was immediately followed by the war in Ukraine, but everyone seems to yearn for a return to the times before corona. In this respect, the war in Ukraine seems to be nothing more than a temporary delay, especially a humanitarian tragedy. There are also companies that benefit from rising energy, metal and food prices. The higher cash flows accrue to oil producers, mining companies and companies in the agricultural industry. Ultimately, shareholders benefit.

Long term in favor of equities

The long-term prospects for bonds are not good either. This is due to the high debt mountain. Central bankers can ensure that this debt burden remains bearable by keeping interest rates below the economy's nominal growth rate. Nominal means real growth plus inflation, so if the U.S. economy grows by 3 percent this year and inflation rises by 7 percent, the nominal growth rate comes out to 10 percent.

As long as both short and long-term interest rates remain below 10 percent, there is reflation, also known as financial repression. The result is that debt as a percentage of GDP falls. It is a proven means of solving a debt problem, while corona has only made that debt mountain rise further.

Financial repression does make use of the interest-on-interest effect, seen by Einstein as the eighth wonder of the world. Given the size of the debt in relation to GDP, central banks need several years to achieve this, although it is of course faster at an inflation rate of 7 percent than at an inflation rate of 3 percent.

Incidentally, central banks do not have to raise interest rates to 10 percent. The sensitivity of financial markets to interest rates has been greatly increased by high debt levels. Moreover, high inflation itself inhibits economic growth. Central bankers will not admit it, but can probably live just fine with inflation between 3 and 4 percent over the next 10 years. If you use current interest rates to calculate the scenario in which a positive real return can still be achieved with bonds, you will come to the conclusion that bond investors are doomed in virtually every scenario. This while a negative real return on equities over a 10-year period is rare.

High investment required

The world has changed by corona and the war in Ukraine has further accelerated certain trends.

First of all, Europe is facing a new refugee crisis, normally at the expense of economic growth. But these refugees are allowed to work immediately and not only in Germany many rural villages are emptying due to an aging population and migration to the city.

Moreover, there is a serious shortage of qualified personnel. The population growth and thus the economy may get an extra boost from the millions of Ukrainians at the right time, and we may also be able to get a piece of the Russian brain-drain. Many companies will welcome these people with open arms.

Furthermore, it apparently took a war to actually set the energy transition in motion. Companies that are active in this field can get their act together. Also, further deglobalization means even more investment in robust production chains. Normally, a recession is preceded by a period of an economic boom where inventories build up and investments are made a little too enthusiastically, but two years of corona has ensured just the opposite.

Furthermore, do not underestimate the multiplier effect of such investments, especially in the area of manufacturing. Of course, there will also be losers as a result of this war, but major changes mainly offer opportunities. At least for equities, not for bonds.

At the moment of turmoil in the financial markets, many investors do not act rationally. Investors have nothing against risk, as long as it does not cost money. You can tell people a hundred times that getting out of the market on the basis of increased volatility will ultimately be at the expense of returns, but the almost animalistic impulses will soon surface. The herd runs wild at the sight of the hunter. When calm returns, investors gradually start to pay more attention to the fundamentals. Not that all signals are immediately green, but an ascending market simply has to climb the wall of fear. The fundamentals are still in favor of equities, not bonds.