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September 17, 2020

Risk and Inflation

Equity markets and risky assets, in general, continue to compensate vs. the traditional deposit or, in the common name, “risk-free” asset. After the “scare” of March, with the appearance of the coronavirus, the following months provided good buying opportunities in the stock markets and in fact those who chose to increase the risk in their portfolio, in general, were rewarded.

It is evident that, as always, in this type of statement, the moment of purchase (the basis) is particularly relevant, that is, those who opted for riskier decisions in periods before adjustments, will not agree with the statement, even so, if they had “nerves of steel” and sustained the investment, their losses today will be reduced and in some cases canceled. On the other hand, the real estate market, namely housing, in Portugal maintained a performance practically unscathed by the impact of the pandemic, supported by the latest data released by INE (1Q20; more recent data point in the same direction) and long series, in terms of return, are even more generous.

Indeed, those who in recent years have taken advantage of market corrections and / or acquired real estate assets - increasing their exposure to risk - have benefited. Undoubtedly, you should thank the almost coordinated policies of the main international monetary authorities in maintaining or lowering the key interest rates and, going further, putting downward pressure on the yield curve, the so-called risk-free interest rates (interest rates on different maturities that different states issue in their currency). In this crisis caused by the pandemic, there was also a help, perhaps unexpectedly, from the tax authorities, that is to say governments, with the adoption of expansionary fiscal policies, something that in the previous crisis, which was manifested in the widening of spreads of the sovereign debt of the Peripheral states vs. the center, was not verified or verified in a mitigated way, being the “collaboration” of the European Central Bank, the famous speech by Mario Draghi in which the famous phrase “… the ECB is ready to do whatever it takes to preserve the Euro ”occurred later, summer of 2012, and was always conditioned by the adoption of fiscal adjustment programs.

In fact, this concerted and explicit action by the fiscal and monetary authorities is relatively uncommon, because both are conjunctural policies that aim to stimulate growth, essentially via domestic demand and as such if applied in excessive doses, they can uncontroll the pace of price appreciation, with negative effects, usually only visible, with time lags.

Therefore, it is evident that the monetary authorities are currently little or nothing concerned with the evolution of prices, the Federal Reserve (US monetary authority) recently changed its inflation target: 2% to an average value, that is, the price level may evolve above 2% to compensate for the period that remained below, without this changing the reference interest rates. The ECB (European Central Bank), currently with negative reference rates, does not comment, but if there is an appreciation of the Euro, it works as a rise in the reference rates and, somewhere, the ECB may be pressured to adopt extra measures and / or to pressure Governments to adopt more expansionary fiscal policies. The remaining central banks are unlikely to behave differently, as they will see their currencies appreciate and condition current growth or recovery.

Increased risk in cash

That said, and knowing that risk-free interest rates - or using a lighter term, deposit remuneration - will remain low, in some countries negative and in real terms (rate of return minus annual rate of inflation), no doubt, negative; the demand for risky assets must remain intense and only doubts about the evolution of the results of companies can curb the “appetite” for risk, manifesting itself occasionally in higher risk premiums.

On the other hand, this “lack of concern” by the monetary authorities with inflation implicitly means that they want inflation to appear and, if so, it is important to hold real assets that track inflation, read stocks and real estate assets; preferably acquired with debt, since debt is a “stock” variable, it does not evolve to inflation, while collateral, shares or real estate, will evolve to inflation. In aggregate terms, the relative value of the debt will be reduced, that is, the absolute value will remain, but the ratio (debt / asset) will be lower.

The governments of indebted countries will like it, as the Public Debt / GDP ratios will decrease; companies will have the opportunity to raise prices and adapt to the cost structure at the same pace, maintain margins, which will multiply by higher sales, resulting in increasing operating results 

and indebted individuals, namely with mortgage loans, will benefit from the same effect.

The most skeptical investor will ask if this behavior assumes the existence of “free lunches”, in fact, it will be savers who will pay the bill, when they see their monetary assets lose relative value. In some way, it is already what has happened, the main “victims” of aggressive policies by the central banks are savers, whose assets evolve at a rate lower than the rate of the basket that measures inflation released monthly, because nowadays, risk-free remunerations are lower than the price basket, however, if we include in the basket, for example, the evolution of house prices then we would see that the dilapidation of monetary assets is considerable.

In short, realizing the difficulty in buying active assets whose valuation multiples are some distance from the average values, in areas that are not recommended, or acquiring real estate assets, whose prices are close to maximums, the truth is that on the basis of any valuation the so-called risk-free asset is abnormally below what would be equilibrium values, due to the very strong performance of the main world central banks. If, to this fact, we add that the inflation target, according to the most important monetary authority, has formally passed into the background, holding cash assets includes an increased level of risk.

Artigo de autoria:
António Seladas