Managing Private Finances During the Economic Turmoil

In our conversations with friends or family, the topic of rising prices has been coming up increasingly common for some time. More and more often, everyday shopping becomes a challenge and saving money requires sacrifices. High inflation is clearly an anomaly for us. For the European Union, an inflation rate above 10 percent has happened for the first time in history. Of course some European countries suffered from high inflation rates during the energy crisis in the 70’s or as a result of structural changes, but most people of working age don’t remember thosWe times. We are now facing accelerating inflation for the first time in the modern economy.

As a traditional solution for high inflation, central banks increase interest rates. High interest rates are also something new, because for over 10 years they were close to zero and cheap capital was the fuel for economic growth.

When we look closely at the data, we can see that over the last couple of years, we experienced negative real interest rates. This happens when interest rates (often even including the bank’s margin) are lower than the inflation rate. What does this mean in practice? It means that if we borrow money from the bank and spend it right away on our future needs we act reasonably, because the cost of capital is lower than the difference between the current and a future price. Of course inflation rate is a weighted average based on a number of products, but we can assume that for most of the goods the above statement is true. It is a strong economic booster, but it has its limits.

While in times of low inflation and even lower interest rates such a procedure was fully justified, now the consequence of this action will be the need to service the debt, which may be problematic if our income does not rise with inflation. An increase in interest rates from 0 to 2.5 percent may cause our loan installment to be even more than twice as high.

In the case of shopping, the negative real cost of capital favors us. What if we would like to take care of our future or build a financial cushion by investing money in such macroeconomic conditions? Theoretically, it would seem that we are dealing with perfect conditions in which capital costs us less in real terms than we will pay back including interest. Unfortunately, looking at the offered rates of return on safe instruments such as deposits or bonds, they are definitely below inflation, i.e. the real value of capital invested in this way will decrease quickly. At the same time, higher risk instruments with higher returns are now in lower demand as the risk premium over safe-haven instruments has become much lower.

What’s more, in 2022 capital market instruments brought losses to investors. The S&P500, which is a popular benchmark lost almost 20 percent of its value in 2022 and its 10 year average rate of return went down from 10.5 percent to 6.5 percent. In addition, the majority of investment funds reported short-term losses and deterioration in the return from their more risky portfolios, except for a few, that luckily happened to include shares of companies benefitting from the war or energy crisis. You can look towards funds based on foreign instruments, which can provide a higher rate of return and are not correlated with the economic situation in the region, but often carry additional volatility risk. The problems of the stock market are mainly caused by the outflow of capital to the previously mentioned, currently high-interest, safe instruments. There is still the VC and PE industry which traditionally outperforms the stock market by 5-15 percent. However, they are long term and non-liquid assets, so are definitely not for everyone and we will know their real numbers in a few more years.

Another investment that commonly was considered as safe and well performing was the real estate market, where you received the rent from the lease and benefited from the increase in house prices. The rise in the cost of money has stunted the demand for real estate and deprived you of the second part of the benefits. This calls into question the sense of leveraging such investments with debt. An interesting option may be alternative ways of investing, such as art, wine or even Lego bricks. Nevertheless, they require deep knowledge and the expert market is much narrower here than in the case of financial instruments.

I don’t have golden, universal advice. Everyone has different goals, horizons and levels of risk aversion. I want to emphasize that the financial market has changed dramatically in the last year. This makes it necessary to rethink how to manage our finances in the current situation and look for opportunities to act accordingly. It is also worth remembering that we do not live in an economic void and there are hundreds of millions of people and companies around us that operate in the same macroeconomic conditions and their operation may affect the results of our investments.