Outlook 2021: Trump, interest rates, cash flow - and what all this has to do with whiskey

We would first like to summarize the general political and economic international environment for the next decade as well as the state of the capital markets in order to then work out the most important trends to be expected in 2021.

Since 2008, politicians have greatly increased their influence on the economy. Firstly, following the collapse of Lehman Brothers in September 2008, the central banks massively lowered interest rates by purchasing government bonds and mortgage securities. The financial system was also heavily regulated. It took a few months to decide on these measures in the USA, but three years in the eurozone. After the outbreak of the coronavirus pandemic, everything happened much faster, and not just in China, where everything always happens quickly. Within days, the European Central Bank (ECB) was already buying up Italian government bonds at the end of February - unlike in 2011, this time without German resistance. Italian interest rates had risen from 1.5% at the start of the year to 2.6%, immediately fell back to 1.5% thanks to the ECB's help and are now at a record low of 0.55%, even though Italy's national debt had already risen from around 130% at the start of the year to 150% in June 2020. At the same time, Greece was at 187% and is paying its creditors just 0.62% interest on 10-year government bonds. Of course, this no longer has anything to do with an interest rate set on the free market that takes into account the risk of bankruptcy. Together with the EU's newly created debt facility of over €800 billion, more than half of which will be granted as subsidies to EU member states particularly affected by the coronavirus, it shows that the EU and ECB will now definitely provide any amount necessary to prevent interest rate rises or even sovereign defaults. One small, ugly detail shows that politicians are well aware of the additional risks to monetary stability and are therefore concealing them. All EU states are liable for this new mountain of debt in proportion to their economic output. But these new liabilities, which are in no way different from the existing national debt, are not to be included in the national debt ratios.

This is the first major - and ultimately overall positive - change in the political landscape that will have an impact beyond 2021: the EU and the eurozone will emerge stronger from the coronavirus pandemic because they are willing and able to provide massive support to their members. Interest rates throughout the eurozone, as in all countries with their own central bank, have now become a politically determined variable and are no longer determined by supply and demand. In the long term, a state-controlled interest rate certainly has negative consequences, but in the short term, crisis management is no longer possible otherwise. As Brexit has also shown that an exit from the EU is extremely expensive for countries, the years of speculation about who will be the next to leave the EU or the eurozone should be over for good. This will also ensure low interest rates for Italy, Spain, Portugal and Greece, which will help the economic recovery of the entire EU and the eurozone. As employees and many companies have also been helped by the state through loan guarantees and subsidies (short-time working allowance), uncertainty among consumers and companies has already fallen sharply before the discovery of various coronavirus vaccines. In China, which is important for Europe's export-heavy countries, the economy is already growing again. What is particularly important for the capital markets is that interest rates worldwide will have to remain low for years, as government debt will continue to rise after 2021 in order to safeguard the economic recovery, but also to step up the fight against climate change. Governments are not only currently forcing interest rates down with the help of the central bank in the event of higher debt, but have already done so after the Second World War (see the example of the USA below) and will certainly continue to do so in the future.

When government debt is high (1946 and from 2008), the government and central bank put massive pressure on interest rates so that the government and private debtors remain solvent. In 2020, however, unlike in 1946, there is not just one huge problem (world war), but many more in addition to corona

The second important change in the political situation was also influenced by the coronavirus pandemic, namely the incipient decline of the populists, who eagerly denied the danger posed by coronavirus and, if at all, intervened late and half-heartedly. This made it clear to at least some voters that this type of politician is only interested in maintaining their personal power and that the well-being of the population is completely irrelevant to them. For example, tax cuts for companies did not help Trump voters, Brexit particularly harms the inhabitants of the poorer regions of the UK (the majority of whom voted for it) and Turkey is becoming impoverished for the benefit of Erdogan. Trump must now bid farewell to power, which he is doing as usual with almost unbelievable silence and even criminal energy - one can only hope that this man will soon be brought to justice, even if only for tax evasion. Boris Johnson's poll ratings are in the basement and he has had to give way in the Brexit negotiations with the EU. Erdogan has already suffered a major election defeat in Istanbul, but is at least innovatively allowing an expert to steer the country's monetary policy instead of his son-in-law. Even Putin is getting nervous and has guaranteed himself lifelong immunity.

Trump's departure will also make the erratic tariff policy, which is completely useless for the US trade balance, more predictable again and the rivalry between the global power USA and its already almost equally strong competitor China will not end, but at least it will not escalate any further. Unlike Trump, the new President Biden will promote infrastructure and the fight against climate change with state support in the trillions. Corresponding programs are also planned in Europe. In addition, consumers in both the eurozone and the US have doubled their savings rate during the coronavirus crisis, meaning that consumption outside China is also likely to pick up strongly as soon as the economic restrictions are eased, at the latest when the more vulnerable part of the population is vaccinated.

Conclusion:

• The rapid and generous government support for companies and employees as well as the decline of populism has curbed general uncertainty worldwide. In Europe, the political strengthening of the EU and the eurozone is also having a stabilizing effect in the short term.
• This will make consumption possible again, investments will increase; there is enough money for this.
• Politicians will keep government spending high to ensure a strong recovery - the intensified fight against climate change also serves this purpose - and central banks will prevent high government borrowing from leading to rising interest rates, which would jeopardize the recovery of the economy. However, these funds will have an inflationary effect in the long term, as governments place little value on the efficient use of funds.
• However, China is increasingly developing into a dictatorship, which is also increasingly influencing the economy, as can be seen from the worsening situation in Hong Kong and the disappearance of Alibaba founder Jack Ma. The long-term consequences are negative for China.

Based on all these considerations, economic researchers are predicting a strong global economic recovery; for example, the Kiel Institute for the World Economy expects real growth of 3.1% in Germany in 2021 and even 4.5% in the following year.

However, as the chart below shows, this does not imply a strong (further) rise in share prices:

Shares have always suffered a considerable price loss before the real economy collapsed. Most of the price recoveries also took place before the economy had reached its low point

Share prices therefore do not rise because a better economy is forecast, but the opposite is true: if share prices have risen, it is 1. safe to expect that economic researchers will raise their forecasts and 2. highly likely that the economy will recover. For example, global economic output in the fourth quarter of 2020 had already exceeded the level before the coronavirus crisis (see chart above right), but global share prices had already made up for all the losses from the first quarter three months earlier with price gains of around 50%. This price increase began at the end of March, when economic forecasts had just been sharply lowered.

The US Federal Reserve also relies far more on the change in the US stock market price than on any other indicators when making its economic forecasts, as the two US economics professors Anna Cieslak (Duke University) and Anette Vissing-Jorgensen (University of California at Berkeley) have shown (The Economics of the Fed Put, December 2016 and June 2020). Share price falls of more than 10% lead directly to falling economic expectations on the part of the US central bank and therefore often to interest rate cuts. This makes sustained price declines virtually impossible, as the central bank immediately counters with new money and/or even lower interest rates. As described at the beginning, the ECB behaves in exactly the same way with eurozone government bonds. If their prices fall, it immediately buys them with fresh money; it seems that nothing more can happen.

This game will not go on forever, because even a doctor who gives a trembling alcoholic two double shots of whisky will combat the trembling, but not the causes. Similarly, the generous central banks tempt governments and also many speculators to take on more debt or to speculate in shares and real estate, i.e. to "keep on drinking". In the long term, central banks will have to buy up and/or cancel debt, as is already being publicly demanded in Italy. This should then lead to a significant rise in inflation expectations.

A forecast of rising share prices in 2021 therefore requires different arguments than the - well-founded - forecasts of a further economic recovery.

The most important argument is the long-term return expectation for the global equity market, which according to our central forecast model is just under 5% p.a. and thus significantly higher than the global bond market (see the two charts below). In conjunction with our expectation of sustained low interest rates (see chart on page 2), equity returns will continue to converge with low interest rates in 2021, which will most likely be achieved by further rising share prices, as an increase in interest rates or falling profits of public companies (declining pandemic, cost reductions, digitalization) are unlikely. This means that the share price potential this year is higher than the average for the next 10 years.

The price/peak earnings ratio means a performance expectation of 5% p.a. for the global equity market until 2031

With a performance expectation of 5% p.a. for the global equity market until 2031, the expected return on equities is almost 4% p.a. higher than on the global bond market and thus more than 3% above the median of the last 50 years

Accordingly, equities worldwide have an additional annual return of just under 4 percentage points p.a. (a so-called risk premium for the additional price risk of equities) compared to government bonds. This is astonishing in a world of zero interest rates, as long-term government bonds nowadays have a short-term risk that can easily match that of equities. 30-year German government bonds, supposedly a "safe haven" for investors, currently offer a yield slightly below zero. If interest rates were to rise again to 1%, the price would fall by 30%, if interest rates were to rise to 2% by 48% and if they were to rise to 3% by over 60%. Even after such a bond crash, the return over the next 30 years would only roughly correspond to the expected inflation rate (3% over the next 10 years). If, on the other hand, the global equity market were to fall by 60% (which central banks would never allow - see above), its valuation would be as low as it was 45 years ago, immediately after a massive price collapse following the first oil crisis, with a performance of 10.1% p.a. over the following 30 years. The current risk premium for equities is therefore far too high, which was even more pronounced in March 2020 after the coronavirus crash. We therefore predicted at the time that the stock market would recover very quickly. This year, too, a crash - which is quite possible for some highly overvalued technology stocks (e.g. Tesla, see below) - will only be short-lived and we will use it to buy shares.

The two key real asset investments, equities and (residential) real estate, have one important thing in common. As described above, low interest rates have not yet had an appropriate impact on rising share prices. The exception is those shares that are considered to have particularly stable earnings power and a high probability of further rising profits in the long term. This applies in particular to the major US technology companies (Apple, Amazon, Alphabet (Google), Microsoft, Facebook and, most recently, Tesla with a market value of USD 800 billion). Their massive share price increases in recent years have given the US stock market the highest valuation not only in the last 50 years, but also before that and on all other major stock markets (see first chart below), according to the key figure of cash flow (profits adjusted for write-ups or write-downs), which can hardly be manipulated by managers.

The high valuation is of course also due to the low profits and therefore cash flows caused by the coronavirus. However, if cash flows return to their pre-pandemic level, the ratio (assuming share prices remain unchanged) will still be above 16 in the US and below 9 in the eurozone. This means that the US equity market could come under pressure even with a slight rise in interest rates due to its high valuation, while eurozone share prices will be much more robust in this respect.

We have created a small calculation example for this. Tesla, the US star in the automotive sector, is currently valued at €656 billion, while the three German car manufacturers (lagging behind, "old economy") are valued at a combined €182 billion, i.e. around 28% of Tesla's value. Analysts expect a cash flow of €5 billion for Tesla in 2021 and €49 billion for the three German companies combined. Tesla's cash flow would therefore have to rise to €177 billion in the not too distant future or the cash flow of the German companies would have to collapse from €49 billion to €1.4 billion for the valuation to equalize. Neither is expected by anyone, so Tesla is too expensive. The company is also coming under competitive pressure from two sides. The IT lead over its German competitors is still large, but is decreasing. BMW, for example, is now also able to update a car's software via the Internet. In addition, the software giants Apple and Alphabet (Google) have concrete plans to enter the car business. It would therefore make a lot of sense for Tesla to use the high share price to increase its capital by 8% (without a takeover premium, perhaps 12% with a premium) and use the money to buy out Daimler, which is the only German car manufacturer without a major shareholder. Cash flow would triple to €15bn and Tesla's price/cash flow ratio would fall from 126 to 44. Conclusion: Tesla's valuation should fall relative to the German carmakers.

The same is likely to be true of the US equity market as a whole in relation to the European market; unfortunately, the price/cash flow ratio is a good indicator of performance over the next 10 years and is currently extremely unfavorable for the US market (see below).

This is because the price/cash flow ratio has only approached a level in the last 45 years during the technology bubble 21 years ago. Since 88% of the future 10-year performance could be explained by this ratio, this model points to a slightly negative performance of US equities (right chart), after the recovery of cash flow to the value before the start of the pandemic to a performance of 3% p.a., which is also not inspiring.

The parallel to the residential real estate market is that luxury apartments in top cities have now reached an extremely high valuation level, similar to US technology stocks, also supported by low interest rates. Net rental yields are often below 1.5%. In contrast, mediocre apartment buildings with a renovation backlog are much cheaper and will perform better both when interest rates stagnate - as we expect - and when interest rates rise, if the renovation work can be carried out efficiently. In contrast to top properties, these properties would probably not be covered by a rent cap.

In summary, we expect the equity markets in Europe, Japan and many emerging markets, which are still relatively normally valued despite low interest rates, to perform in the upper single-digit range, while the US market is likely to struggle, particularly in the technology sector, and should only achieve a low single-digit performance, possibly after a noticeable correction, especially as only the US is currently seeing a slight rise in interest rates. The US equity market is also benefiting the least from China's strong recovery and the already clearly visible recovery in global trade, which will be less disrupted politically in the future.

Prices for residential properties in the lower and middle segments are likely to remain stable or rise slightly in all countries where interest rates are and remain low. Government debt, which rose sharply during the coronavirus crisis, is likely to increase further to secure the incipient recovery. In the coming years, governments will continue to drive up debt by combating climate change, in which they will, as usual, not pay attention to the efficient use of capital. It must be irresistibly exciting to be allowed to spend other people's money on a grand scale. This means that any interim rises in interest rates are likely to be short-lived.

The pandemic will probably have less and less of an impact on the global economy in the second half of the year, which is currently depressing the gold price somewhat. However, this will in no way solve or even alleviate the debt problem. The gold price will therefore still have a few good years ahead of it.