Inflation is coming back - and investors are right to be calm

After the collapse of the internet and telecommunications bubble from 2000 to 2003 and the second Iraq war in 2003, the US Federal Reserve began to loosen monetary policy considerably. In addition to sharp interest rate cuts, other central banks also printed money on a massive scale from 2008 onwards for the first time since the Second World War due to the financial crisis, and again since the start of the coronavirus pandemic in 2020.
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‍Inflationand real assets

Accordingly, the growth in the money supply has risen to 8% p.a. on a 10-year average (see Figure 1a). The fact that the inflation rate has nevertheless not exceeded the 2% mark on a long-term average leads many investors to assume that the previous correlation between money supply growth and inflation rate has been lost due to globalization and modern technologies; currently, inflation is expected to average 2.3% p.a. in the USA and 1.6% p.a. in the eurozone by 2031.

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Figures 1a-b above show that the inflation rate should be significantly higher with money supply growth of 8% p.a. The following reasons suggest
that the causes that have kept inflation rates low to date will soon come to an end and that they will rise significantly in a few years at the latest.

• The strong growth in the supply of labor is coming to an end; in Europe and Asia (less so in the USA), labor shortages are beginning to cause higher wages - an important component of the inflation rate - which, according to a study by the Bank for International Settlements (BIS), will increase the rate of price increases by an average of more than 3 percentage points per year over the next few decades.

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• Inflation-reducing globalization has passed its peak; in future, the world will become more fragmented into partially isolated regions (USA, Europe, China, Russia) (see chart below).

• The fight against global warming will generate significant price increases even if policymakers worldwide (see the Capital Market Outlook from August 2021, which you can find here ) choose the most efficient path, namely a uniformly high global carbon tax.

Figures 4a-b above show an estimate of the impact of a carbon tax on the prices of various commodities. However, we are certain that, in addition to the carbon tax, policymakers will demonstrate their drive through efficiency-reducing micromanagement in the form of countless regulations and incentives, thereby driving up inflation risks more than necessary. This expected waste of capital will cause government debt to rise further and thus further increase long-term inflation risks, because in the age of paper money, countries with particularly high levels of debt can use their central bank to push down interest rates, as the following charts show using the USA as an example.

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This raises the question of what return is needed in the future to maintain wealth in the long term.

Long-term real wealth preservation can only succeed if the average annual asset growth after deduction of asset-related taxes, asset management costs and private withdrawals (which grow with the annual inflation rate) is at least equal to the expected inflation rate. For a wealth in the mid single-digit (million) range, the calculation could look like this:

This means that you will still be able to pay for the goods and services you purchased in 2021. However, if you gradually increase your expectations, it will not be enough to compensate for the inflation rate. For example, mid-range cars from 1975 such as the VW Passat (85 hp), Ford Consul (75 hp) or Opel Rekord (83 hp) cost around €6,000. ABS, navigation systems, airbags or driver assistance systems would not have been available for these cars because they had not yet been invented. Air conditioning or electric windows were already available, but only as (expensive) optional extras from the upper mid-range upwards. Anyone who could afford a car for €6,000 back then and has achieved an increase in wealth equivalent to the subsequent inflation could pay around €16,000 for a car today. But that would only buy a moderately equipped small car. However, if wealth has kept pace with nominal national income (= inflation rate + real economic growth) after taxes, withdrawals and costs, you could still afford a car for €36,000 today. In the long term, growth in nominal national income is therefore the better target for the desired growth in wealth. Historically, this would have required asset growth of just under 4% p.a. since 1975; the inflation rate in the same period was only 2.1% p.a.

However, even in a future world with higher inflation rates (current assumption: 3% p.a. for the next 10 years), a growth target for the wealth of around 4% p.a. will suffice, because real growth will hardly exceed 1% p.a. in the coming decades in view of the shrinking population and the fact that productivity will hardly increase. This results in the following calculation:

The data must then be adapted to personal circumstances in order to determine a suitable individual investment strategy, whereby the expected inflation rates may differ in addition to private withdrawals. If you want to afford an upmarket lifestyle in the long term, you should expect a slightly higher inflation rate.

Figure 8 below shows that, excluding private withdrawals but including asset management costs, the target of asset growth at least equal to economic growth would have been achieved with all three main tangible asset investments (residential real estate - in this case condominiums in Germany -, German equities and gold, all calculated in € and after tax). The currently applicable tax rules were applied to the historical after-tax returns.

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However, investing the wealth only in gold would not have allowed any private withdrawals; in the case of real estate, a maximum of 0.7% p.a. would have been permitted. Equities therefore appear to be the ideal solution.

Unfortunately, as Figure 9 below shows, it is not that simple. In contrast to the entire period since 1975, equities have performed the weakest and gold the best since the turn of the millennium. Contrary to popular assumptions, since 1975, with an average inflation rate of 2.1% p.a., real estate and gold, which are supposed to offer the best protection against inflation, have been easily beaten by equities, but in the last 21 years with lower inflation (1.5% p.a.), real estate and gold have performed far better. A mix of all three tangible asset investments is therefore better equipped for various scenarios.

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The sharp fall in German share prices of over 50% after the turn of the millennium is likely to be too much for even hardened long-term investors if the entire wealth is invested in shares. It therefore makes sense to add the two other tangible asset investments to reduce risk, as shown in Figure 10 below. At 8.4% p.a., the wealth invested in equities has clearly exceeded the mark required to achieve the investment target of 6.8% p.a., but at the cost of an average annual fluctuation of 20.6%. This means that 5/6 of the years are likely to produce a result in the range of 6.8% plus or minus 20.6%, but 1/6 of the years will also be worse than -15.8%.

If, on the other hand, you settle for 60% equities and add 30% real estate and 10% gold, the return of wealth is still 1% above the target return of 6.8%, but the fluctuations fall to 12.2%, so that 5/6 of the years end with a result of over -5.4%. In the worst of the 46 years under review (2008, the year of the Lehman bankruptcy and the subsequent global banking crisis), this mixed real asset portfolio would have lost 22%, while the pure equity portfolio would have lost over 40%.

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It now remains to be clarified whether future income will also be sufficient to maintain wealth. In the coming decades, wealth will have to increase by an average of 4% p.a. after taxes, private withdrawals and asset management costs in order to maintain the standard of living; the investment target therefore remains at 6.8%.

First, we look at the German equity market, whose valuation is barely higher than the average value since 1975 (see Figures 11a-b below). This means that average annual returns can easily reach 10% p.a.

If only the most reliable, internationally well-functioning indicator of share prices in relation to cash flow is used for the earnings forecast, the earnings expectation is still 6% p.a. (see Figures 12a-b below). The average value of both forecast models thus reaches 8% p.a. before tax; this corresponds to just under 7.4% p.a. after tax, i.e. only 1 percentage point less than in the 46 years since 1975.

Since German reunification, the real interest rate, consisting of net rental income less provisions for repairs and rent losses and increases in value, has had the greatest influence on the total return on condominiums in Germany. If one makes the extremely conservative assumption that this will reach the average value from 1991 to 2021, namely 1.68%, over the next 10 years, the annual after-tax performance should reach just under 6% (see Figure 13 below).

However, as we showed at the beginning, the high level of government debt will generate much lower real interest rates. With an inflation expectation of 3% p.a., the interest rate on 10-year German government bonds would have to rise from the current -0.2% to 3% for the real interest rate to reach 0%. This is hardly conceivable because it would be almost impossible for highly indebted countries to finance, but would be sufficient for an annual condominium performance of just under 8% p.a. It is more realistic to assume that the interest rate remains at around 0%, so that an annual performance in the double-digit range is possible over the next 10 years with the resulting real interest rate of -3% on average.

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Interest rates that are permanently far below the level of inflation will make more and more anxious savers nervous and lure them into real estate investments rather than shares, especially as construction costs are rising due to the shortage of labor and the increase in the price of building materials, and many homeowners do not want to sell in view of the low interest rates. They simply do not know how to invest the money. In view of the huge sums that German investors, less than 50% of whom own real estate, have invested interest-free in fixed-interest securities, life insurance policies and savings and current accounts (€6,000 billion), a further real estate boom is indeed quite possible. With 300,000 apartments costing €300,000 each, the annual volume of new construction amounts to "only" €90 billion; this means that only 1.5% of the largely interest-free "fixed-interest" investments can be exchanged for real estate ownership each year. Buying a second-hand property does not count, as the seller then has the reinvestment problem.

In the next 10 years, condominiums may well generate higher returns than in the last 46 years, especially as there are no longer any overly dramatic risks of expropriation, rent restrictions or taxation following the outcome of the Bundestag elections (as of Monday morning).

It is not possible to make reasonably accurate yield forecasts for gold due to the lack of current yields. However, if you look at the purchasing power of gold, everything points to the price of gold being too low, as shown in Figure 14 below.

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When one ounce (31 grams) of gold could buy less than 0.5 units of the US S&P 500 stock index, gold was very cheap and, after the two previous periods when it fell below this level (before 1971 and around the year 2000), made strong gains of 1,730% and 600% respectively in the following years. In a future world with extremely low interest rates and quite high inflation, gold should again have high profit opportunities.

Conclusion:

All in all, you can expect returns from all three tangible assets mentioned over the next 10 years that should be sufficient to maintain your current standard of living, as has been the case for the last 46 years. We have calculated an example here that a not entirely inexperienced investor could implement himself without professional help. With a wealth of €5 million, buying three condominiums worth €0.5 million each, an ETF on German equities for €3 million and Xetra-Gold (gold ETF backed by physical gold) for €0.5 million is not rocket science.

FINVIA offers you the opportunity to work with you to optimize your investment strategy based on your personal requirements. German shares are certainly not the only interesting option. European and emerging market equities as well as ETFs for healthcare or consumer staples also offer attractive risk/return expectations and significantly better diversification. Replacing some of the equities with equity funds should also have a particularly favorable effect on the return and diversification of wealth . In the real estate sector, we would indeed focus on German residential real estate, albeit in the form of fund solutions that generate not only very stable returns but also a positive climate effect through the (also energy-efficient) refurbishment of rather low-priced apartment buildings. Xetra-Gold is actually the best and simplest solution when it comes to gold.

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