Inflation will come - but this time for real!

Prophets of crisis on the stock market are always right. Anyone who warns every week that the next bubble will burst or says that the financial markets will soon collapse again will be right again at some point. Even books can be sold well with such scenarios. And because it's so nice, I'm doing the same now. Don't worry, I'm not currently working on a dubious book about the end of the (financial) world. But I must at least point out that inflation will rise in the coming years. This is expressly no reason to panic - but you should be aware of what is happening.

In our outlook from June 2020, which you can find here, we described in detail the technical prerequisites for the emergence of inflation:

• The state has run up large debts without paying attention to the profitability of expenditure necessary for debt repayment, which is the case, for example, with excessive social benefits
• The state borrows in a currency which - unlike the precious metal-backed currencies that were common before the First World War - it can produce itself and multiply quickly and at will, i.e. the "paper currency" that is common everywhere today
• To do this, the respective central bank must be dependent on the government. Since the start of the coronavirus pandemic, this has also applied (de facto, not legally) to the ECB, which is not actually subordinate to any government. Unlike during and after the 2008 financial crisis, the ECB, just like the central banks of the USA, Japan and the UK, immediately produced massive amounts of new money from the end of February 2020 to support the prices of Italian and soon all other € government bonds, incidentally without any German resistance
• The share of the workforce in the total population has been declining for several years in the countries integrated into the global economy (see chart below). This was also the case in the industrialized countries in the 1950s and 1960s as a result of the baby boom. When the "baby boomers" entered the labor market in the late 1970s, the proportion of working women increased and China opened up to the global economy with several hundred million hard-working and cheap workers, inflation rates began to fall for decades. Now the trend is reversing again, as the "baby boomers" - also in China and for a long time in Japan - are retiring and consuming a lot, especially health and care services in old age, and earning very little. This means that high demand is offset by falling supply; inflation rates can rise. Wars also usually lead to inflation due to a declining proportion of the workforce, to which soldiers cannot be added.
• To combat the coronavirus pandemic, governments around the world have introduced drastic - and in principle entirely justified - regulations. The price-driving effects of these regulations (restaurants, hairdressers, etc.) will largely disappear once the pandemic is over, even if not all restaurants and bricks-and-mortar retailers will survive. However, the joy of regulation is likely to remain with us. The failed Berlin rent cap is a first indication of this. This project, which only appears to be economically beneficial for the "little people" in the short term, will not be buried, but the (main) economically conservative part of the political spectrum is likely to strive for a nationwide introduction, thereby promoting the scarcity of rental apartments and causing significant rent increases in the long term.
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So even if there are a number of prerequisites for rising inflation rates, there has been no concrete trigger for this to date. In a study from May 2016, the Canadian analysis firm Bank Credit Analyst used 57 hyperinflations from the last 150 years to show that the money supply in a country can rise sharply for years without consumer prices following suit. Then suddenly there is an event that causes people to clear out their accounts and spend the money. Triggered by this, the consumer price index rises much faster than the money supply. A typical example is shown in the chart below.
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For three years, the annual increase in the money supply averaged 41%, but the inflation rate "only" reached 33%. The following year, the money supply increased by a further 60%, but prices suddenly shot up by 636%; hyperinflation had arrived.

Using an example from the recent past, which bears certain similarities to the global situation in 2021, namely the USA in the 1960s, we would now like to show possible triggers for a sharp rise in inflation. We will then look at current developments that could create an inflationary mentality in the coming years.

Since the end of the American Civil War in 1865, the USA has only experienced occasional brief phases of higher inflation rates, particularly as a result of the two world wars. One hundred years later, years of rising inflation rates were therefore a relic from the distant past. Despite an ever-decreasing unemployment rate, the inflation rate remained constantly low at around 1.5% p.a. In 1964, however, the USA entered the Vietnam War, which suddenly led to a massive increase in military spending. One year later, "Medicare", a public health insurance scheme for the elderly, was introduced. This marked the beginning of a sharp rise in healthcare costs. The state therefore suddenly had to cope with considerable additional expenditure, which was not offset by any additional production of goods (except for unproductive military equipment) or services.
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Despite these additional burdens, government deficits remained relatively low due to the ongoing post-war boom and only rose sharply in the mid-1970s. The actual cause of the sudden rise in the inflation rate was therefore not just high spending, but an emerging inflation mentality based on the fact that the state was obviously able to raise and spend enough money for social programs and for a war at the same time. The state, in turn, was able to afford the high expenditure because the national debt had fallen from 153% of national income in the Second World War to 61% in 1965.

In Europe, too, many countries began a massive expansion of the welfare state, partly stimulated by student unrest from 1967 onwards. The resulting high government spending (and rising incomes of the socially disadvantaged) led to higher wage demands on both sides of the Atlantic, which forced companies to raise prices. This led to a wage-price spiral, which was accelerated by two oil crises from 1973 onwards and resulted in double-digit inflation rates in many countries until the early 1980s. Within a few years, a general inflation mentality had formed - people believed that prices would continue to rise, demanded higher wages and spent money quickly, which also boosted demand.

The first financial parallel to the current situation is the massive increase in government spending since the start of the pandemic just over a year ago, which corresponds to the start of the financial burden of the Vietnam War. However, at around 30% of national income, the current economic aid provided by the US government, for example, is far greater than the ongoing war costs at that time.

The following chart shows that the US government has had to accept an extremely high national deficit since the start of the pandemic in order to ensure the livelihood of the poorly protected unemployed in the US. Even during the global financial crisis in 2009 after the Lehman bankruptcy, the worst recession since the Second World War, the government deficit was significantly lower with higher unemployment.

The above and the next two charts show how extraordinarily high the economic stimulus packages have been from 2020 compared to the financial crisis from the end of 2008 in the industrialized countries to date. Even after the economies are back on the road to recovery, many countries will continue to invest extraordinarily large sums in new spending programs from 2021, e.g. for climate protection, infrastructure and broad social and education programs.
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The introduction of "Medicare" in the USA in 1965 can be compared with the explosion in healthcare costs over the next few decades, an inevitable consequence of the growing number of older people, not only in the USA. The next chart uses the example of an average US citizen to show what a person earns during their lifetime and what has to be spent on them (by themselves and/or the state).

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Governments implemented these two major spending programs from the mid-1960s onwards on the basis of low levels of government debt compared to today (chart below left) and, by creating the appearance of infinite financial resilience, created a 15-year inflationary mentality (see chart below right) that immediately generated high inflation rates.

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Today, on the other hand, far larger spending programs are being launched - also relative to the respective national income - than in the 1960s in a much worse starting position, namely a record-high national debt, which will be exposed to further burdens for decades to come due to demographic developments and the resulting healthcare costs alone. The fight against the pandemic (coronavirus aid of USD 900 billion in the USA in December 2020) was just the beginning. Now three more trillion-dollar programs are being added in the USA (conversion aid for the new world of large numbers: 1 (German) trillion = 1,000 billion = 1,000,000 million):

• Further corona aid: USD 1.9 trillion in March 2021
• for infrastructure (American Jobs Plan: $2.3 trillion, of which only $157 million for infrastructure)  
• for the expansion of the welfare state: American Families Plan with $1.8 trillion

In total, the US government has therefore provided additional spending of $6.9 trillion or almost 32% of national income in the form of "temporary" spending programs for mostly new social benefits in 6 months. The Nobel Prize-winning economist Milton Friedman once said that nothing is as permanent as temporary government spending programs. The following chart clearly underlines this.

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The first wave of sharply rising transfer incomes and social spending from 1966 to 1982 was accompanied by high inflation rates (see previous double chart on the right). In the following quarter of a century, social spending remained roughly constant until the 2008 financial crisis, i.e. it was not reduced again. The second wave since 2008 has so far not been accompanied by rising inflation rates, mainly for the demographic reasons outlined above, which are now reversing. However, the chart also shows another development, namely the growing inability of the state to finance rising expenditure through corresponding tax increases. Accordingly, government debt was still falling until the beginning of the 1970s, but has risen sharply since the turn of the millennium (see previous double chart on the left). In all industrialized countries, the expansion of the social system without raising taxes, but through debt - if possible with the help of the central bank - has tended to be the main reason for the decades of growing public debt. Historically, inflation has mostly been the result of weak governments that were unable to finance the spending requests they received through tax increases, but only through debt.

Europe has even created a new opportunity for the EU to borrow directly from itself. In doing so, it cleverly avoids fanning the flames of nervousness among holders of European government bonds by making the EU member states proportionally liable for the new debt, but not adding this share to the national government debt. High debts always encourage the debtor's creativity. As in the USA, this fresh money should be spent on infrastructure spending, education and climate protection.

The governments of industrialized countries are therefore once again demonstrating that they can even make exceptionally high new expenditures at a time of extremely high debt. However, this creates a further prerequisite for the emergence of a new inflationary mentality. The commodity price increases currently much discussed in the media could also contribute to this:

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However, these high growth rates are likely to be largely due to the slump in demand during the first lockdown in spring 2020 and are therefore not particularly sustainable. By contrast, the problems in procuring the necessary primary products, which 45% of German industrial companies are currently complaining about (see chart below left; the shortage of primary products has never been anywhere near as high as it is today in the last 30 years), are much more sustainable. This is due not only to the pent-up demand following the pandemic, but also to the gradual slowdown in globalization (see chart below right) and the growing demand for raw materials for the green revolution.

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The exploding freight costs over the past year (air freight + 50%, Shanghai Container Freight Index + 280%, Baltic Dry Index for ship transportation of dry bulk + 380%, source: Refinitiv Datastream) have also contributed to the procurement problems. Rising electricity prices will not simply disappear either, as they are closely linked to the increasing use of wind and solar energy.

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According to a study by Handelsblatt (handelsblatt.com from 16.4.2021), Germany could face particular problems with rising electricity prices or even an unstable power supply. Thyssen-Krupp's steelworks, for example, produces around 20% of Germany's CO2 emissions. In order to cover the energy requirements of this one industrial company alone with hydrogen in the future, 40 terawatt hours of green electricity would be required (= 7% of German electricity consumption). This would require 12,000 large wind turbines in the 5 megawatt class - there are currently around 30,000 wind turbines in Germany. According to calculations by the Institute of Energy Economics at the University of Cologne (EWI), electricity consumption in Germany will increase by almost 20% by 2030; however, the federal government's forecasts predict only stagnation. This means that further electricity price increases or even declining electricity supply security are lurking in the longer term, which would result in a declining supply of goods. This indicates a further risk of inflation.

The issue of inequality is also unlikely to be tackled effectively, particularly by a green-red-red government. Low-income earners in Germany, who are burdened with a uniquely high marginal tax and social security contribution burden (see Capital Market Outlook from March 2021, which you can find here ), have received an expensive pension scheme from an SPD-led government in the form of the Riester pension, which is only profitable for the insurance industry. This is so bad that the number of corresponding contracts has been stagnating for years. Other countries, such as Sweden, do a much better job. This means that Germany is unwittingly (?) perpetuating the lack of assets among broad sections of the population. In future, this will necessitate higher pension payments from a state that is already increasingly overstretched financially than would be necessary with a sensible pension plan.

Instead of making the poor rich, they would rather make the rich poor through high taxes; this obviously promises a greater political tailwind. However, they forget that the poor will also suffer as a result. The majority of politicians are unaware that dividends from corporations (limited liability companies, public limited companies) are not only subject to the 25% flat-rate withholding tax, but also to trade and corporation tax of around 30% in total.

This means that the tax burden on business income already amounts to 48% (see table below). If they knew, many would still not care as long as the voters don't know; wealth bashing always goes down well. So if the flat-rate withholding tax were to be abolished and a wealth tax of 1% introduced, the calculation would change as follows:

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73% corporate profit tax would be a world record among halfway reputable countries. Unfortunately, if the tax burden is too high, the rich tend to either stop working - after all, they have enough - or move their place of residence and company headquarters abroad. The resulting loss of tax revenue and well-paid jobs in company management make these tax increases a bad deal for the state. The financial capacity of the (welfare) state would be further eroded; the risk of inflation would increase.

A large part of the global coronavirus aid is being used to directly support companies and employees with coronavirus-related loss of income. Unlike the money creation during the financial crisis from 2008 and after the turn of the millennium (collapse of the stock markets from 2000, terrorist attack in September 2001 and the Iraq war in 2003), this time the fresh money will flow mainly into store cash registers once the lockdown ends. This means that the consumer price index is likely to follow the direction of money supply growth again after a 20-year break, and there is a lot of catching up to do (see chart below).

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In summary, there are many indications that inflation rates will rise noticeably worldwide over the next 10 years:

• Many countries have taken on debt in recent decades, particularly for high social benefits, without taking into account that this expenditure would not generate corresponding tax revenues in the future; the growing national debt was therefore consciously accepted
• Especially after the financial crisis, governments were able to rely on the help of their central banks, which had always ensured that interest rates fell by buying government bonds when investors lost confidence in a debtor country (most recently in Italy during the coronavirus outbreak in February 2020)
• The future global demographic trend of a declining workforce as a proportion of the total population increases the potential for inflation, as there are fewer productive workers and more pure consumers. In addition, the rapidly growing number of older people is causing high and constantly rising healthcare costs, which must be borne primarily by the state
• Increasing de-globalization and growing regulatory zeal on the part of politicians (the former Berlin rent cap and perhaps soon a nationwide rent cap) are reducing supply and are already making production more expensive. Higher tax burdens for entrepreneurs ("the rich") would also have an effect
• The failures of German politicians of all parties to design or reform the overpriced and low-return funded pension scheme (Riester pension) will require higher pension payments at the expense of the state coffers in future
• The extremely large economic stimulus programs to combat the consequences of the coronavirus, but also climate change, despite the already extremely high national debt, could trigger a general inflation mentality as 55 years ago (politicians spend a lot of money, which increases wages and costs, which generates further demands for wage increases, etc.).

In our view, inflation expectations on the capital market for the next 10 years are far too low at around 1.5% p.a., particularly in the eurozone, in view of the developments mentioned above; inflation expectations in the USA, which are already at 2.5% p.a., are also likely to be exceeded. We anticipate inflation of at least 3% in the industrialized countries, which the central banks will at best combat with very weak interest rate hikes, unlike in 1980, given the enormous debts of their governments. This means that the environment for equities, investment funds, residential real estate (not in the luxury sector!) and gold remains positive, especially as most equity markets are still largely normal compared to their history and all equity markets are undervalued compared to bonds.