The future impact of the global rise in interest rates on the capital markets

The rise in inflation rates led to a sharp increase in short and long-term interest rates in most countries from the beginning of 2022, resulting in price losses on the bond markets. As a result, the equity and real estate markets also experienced a period of weakness. Does this mean that the rise in interest rates on the capital markets is over?

The rise in interest rates from the beginning of 2022 looks rather harmless compared to the trend in the 1970s (chart 1, example USA since 1871). However, as it began in the US at an interest rate level of just 1%, the price losses on 10-year government bonds were hardly mitigated by interest income. As a result, 2022 was by far the worst year on the US bond market in over 150 years (chart 2).

As US equities also reacted negatively to the rise in interest rates in 2022, 2022 was the second-worst year for a mixed US equity and bond portfolio since 1871 (chart 3, red arrow).

Wenn man die zehn schlechtesten Jahre (die Jahre mit einer Performance < -6% in Grafik 3) genauer betrachtet, dann ergibt sich für alle Jahre außer 2022 und die beiden mitten in der Weltwirtschaftskrise (1929 bis 1933) liegenden Jahre 1930 und 1931, dass die jeweils folgenden Jahre immer eine zweistellige Performance erreicht haben (Durchschnittswert: 16%, siehe Grafik 3: gelbe Jahreszahlen).

In Germany, the situation is the same with a smaller database - before 1960 there were considerable distortions due to the two world wars. Here, too, the rise in interest rates in 2022 was not very impressive (chart 4), but the extremely negative performance of German government bonds (-21%, chart 5) ensured that mixed securities assets delivered the worst performance in the period under review (chart 6). In the years following the 5 worst years since 1960 (except 2022), performance was always in double digits, as in the US, averaging 17% (chart 6, yellow annual figures).

Can we now sit back and relax because the rise in interest rates on the capital markets last year has been absorbed and calm times can now be expected again?

This question could only be answered with an unqualified "yes" if the economic outlook for the next few years was at least average. However, this is not the case even in the USA, where the economy is currently still growing. Every month, the US Federal Reserve publishes an in-house model to estimate the probability of a recession in the next 12 months based on the interest rate structure (chart 7), i.e. the difference between long-term and short-term interest rates (see the Capital Market Outlook from May 2023, which you can find here ). According to this, the probability of a recession in the USA in 2024 is currently 66%. In the past, a value of less than 50% was usually enough to trigger a recession. Unfortunately, the European Central Bank does not offer this service, but here other indicators such as money supply growth point to a considerable risk of recession (chart 8). Even a weakly growing money supply (orange line below the dotted 5% line) caused stagnation 12 months later (early 2002 and 2003) or a recession (2009 and 2011, green line).

Otherwise, there has not been a sharp contraction in the money supply (currently -8%) for over 40 years (charts 8 and 9) - but the synchronization of the money supply and economic growth 12 months later (chart 8) suggests a considerable risk of recession.

US Federal Reserve Chairman Powell is probably familiar with the in-house forecasting model for the probability of recession. Accordingly, interest rates have been raised further in the US in recent months, consciously accepting the growing risk of recession. ECB President Lagarde should also be aware that the three interest rate hikes since the ECB was founded have triggered two stagnations (2002, 2003) and two recessions (2009, from 2011) (Figure 10). Nevertheless, interest rates have been raised more than ever since July 2022, even though growth has already fallen to almost zero.

So far, the interest rate hikes by the two major central banks since 2022 have not yet led to a recession, but only to a high probability of recession. However, this risk is being ignored on the major stock markets (chart 11, the price losses of US and Japanese bonds are due to falling exchange rates).

The example of Europe shows that there is actually no threat of major losses on some stock markets. Share prices in relation to dividends, gross profits (cash earnings) and the book value or equity of companies are roughly at the average level since 1974 (chart 12). This results in a return expectation of around 9% p.a. for the next 10 years, which also roughly corresponds to the average annual return on European equities since 1974 (chart 13).

As interest rates for European government bonds (10-year term) are currently well below the average value since 1974 of 6.25% at 3.6% (chart 14), equities remain very attractive in Europe compared to bonds and would become even more attractive due to falling share prices as a result of the recession and falling interest rates.

In chart 15, the expected return for equities issued by the forecast model (charts 12, 13) is used to forecast the excess return on equities over government bonds over the next 10 years. For this purpose, the interest rate for ten-year government bonds is deducted from the expected return on equities (red line). In the past, this expected additional return corresponded quite closely to the actual additional return (blue line). For example, at the height of the technology and internet stock bubble in December 1999, the expected return on equities was -3% p.a. for the next 10 years (chart 13, dotted line on the far right) and the interest rate was 5.3% (chart 14). The expected additional return on equities was therefore -8.3% p.a. (lowest value on the red line), while the actual value measured 10 years later in 2009 was -6.4% p.a. (lowest value on the blue line). We can currently expect equities to outperform bonds by just under +6% p.a. in Europe up to 2033.

The fact that the economic researchers surveyed by the Philadelphia branch of the US Federal Reserve since 1970 are still almost as cautious as they were in autumn 2022 also speaks against sustained price losses for European equities, which are particularly promising compared to bonds. Almost 12 months ago, the level of pessimism was unprecedented since the start of this survey (chart 16). Not only the US stock market but also the European stock market fell significantly during this period (chart 17). A recession should not really come as a surprise to investors due to the still very high fear of a recession.

In addition to the European equity market, the UK equity market is also attractively valued with an additional return of almost 9% p.a. (chart 18), the German equity market with an additional return of 11% p.a. (chart 19) and the Japanese equity market (chart 20) with 6% p.a. and should be able to stabilize quickly in a possible recession.

The risks on the US equity market are significantly higher. Even after the moderate price losses of recent days, the US equity market is still heavily overvalued (chart 21). Only during the internet and telecoms bubble over 20 years ago and in 2021, when long-term US interest rates were still below 1.5%, were US equities more expensive than they are today. Over the next 10 years, US equities are therefore likely to return only 1% p.a. on average (chart 22).

However, as interest rates on 10-year government bonds are currently much more attractive at 4.3%, American investors may quickly come up with the idea of cashing in on safe interest rates instead of testing the vulnerability of the highly valued stock market to recession in the event of growing economic problems.

The additional return on equities expected by our forecast model, which has been highly accurate in recent decades, is -3% p.a. (chart 23). Unfortunately, the current forecasts of other models that have provided reliable 10-year forecasts for 70 years, such as the high equity ratio of US private investors or the low unemployment rate, are also no higher than 1% p.a. (see the detailed capital market outlook from July 2023, which you can find here ). This means that the expected additional return of equities over bonds of -3% p.a. is based on a broad foundation.

In the short term, US equities are not only exposed to the indirect risk of a recession triggered by interest rate hikes and a very high valuation, but also exhibit another worrying parallel to the bubble that burst in March 2000 (chart 25).

For comparisons of US equities and US government bonds, bonds with a particularly long maturity of 30 years are the most suitable, as a large part of the returns on these, similar to the many growth stocks represented on the US equity market, lie in the distant future. From 1989 to July 2021, the interest rate on 30-year government bonds fell from 9% to 1.2% (chart 24). Meanwhile, the value of a portfolio invested in these bonds increased tenfold, as did the US S&P 500 equity index (chart 25). At the peak of the bubble in March 2000, the equity market had initially far outperformed 30-year government bonds, which were briefly worth only half as much as equities. By July 2002, however, government bonds had caught up with equities again. They had gained 30%, while equities had fallen by 38%. In the summer of 2023, equities also outpaced the sharp fall in government bonds. However, bonds will catch up again. In addition to the weak earnings expectations for US equities and the fact that interest rates on 30-year government bonds are once again quite attractive at 4.4%, there is another reason for this.

US government debt as a percentage of national income is currently around the same level as at the end of the Second World War, but has so far caused only low interest costs due to the low level of interest rates, both in 1945 (chart 1) and in the years up to 2022 (chart 26).

However, there is a huge difference in US government revenue from corporate taxation between 1945 and 2023. In 1945, US companies paid taxes amounting to 7% of national income (Figure 27); at the end of the 1960s it was just under 4% and even in 2015, the year before Donald Trump was elected president, it was still 1.9%. Since Trump's corporate tax reform in 2018, this figure has almost halved. In 2020, corporate taxes only amounted to 1% of national income. This percentage was similarly low in the early 1980s after Republican President Ronald Reagan implemented a corporate tax cut. Not only, but also because of this, the US national debt began to rise at the same time from 32% to around 120% of national income today. We do not believe that such favorable corporate taxation is sustainable in view of the extremely high national debt, especially as the US government's interest cost burden will rise from below 2% to 4.5% of national income in the next two years due to the rapid rise in interest rates (chart 27). This will be a historic record in the entire history of the US and will force politicians of all stripes to either raise corporate taxes - certainly a heavy burden for the highly valued US equity market - or to print money again, regardless of the inflation rate, in order to lower interest rates sharply. This would then weigh on the dollar exchange rate. For European investors, this is another reason to underweight US equities.

In most countries, with the exception of Sweden and Germany, residential real estate has stagnated or even achieved further slight increases in value since mid-2022 despite the rise in interest rates (Figure 28).

However, only in Japan and the USA have house prices risen faster than per capita income since mid-2022 (chart 29). Although house prices in Germany and Japan have risen faster than per capita incomes in the last 15 years, their overall growth has been more than 30% weaker since 1970. However, this does not take into account interest rates, which are still low compared to previous decades (see chart 4 for Germany). As a result, German residential real estate is not expensive by both international and historical standards.

House prices in Germany have fallen by 5% between mid-2022 and March 2023 (Figure 28), but by almost 10% compared to rental income (Figure 30). This suggests that rents have risen in this short period of time, which is not surprising given the population growth in Germany of 1.1 million inhabitants (source: Destatis, 19.1.2023) and the far too low level of new construction activity (Figure 31).

There is a close correlation between the mortgage interest rate (currently 3.8%, see chart 32) on the one hand and the rental yield (3.1%, source: Bulwien Gesa) as well as the expected rental growth, which corresponds to the average inflation of the last 10 years (currently 2.4%) when valuing real estate. The chart shows that 3.8% mortgage interest rates (short orange arrow), rental yields (3.1%) and expected rental growth (2.4%) should add up to 5.5%, which is currently the case (dashed orange arrow). Apartment prices are therefore exactly in line with the rise in interest rates; if average inflation is higher than 2.4% over the next few years - we expect 3.5% p.a. - German condominiums are even undervalued and should generate total returns of over 6% per year over the next 10 years.

In summary, we can state that most equity markets and the German residential real estate market are fairly or even favorably valued in relation to the rise in interest rates and can expect significantly higher returns than government bonds in the coming years. In the event of a possible recession in Europe and especially in Germany, a fall in interest rates can be expected, which would quickly counteract any significant fall in share prices. The Japanese equity market is also attractively valued and the risk of recession is low anyway due to the very small increase in interest rates. In the USA, however, government bonds are much more attractive than the highly valued equities, which have so far ignored the rise in interest rates. This means that US equities have a very unfavorable risk/reward ratio.

Finally, our key statements from the Capital Market Outlook from September 2020, which you can find here :

• The main topic was the increasing tendency towards dictatorial policies in China, Russia and Turkey, from which we had deduced long-term disadvantages for these countries.

‍

You can also download the capital market outlook here.