Earnings expectations in times of war, inflation and higher interest rates

Inflation rates and interest rates have risen significantly worldwide in 2022. In addition, there is a threat of recession in Europe due to extremely high energy prices and the general uncertainty caused by the war. The US economy is increasingly suffering from tough monetary policy. Today, we examine our earnings expectations in this unpleasant environment.

Chart 1 shows that the performance of the most important asset classes of our client assets has not kept pace with the rise in consumer prices since the beginning of the year. Nevertheless, gold in euro terms and residential real estate generated slightly positive returns. Healthcare stocks were also quite stable with a fall in value of only 3%, while inflation-linked government bonds in the eurozone and global equities in euros generated moderate losses of around 10%. Eurozone government bonds were weak at -17% and German equities at -27%, which suffered from the German economy's particular dependence on Russian natural gas.

The weakness of German share prices in an international comparison calculated in euros (see chart 2 a) is also striking in light of the fact that the gross profits (cash flows) of German companies (also calculated in euros) have actually risen slightly since the start of the war up to September 2022 (chart 2 b).

However, this development is in line with previous recessions (see the capital market outlook from July 2022, which you can find here), in which share prices fell earlier than economic output and also rose again earlier (chart 3a). In contrast, gross corporate profits (cash flows) lagged behind the economy (see chart 3b, example of the financial crisis from 2008).

Share prices have fallen for a reason, despite the fact that cash flows are still rising. The most likely scenario for the USA in the coming months is a recession that will lead to falling cash flows (chart 4). With one exception (in the mid-1960s), a recession has followed after an average of 13 months since 1953, when the blue line has broken through the horizontal black line. The 1-year interest rate was then higher than the 10-year interest rate (red circles, chart 4). Since July 2022, this situation has occurred again and the yield curve is currently at -50 basis points.

In the eurozone, the interest rate structure could only be used until the 2008 financial crisis, as until then it was believed that Italian government bonds, for example, were just as safe as German bonds and therefore the interest rate structures of both countries were the same (chart 5 a). However, since this belief is no longer generally shared after the Lehman bankruptcy, the interest rate structure in Italy is significantly higher than in Germany. However, this does not mean that Italy is less at risk of recession than Germany. Italy's weaker credit rating has since been reflected in higher long-term interest rates for government bonds, but the short-term interest rate set by the ECB for the eurozone as a whole is the same in Germany and Italy. As a result, the interest rate structure in the eurozone has not provided any meaningful indications of a possible recession since the end of 2008.

This task is performed by the growth of the real money supply (chart 5 b). If this falls below the red zero line (red circles), a recession follows after a few months to two years. The current value is -2.4% . Only in the three months before the Lehman Brothers bankruptcy in 2008 did the real money supply shrink even more.

The coming recession will significantly reduce inflation rates (chart 6). In the 13 major recessions since 1974 in the USA, the eurozone and Germany, the inflation rate has fallen by an average of 3.2 percentage points (see also the capital market outlook from July 2022, which you can find here).

Other factors that have previously driven inflation but are currently already reducing inflation are commodity prices. Their sharp rise since 2020, i.e. long before the start of the war (see chart 8 a), had contributed to rising inflation rates and thus also to rising interest rates. Commodities are an important component of producer price trends, which have a significant impact on the inflation rate in Germany, for example (chart 7).

However, there are already signs of a slight easing at this point (chart 8 a - c). Both the broad-based CRB commodity index (oil, metals, ..., Figure 8 a) and gas (Figure 8 b) and electricity prices in Germany (Figure 8 c) have clearly left their record highs of summer 2022, although the electricity price is subject to considerable fluctuations. In addition, container freight costs are falling sharply (Figure 8 d), facilitating international trade.

Over the next few years, the collapse of the Chinese construction boom, which resulted in enormous consumption of raw materials and energy, will lead to a global economic decline in demand for raw materials and exert pressure on commodity prices for years to come (see capital market outlook from September 2022, which you can find here).

Another component of future inflation rates will be wage development. IG Metall is demanding an 8% increase in wages, and for the public sector it is even calling for salary increases of over 10%. This is likely to force a number of companies to further increase the prices of their products. However, comprehensive data on future wage trends is not yet available.

Overall, however, inflation-lowering factors will predominate over the next 12 months. In addition, there is another interest rate-lowering development that is independent of the inflation trend, namely the growing nervousness of central banks (chart 9).

In June, the ECB feared that the particularly sharp rise in interest rates in Italy since the beginning of the year could be dangerous for the highly indebted country and invented a new program that allows the targeted purchase of government bonds from individual eurozone countries if the ECB deems it necessary. In England, interest rates rose sharply at the end of September after the new Prime Minister, who has since resigned, presented a half-baked program to cut taxes for top earners and companies, which would further increase the state's already very high level of debt. Because British pension funds got into difficulties due to the fall in the price of government bonds, the Bank of England intervened by printing money to buy bonds, although at the same time it wants to raise money market interest rates further in order to combat inflation. Overall, we are close to the peaks of inflation rates and long-term interest rates on both sides of the Atlantic.

Gold

The gold price in US dollars is particularly dependent on the US inflation rate. Since the US dollar was unpegged from the gold price in 1968, the gold price has risen by an average of 6.9% p.a. to USD 1,621 by 2022 (chart 10 b). With rising average inflation in the previous 7 years, a higher price compared to the trend was also justified (chart 10 a), but in some years, such as 1980, 1987 or 2012, the gold price was far higher than would have been appropriate in terms of the trend and average inflation. After such points in time, the gold price fell for years.

Given that US inflation has already risen to 3.25% on a 7-year average, the gold price should already be over 30% higher now (chart 10 a, red dot) and should achieve around +10% p.a. by 2032 even if the inflation rate only reaches an average of 3.5% by 2032.

Despite the sharp rise in mortgage interest rates (10-year fixed rate since Dec. 2022 from 0.73% to currently 4%, see chart 11), there is unlikely to be a sustained slump in average residential properties. Since 1975, property buyers and sellers have also factored the expected growth in rental income into their price calculations. Similar to the gold market, this future growth in the real estate market was obviously derived from the long-term average inflation of the last 10 years (for gold: 7 years). If this past 10-year inflation rate is added to the respective rental yield of a year (determined by the real estate research company Bulwien Gesa) as an estimate for the expected future rental growth rate, the total future annual return expected by investors is obtained (a more detailed explanation of the financial mathematical relationship, that a cash flow A with an initially low yield but steady growth is worth just as much as a cash flow B that does not grow but permanently corresponds to the sum of the initial yield and the steady growth rate of cash flow A, is provided by the capital market outlook from December 2021, which you can find here). This makes it understandable why condominiums were hardly less profitable in 2021 (rental yield 3%) than in 1981 (rental yield 3.3%), although the mortgage interest rate was at a record level of 11% at that time and a record low of 0.73% was recorded in 2021. Average inflation was 5.3% p.a. from 1971 to 1981, but only 1.4% p.a. in the 10 years to 2021. Accordingly, the expected total return was 4.4% last year, but 8.8% in 1981. The current rental yield of around 3% now at 4% mortgage interest only fits the long-term calculation method if long-term rental growth of only 2.7% is expected for condominiums. As soon as it becomes clear that the inflation rate - even in Germany - is more likely to be between 3.5% and 4%, the expected total return of over 6.5% will be higher than the current value (horizontal orange arrow). This means that condominiums are currently even a little too cheap.

Shares and bonds

The war in Ukraine and sharply rising interest and inflation rates have depressed share prices (chart 1) and also the mood of equity investors. In the meantime, the pessimism of professionals, as measured by Bank of America in a monthly survey of international equity fund managers based, among other things, on the cash ratio in fund assets (chart 12), has reached its highest level since May 2001. This means that sentiment is worse than in any crisis since the crash in telecoms, media and technology stocks (TMT) from March 2000. The peaks of pessimism marked with red circles proved in retrospect to be very good buying times; the average price increase in the following 12 months was 8.9%, while the average 12-month price gains since 1999 totalled only 2.7%.

As a result of the share price losses, but also the fact that most companies' cash flows have continued to rise to date (see charts 2 a and b), the valuation on the equity markets has become significantly more favorable (see chart 13 as an example of one of the forecast models for US equities). The price/cash flow ratio, which is well suited for forecasting purposes for the next 10 years, has fallen from almost 19 to 13 since the beginning of the year and the expected return for US equities has risen from -1% p.a. to +7% p.a. as a result.

Earnings expectations for the next 10 years have also risen very significantly in some cases (IT sector!) on the other major stock markets (charts 14 a, b). They are thus all in the upper single-digit or low double-digit range. Despite the sharp rise in interest rates, the yield expectations for 10-year German government bonds are far lower than those for equities.

Conclusion

The overall picture (chart 15 a, b) shows how significantly most earnings expectations have improved. If the assumption that inflation rates and interest rates will soon exceed their peaks is correct, the current price losses on equities could be offset in the next one to two years.

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You can also download the capital market outlook here.