Geopolitics, inflation, interest rates - quo vadis, capital market?

There were a number of crises after the Second World War, but never as many at the same time as today: Putin's war, energy crisis, inflation, deglobalization, global warming, record-high debt, corona, China, ... . However, there are also some bright spots that we would like to highlight in today's look at the next decade.

It is probably no coincidence that the index of economic policy uncertainty has risen significantly since 2008, the beginning of the financial crisis, after 20 years of sideways movement (chart 1). The high level of debt even at that time brought the global financial system to the brink of collapse after the bankruptcy of the US investment bank Lehman Brothers, which could only be avoided by massive money printing by many central banks. In 2011, the European Central Bank, which had been reluctant to act during the financial crisis, also had to save the euro by printing money, as Italy and Spain were on the brink of national bankruptcy. As the financial crisis progressed, only a few investment bankers lost their homes, but millions of "normal" Americans did, and globalization also caused many industrial jobs to disappear in countries such as the USA and the UK. This allowed populists such as Donald Trump or Boris Johnson, who drove the UK into Brexit, to come to power with the votes of the losers. Governments later had to take on high levels of debt again to cope with the coronavirus pandemic and the central banks printed a lot of money again. This created the conditions for high inflation rates, which reached record levels for over 50 years as a result of Putin's war of aggression against Ukraine and rising energy prices, particularly in Europe and also in Germany (chart 2b).

However, there are now some positive developments. Trump, Johnson and the Brazilian "tropical Trump" Bolsonaro have lost the last elections in their countries. 60% of Britons have long been convinced that Brexit was a mistake (source: Welt, 17.02.2022). Further exits from the EU have become very unlikely for the time being.

Investors have learned how quickly central banks can get to grips with major financial crises, so that the slump on the stock markets at the start of the coronavirus crisis lasted only a few weeks and was followed by a rapid recovery as more money was printed. Governments used this money to skillfully mitigate the social consequences of the lockdowns.

Contrary to fears last fall, the coronavirus pandemic no longer requires any special measures; in Germany, the obligation to wear a mask when traveling by train will be lifted from February.

Fears of a gas shortage this winter also proved to be exaggerated. As in every crisis, politicians, consumers and companies were flexible and adaptable; German gas storage facilities were filled to an above-average level of over 90% in January 2023 (source: Handelsblatt online, 17.01.2023).

The problem of Russia's war of aggression, which has so far been surprisingly unsuccessful, remains unresolved. The powerful Putin, who was admired by many populists, must now fear for his own job. The resolute sanctions against Russia and the high efficiency of Western weapons should also impress Xi Jinping, the dictator of China, so that the danger of a Chinese attack on Taiwan may have diminished somewhat. However, the war is exacerbating the problem of deglobalization, as Europe in particular has realized how dangerous it is to be heavily dependent on a potential opponent for important raw materials in connection with energy supplies.

After all, the mountains of debt that started the series of crises since 2008 have continued to rise sharply since then (see chart 6a) and will place a heavy burden on government budgets in future as interest rates rise. Politicians are covering up the assumption of additional future debt. There is a financial market stabilization fund (€ 480 billion), an economic stabilization fund (€ 250 billion), a special fund for the German armed forces (€ 100 billion) and various other "special funds". However, these are not "funds" or "wealth", but simply the state's willingness to take on further debt in the aforementioned amount (source: Prof. Hans-Werner Sinn in Wirtschaftswoche, 20.01.2023). Global warming will also cause high costs and growing state subsidies in the coming decades. We will come back to this later.

Now let us first look at the inflation and debt problem. Chart 2a shows the performance of the main asset classes for a German investor since 1970. Equities have performed best by far, but gold, government bonds and residential real estate have also risen significantly faster than consumer prices.

However, the ranking looks different in the two phases with high inflation rates (chart 3a: 1970 to 1980, chart 3b: from 2020).

In both cases (chart 3a, b), gold is in first place and residential real estate in third place, ahead of the consumer price index. However, bonds have been by far the worst performers since 2020, whereas they were in second place until 1980. By contrast, equities have performed much better than in the 1970s. There are reasons for the different performance of equities and bonds that will also have an impact in the coming years and will be explained later (see chart 10a, b).  

In the USA, the inflation trend in recent years appears to be very similar to that in the first years of the inflation decade from 1970 (chart 4a). During this period, interest rates were sometimes above and sometimes below the inflation rate, which was sometimes in double digits (chart 4b). It was only when the interest rate reached double digits, making saving attractive again (chart 4b, green oval), that the inflation rate fell sharply and the 40-year phase of low inflation rates began (see also the capital market report from October 2021 (last page, which you can find here )). Today, by contrast, interest rates have been below the inflation rate for three years (chart 4c), meaning that interest rates have no significant inflation-reducing effect.

In Germany, inflation in the 1970s peaked at 7.5%, which was significantly more moderate than in the USA at the same time, where it reached almost 15% at the beginning of 1980, but also weaker than since 2020 (chart 5a). The main reason for this is shown in chart 5b. Unlike in the USA, interest rates were significantly higher than the inflation rate throughout the entire inflation decade and also much higher than today (blue line in charts 5b and c), which explains the much better pension performance in the 1970s compared to today. The high interest rate in Germany at that time successfully created a permanent downward pressure on inflation. Today, the picture in the eurozone (chart 5c) is very similar to that in the USA (chart 4c). Interest rates have been below the inflation rate for years.

The reason for this is not that monetary policy is no longer conducted by the Bundesbank, but the extremely high level of global debt compared to the 1970s (chart 6a). In 1981, the sustained decline in inflation rates began in the USA and Germany (chart 2b), but also in the other industrialized countries. The main reason for this was the record-high long-term interest rate level at the end of the 1970s (chart 6b), which was made possible by the fact that government debt was much lower everywhere in 1980 than it is today (chart 6a).

Since 1945, there has been a statistically close correlation between the level of government debt as a percentage of national income and the interest rate level of long-term government bonds (Figure 7a, the value of 0.63 for the USA, indicated by the R² figure, shows a very close correlation between the two variables; R² can lie between zero (no correlation) and 1 (maximum correlation)). This mechanism also exists in most of the other countries shown. The value of R² is between 0.77 (Japan) and 0.31 (UK). There is a clear economic logic to the relationship between government debt and interest rates, which is also well understood by politicians. High government debt only remains unproblematic when interest rates are very low, such as after the Second World War or today.

This can be seen very clearly in practice. When real interest rates soared from 1980 onwards, a phase of significant defaults by sovereign debtors began worldwide with a short delay (chart 7b shows the US real interest rate, which is the most significant worldwide). It was not until 1990, when real interest rates had already fallen again, that the wave of sovereign defaults gradually subsided. Since real interest rates were barely above zero as a result of the loose monetary policy to contain the financial crisis in 2008, there have been almost no more defaults on government bonds despite high and rising government debt.

What is worrying, however, is the fact that more than 80% of the significant defaults on government bonds after 1980 (chart 7b) up to 1990 related to the government debt of industrialized countries (source: World Economic Forum Davos: Global Risks Report 2023, p. 18), although the industrialized countries had very little government debt in 1980 compared to today (chart 6a). Total debt, including the debt of private households and non-financial companies, was also much lower in 1980 than in 2021 (charts 8a, b).

The massive increase in government debt in relation to economic output alone requires central banks to exercise particular caution when raising interest rates so that governments' financial problems remain manageable. This is why the ECB and the Bank of England "lost their nerve" last year after an interest rate rise of 300 basis points in Italy and 350 basis points in the UK and printed money and bought the respective government bonds despite rising inflation (chart 9a).

Compared to 1980, however, the increase in private sector debt everywhere (households, companies) is a further problem (chart 8b). The following example shows why governments cannot be indifferent to this debt. During the real estate boom in the USA up to 2007, private household debt rose sharply (chart 9b). For the first time, they were able to borrow money for house purchases even if they had a weak credit rating due to lax lending rules desired by the government. From 2007, many of these financially weak homeowners were no longer able to repay their loans, causing the banks to run into difficulties. To rescue the banking system, the US government had to take on large amounts of debt from 2008, as can be seen from the rise in the red line in the middle of chart 9b. This is how excessive private debt can turn into government debt (not only in the USA). The unprecedented rise in Japanese government debt from 1990 onwards (chart 6a) is also attributable to the bursting of a huge real estate bubble (see the capital market outlook from October 2020, which you can find here ).

The historically record-high level of international debt will force central banks to keep real interest rates very low - preferably below zero - for years to come in order to keep the global financial system stable. The reactions of the ECB and the Bank of England last year have shown this. Bonds will therefore remain an unattractive form of investment for the next 10 years.

The rather good performance of equities since 2020 compared to the 1970s has a somewhat surprising reason. The Swiss newspaper Finanz und Wirtschaft shows the share of growth in corporate gross surpluses in the US and the eurozone in domestic inflation Figure 10a, b).

First of all, we can see that, unlike macroeconomic inflation, which in the eurozone is even higher than US inflation due to soaring energy costs in addition to domestic price increases, inflation in the eurozone is much lower than in the US. The main reason for this is the fact that the US government spent money amounting to 25% of US national income from 2020 onwards to alleviate the financial consequences of the coronavirus crisis (chart 11a). This money could then be spent from 2021 onwards as coronavirus-related restrictions on the economy eased, fueling inflation considerably. The eurozone was much more cautious; only Italy and Spain spent slightly more than 10% of their respective national incomes.

In both regions, many companies had little problem passing on rising costs to customers, often even with an additional surcharge, thereby driving up their profits as well as inflation. They were expecting price increases everywhere anyway due to inflation and hardly noticed them. As a result, the gross profits of companies in the developed countries of Europe and Asia as well as in the USA rose even after the start of the war (chart 11b). Only China's companies suffered from home-grown problems.

This explains the better equity performance since 2020 compared to the 1970s (see chart 3a, b), but of course does not guarantee that it will remain as easy for companies to pass on costs as before. However, as inflationary pressure is gradually decreasing (see charts 4c, 5c), this issue should become less important.

Another issue that will cause the mountains of debt to grow further is climate policy. In our Capital Market Outlook from August 2021, which you can find here, we unfortunately correctly predicted that politicians would not pursue the most efficient and affordable path to a sustainable reduction in CO2 emissions. This consists of a uniform global CO2 tax with compensation payments to individuals and countries that cannot afford higher energy prices as a result of a CO2 tax. The fuel rebate is the intellectually embarrassing opposite of this. Instead of the increased energy costs having a consumption-reducing and climate-protecting effect and low-income earners receiving support payments, the fuel rebate grants subsidies to car owners so that they do not have to restrict their consumption. Those without a car, on the other hand, receive nothing.

In order to buy votes, money is once again being distributed to as many recipients as possible and not limited to those in need. In view of the level of debt, this is extremely irresponsible and increases the risk of inflation in the long term, because the ability to combat inflation is further undermined by increasing debt. An efficient and affordable fight against global warming in the long term cannot be achieved through these strange detours.

This questionable handling of money also has something to do with populism. It is not only in Germany that people want to minimize the number of losers who might vote for a populist politician. However, it is possible that the current failures of populists and dictators are the beginning of a gradual decline in this style of politics. The following chart 12 shows an interesting correlation for the USA for over 100 years, which the dictators are obviously aware of. At the beginning of the 20th century, the distance between the political convictions of Democrats and Republicans was almost as great as it is today, meaning that they held opposing views on key issues. At the same time, income inequality was very high. Back then, as today, the hundredth of the population with the highest income earned almost 20% of the total income of all Americans.

Income inequality reached its highest level of 19.6% in 1929, at the beginning of the Great Depression. After that, inequality initially began to fall moderately - corporate profits fell during the crisis, but so did wages - before falling sharply during the Second World War and only rising again since the end of the Cold War. In view of the global economic crisis and the fight in the Second World War against the dictatorships of Germany and Japan, many politicians buried their differences in order to save their state; the blue line in chart 12 fell sharply from 1929 onwards. Only when the fall of the Berlin Wall and the subsequent break-up of the Eastern Bloc seemed to have eliminated all problems and rising corporate profits caused inequality to increase again (chart 13b) did the polarization in American politics rise again. Until 1989, national income in the US had risen six times faster than corporate earnings (dividends) (chart 13a), which reduced income inequality, while since 1989 dividends have risen significantly faster than national income (chart 13b).

Problems that seriously threaten the state, e.g. a major war, therefore weld politicians and, indirectly, the people together. This is why populists and dictators like to instigate foreign policy conflicts. Moreover, top American earners were patriotic enough at the time to pay enormously high top tax rates of around 90% (from 1942 to 1963, source: Wikipedia: Income tax (United States)), which of course significantly dampened inequality. The hope for the future is that the new major problems threatening the Western and Far Eastern industrialized nations, namely the Putin war, China's growing aggressiveness, deglobalization and global warming, will once again reduce the polarization of politics not only in the USA. In addition, the demographically induced labor shortage will reduce inequality through high wage increases. Finally, the populist politicians have largely failed so far, which has certainly not only become clear to the British.

Conclusion:

The growing economic policy uncertainty in Europe and the USA over the past 15 years is primarily due to the sharp rise in national, corporate and private household debt over the past 40 years, which first revealed the vulnerability of the global financial system during the 2008 financial crisis. Added to this was a populist political style made possible by the losers of the financial crisis, but also by globalization, which has led to economic damage through trade wars against China or Brexit. Added to this are the current Putin war and the future costs of global warming.

None of these problems have been solved yet, but some reassuring developments can be identified. The financial system can cope with the further increase in debt since 2008 if the central banks step in in the event of a crisis, which they did successfully in 2008 and then again in 2020 due to the coronavirus crisis, which put a massive strain on national budgets. The Putin war has so far brought about a surprisingly rapid unification of Western democracies and a revival of NATO. This and Putin's lack of success so far should reduce the future risk of military conflicts in Europe, but also in the Far East. Populism is likely to become less important in the future, as the actual cause, the inequality that has been growing for 40 years, is likely to weaken in the future due to demographically induced higher wage increases.

The seemingly threatening high level of debt is likely to mean that interest rate hikes to combat inflation will be moderate, as otherwise governments will run into financial problems. With interest rates below inflation, bonds remain an unattractive investment, but stock corporations have coped surprisingly well with this so far and will probably continue to do so in the future.

Who would have known exactly 3 years ago as an investor from a € perspective:

1. There will soon be a pandemic with a more severe recession than after the financial crisis, and governments will have to take on more debt to combat it
2. Then inflation begins to rise
3. This is followed by a war in Europe, which further fuels inflation and leads to sharp increases in interest rates
4. The supply of energy and other raw materials and vendor parts is at risk, particularly in Europe,

would hardly have predicted that the stock markets would still gain between 4% and 25% (chart 14). He would have underestimated the positive effect of inflation above interest rates on company profits and the adaptability of companies.

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You can also download the capital market outlook here.