High inflation rates, rising interest rates and the consequences for tangible assets

Following the global decline in share prices over the last two weeks, European and German share prices have returned to their lowest levels since the beginning of the Putin war; US shares have even reached new lows for the year, particularly due to the slump in technology stocks.

The trigger for this development is the sharp rise in interest rates, which is due to rising inflation rates and the sudden realization by central banks that inflation is probably not temporary and will disappear on its own, as previously assumed, but that interest rate hikes are necessary to combat inflation.

In the last Capital Market Outlook, which you here we showed why the rise in interest rates will not match inflation rates and that bonds will therefore not become an attractive alternative to equities, unlike in the late 1970s with double-digit interest rates. Equities are therefore likely to remain attractive in the coming years despite fairly high inflation.

A look at the current interest rate and inflation situation shows that there have been no significant changes in recent weeks. Interest rates remain well below the inflation rate.

This raises the question of how sustainable the price decline on the stock markets is.

An initial look at the valuation of US (chart 2a) and European (chart 2b) equities does not suggest that equities have already become as cheap as in previous times of crisis. The marked crises had led share prices to below-average valuations, which always triggered strong price recoveries in the aftermath. However, European equities are currently only approaching an average valuation and US equities have so far only left the overvaluation zone.

The German stock market looks far more interesting and is now even cheaper than at the end of the first oil crisis at the beginning of 1975. At that time, German shares had suffered price losses of well over 40% and, as today, there was pronounced pessimism about the security of energy supplies. Oil prices had tripled in just over a year after the Arab oil-producing countries had turned off the oil tap for weeks in 1973. However, share prices then rose by 36% in 1975.

The current particularly low valuation of German equities is certainly also due to the fact that there are no oil and commodity stocks or major healthcare stocks in Germany as in other European countries and the USA, but rather numerous industrial stocks with supply chain problems and concerns about the global economy and dependence on China. Valuation alone is therefore not a clear buy recommendation for German equities. However, there are other aspects that point to a brighter future for the stock markets.

Unlike the valuation, the pessimism of fund managers, which can be seen from the high cash ratio in fund assets, paints a clearer picture. Since the terrorist attack on the World Trade Center in New York on September 11, 2001, the cash ratios of international fund managers have never been as high as in May 2022 (6.2% of fund assets, see chart 3), according to a regular survey by the Bank of America, although there have been a number of severe crises since then.

A high cash ratio indicates high price gains in the following months. Even if one includes the first two months of high cash ratios at the beginning of the crash in technology, media and telecom stocks (TMT) from March 2000, although the stock markets were still extremely overvalued at that time (see charts 2a - c), an average price gain of 8.9% was achieved in the following 12 months. If the high cash ratios had only been used as a buy signal from September 2001, when the stock markets had left the area of overvaluation (above the red lines in charts 2 a-c) for the first time, the average price gain after one year would have been 14.2%. Compared to the average price increase of the global equity market (2.7% p.a. since December 1999), high cash ratios were therefore a good time for fund managers to enter the market.

We now examine whether bonds have become an attractive alternative to equities due to the rise in interest rates. The result of a simple comparison of the changes since December 31, 2021 shows that yields on the equity markets, particularly in Germany, have risen even more sharply than bond yields (see chart 4). This means that even after the rise in interest rates, bonds have become even less attractive compared to equities.

The German equity market in particular is valued far too low, even taking into account the rise in interest rates (chart 2c shows the valuation excluding interest rates), as the cash flow yield in Germany, unlike in Europe, the US or China, has risen more than twice as much as interest rates (chart 4). It is also striking that the cash flow yield of over 17% is at the level of the above-mentioned euro crisis (chart 5, red dot), without a comparable crisis having broken out to date. The cash flow yield on equities is therefore far too high; equities have clear positive price potential if interest rates stabilize.

A special development is taking place in China. We have not forgotten to include the yield changes for Chinese bonds and equities in chart 4, but they are so small that you can hardly see them. In our capital market outlook from November 2021, which you can find here we had predicted falling interest rates for China due to the huge problems in the Chinese real estate market, which has been true since then, even in a global environment of sharply rising interest rates. This trend of rising interest rates should also soon come to an end outside China. High government debt has been forcing low interest rates for almost 100 years (chart 6a, example USA). In the meantime, the European Central Bank has become nervous about the rising interest rate differential between Italy and Germany and last week announced measures to limit interest rate differentials in the eurozone (chart 6b). If interest rates are too high for the Italian state, which has debts of over 150% of national income, this could trigger another euro crisis like the one in 2011. Back then, the new central bank president Draghi ended this crisis in summer 2012 by announcing that he would print money to buy government bonds ("whatever it takes").

Apart from the financial difficulties of over-indebted countries, there are other reasons that stand in the way of a further massive rise in interest rates. Chart 7 shows the wage trend in the US, which has already peaked and is likely to put less upward pressure on the inflation rate in future.

Container freight costs had also peaked before the start of the Putin war and have already fallen significantly (Figure 8).

Encouraging signals are also coming from the oil market. In the US, the population's inflation expectations, which have been determined in surveys by the University of Michigan for decades, are strongly influenced by oil and gasoline prices and are currently very high at 5.4% p.a. for the next 5 to 10 years (chart 9).

However, the oil price is unlikely to achieve any major increases in the future. Since the late 1960s, high oil prices have led to oil prices falling for years in the future (Figures 10a, b). The reason was ultimately the same in the past as it is today: a high oil price prompts oil consumers to save money and increases demand for more energy-efficient products and real estate, which permanently reduces the demand for oil. This time, there is also the absolute desire to become independent of Russian energy resources and to reduce the consumption of oil, coal and natural gas as much as possible for climate protection reasons. The oil-producing countries will increase their supply because they are naturally aware of the demand-reducing effect of high oil prices and do not want to support them.

On the futures market, oil with a delivery date of December 2024 can be bought for USD 80; speculators, oil producers and oil consumers also expect oil prices to fall (chart 11).

In summary, we are currently in an environment of high and rising inflation (chart 12 a), which historically, including the 1970s, has produced a weak performance of equities and bonds, a very good performance of gold and an above-average performance of residential real estate, as the last few months also show. However, if our considerations are correct, we will soon be moving into the area of high but falling inflation, in which the conditions for equities and bonds will improve significantly (chart 12 a, top left). If we look at the influence of interest rates on the quarterly performance of asset classes instead of the impact of inflation, we are already in a favorable environment for equities and residential real estate (chart 12 b bottom right) with low but rising interest rates.

Despite the sharp rise in interest rates in recent months, interest rates (chart 13 a) and the expected performance of bonds (chart 13 b) remain below average.

The rise in interest rates will not be able to depress residential real estate prices in the long term. Rising mortgage interest rates do indeed cause rental yields to rise and thus property prices to fall (assuming stagnating rental income), but only at very low mortgage interest rates (chart 14 a, oval red line). Even at interest rates of over 1.5%, there is no longer any influence on rental yields. In 1981, for example, at interest rates of 11%, the rental yield was a below-average 3.3%, barely higher than in 2021, but the mortgage rate was 11%. A property with a purchase price of €1 million would have meant interest costs of €110,000 with a rental income of €33,000. Nevertheless, the buyers did not hesitate. Then, as now, they not only calculated the current rental yield, but also included the expected rental growth in their calculations. This was obviously derived from the average inflation rate of the past 10 years, which was 5.5% p.a. A cash flow with an initial yield of 3.3% is worth just as much with a perpetual growth rate of 5.5% as a perpetual cash flow of 8.8% (for an explanation, see our capital market outlook from December 2021, which you can find here can be found here). With an annual return expectation of 8.8%, the interest rate of 11% appears far more moderate. Figure 14 b shows that the real estate market has been calculated in this way for almost 50 years - the mortgage interest rate explains 82% of the sum of rental yield and future rental growth, derived from historical average inflation. With a rental yield of 3%, investors would currently be satisfied with a total return of 5.3% (horizontal orange arrow in chart 14 b); they therefore expect rental growth of 2.3%. This figure is likely to rise significantly over the next few years, as higher inflation and a shrinking workforce will cause wages and therefore rents to rise much more sharply in the long term; (energy-efficiently renovated) residential properties will therefore remain an attractive inflation hedge in the long term.

Just like residential real estate, the price of gold also requires high inflation expectations to rise, which only form when inflation rises significantly over several years (chart 15). In 1979 or 1980, Americans looked back on 7 years with an average inflation rate of 9% p.a. and drove the gold price up to 6 times the price that would have been achieved in these two years with a steady (trend) growth rate of approx. 7% p.a. since 1968. This also explains the current moderate rise in the gold price. The majority of investors are not yet convinced that inflation will continue to rise.

Due to the fall in share prices in recent weeks, our long-term earnings expectations for equities and the related private equity funds have risen significantly (chart 16). Overall, the outlook for real assets remains positive even after the significant rise in interest rates.

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