Decline in inflation, recession risks and banking crisis

The danger of a recession, which was widely expected last fall but has not yet materialized, has not been averted in either the US or Europe, as the rise in interest rates is weighing on parts of the economy, most recently the banking sector. Nevertheless, inflation rates will fall in the coming months. This time we look at the consequences of this environment for the capital markets.

In the May 2022 Capital Market Outlook, which you can find here, we analyzed the differences in the performance of various asset classes in times of low and high as well as rising and falling inflation rates. The result was that, since 1970, equities had achieved very below-average returns in quarters with high and rising inflation rates, which had been the case since the second quarter of 2021 and was also to be expected for the coming quarters after the start of the Putin war. The performance of German government bonds was also below average, while German residential real estate generated slightly above-average returns and gold strongly above-average returns.

Extending this analysis to the period up to February 2023 confirmed the results from May 2022 (chart 1a). Since the first quarter of 2022, when the war began, the returns on equities and bonds have even been clearly negative (chart 1b, dashed bars). Since then, not only have the already high inflation rates in Germany continued to rise (with the exception of Q4 2022), but interest rates have also risen for the first time (chart 2). The gold price has also achieved the best performance of the asset classes examined here since the end of 2021, as it has done on average in the quarters with high and rising inflation since 1970; the returns on residential real estate were average (chart 1b).

The reason for the weak performance of equities in times of high and rising inflation since 1970 was not due to the weak development of companies' gross profits (cash flows); in such an environment, these achieved the highest growth rates both globally and in Europe (chart 3a). By contrast, the multiples on cash flows, the price/cash flow ratios, fell sharply (chart 3b), so that the effects of rising profits were largely eliminated by falling valuations and equities only achieved a very low performance (chart 1b).

Since the end of 2021, corporate cash flows have risen even more strongly than the average since 1970 amid high and rising inflation (chart 4a), but valuations have also fallen more sharply than the long-term average (chart 4b), with the result that equity performance has even turned negative since the end of 2021 (chart 1b, dashed bars).

In our Capital Market Outlook from August 2022, which you can find here, we analyzed which stocks have achieved the highest performance since 1995 and were less risky in times of crisis. Among the regions, the US equity market, which recorded the highest performance during this period, had the lowest losses on average; among the sectors, the IT sector was the most profitable worldwide, followed by healthcare stocks and consumer staples stocks, which also performed best during recessions.

If we examine the three best-performing sectors since 1995 in terms of their performance in times of high and rising inflation, we can see that all three have performed well above the global average (chart 5). Since the end of 2021, however, only healthcare and consumer staples stocks have been reasonably stable, but at least better than the global average, while the IT sector has been hit hard by the rise in interest rates since the start of the war.

Even in the best sectors, the problem was not cash flow growth (chart 6a), which was above average overall, but the stagnating or falling multiples (price/cash flow ratios, chart 6b).

This trend has also been evident since the end of 2021, albeit again much more pronounced. Cash flows rose more significantly than the average of all quarters with high and rising inflation (chart 7a), but the multipliers fell very sharply (chart 7b).

So far, we can state that the behavioral patterns of equities that we had determined on the basis of data from 1995 to the beginning of 2022 for periods of high and rising inflation were also valid for the following period up to February 2023 (charts 7a and b), namely above-average growth in cash flows, but stagnation or in some cases a significant decline in multiples (price/cash flow ratios).

This means that we can also use this type of analysis to examine the characteristics of equities in an environment of high but falling inflation, which the capital markets will now enter. This is shown by the strong, but delayed (6 months) impact of energy prices on the core inflation rate in the eurozone (chart 8a). In addition, after the lifting of all corona restrictions in China, the supply chain problem is weakening significantly and the container freight cost index has fallen by over 80% worldwide (source: Drewry Supply Chain Advisors, March 2023).

The results for periods of high and falling inflation are interesting in two respects. On the one hand, such a phase has not been particularly good for equities since 1995 (chart 8b, dashed bars), as the pattern of slightly rising cash flows but sharply falling multiples is also evident here (chart 6a and b, top left in each case). On the other hand, the two sectors that have already performed above average in the phases of high and rising inflation as well as in the difficult period since the end of 2021, namely healthcare and consumer staples (chart 5), are proving to be very stable even with high and falling inflation. The reason for the weak performance of other equities in these phases since 1995 - especially in the best sector of this entire period, the IT industry - is that, unlike before 1995, the periods of high and falling inflation predominantly fell in economically weak phases (Asian crisis 1997, financial crisis 2008, euro crisis 2012, 4th quarter 2022), while healthcare and consumer staples equities are not or only very little affected by the economy.

This raises the question of which factors could currently trigger a recession in the US or Europe. The most important factor is the sharp interest rate hikes in the USA by the US Federal Reserve. These have already caused the interest rate structure (interest rates for 10-year government bonds minus interest rates for 1-year government bonds) to turn negative in July last year; a few days before the latest banking crisis, a record level for over 40 years was reached in the USA at the beginning of March with a drop of over 1% (chart 9). On average over the last 70 years, a recession followed 13 months later, with one exception in the mid-1960s. The probability of a recession will therefore increase from August 2023. The enormously high overall level of debt in the USA, but also worldwide, naturally increases the vulnerability of countries or sectors such as the very interest-sensitive real estate market in the event of rising interest rates (see the January 2023 Capital Market Report, which you can find here ).

The current banking crisis was triggered by the sharp rise in interest rates and the resulting fall in the value of Silicon Valley Bank's bond portfolio, which in this case was offset by investors' deposits and therefore short-term liabilities. Since then, investors on both sides of the Atlantic have realized that other banks could also have a similar problem, as most banks today have large bond portfolios - the counterpart of record-high global debt. For the US banking system, the current (unrealized!) loss of bond holdings is estimated at USD 340 billion (source: The Macro Strategy Partnership, March 2023), but the equity of US banks is estimated at USD 2,000 billion in total. This means that the risk of a banking crisis comparable to the crisis following the collapse of Lehman Brothers in September 2008 is low. In the eurozone, the equity ratios in the four major countries of Germany, France, Italy and Spain have each risen by more than half since 2010 and non-performing loans have fallen sharply since 2014 (source: BCA, 17.3.2023). As a result, the banking system in Germany is also in a very solid position.

Fortunately, there are other major differences to the financial crisis of 2008, when it took the US government and the Federal Reserve several weeks after the Lehman bankruptcy to decide on support measures for the financial sector. This time, the crisis began on Thursday, March 9, and the following weekend the government decided to guarantee all deposits of the two banks affected at the time. A week later, it became clear that the CHF 50 billion in emergency aid granted by the Swiss National Bank to the faltering Swiss bank Credit Suisse after the bankruptcy of Silicon Valley Bank was not enough to restore confidence in the institution. The following weekend, at the insistence of the Swiss government, the takeover of Credit Suisse by its larger competitor UBS was once again agreed and made possible with a further 150 billion francs from the Swiss National Bank. An even more important difference is that the global financial crisis of 2008 was triggered by the fact that banks and insurers around the world had invested huge sums in bonds consisting of mortgage loans to borrowers with poor credit ratings. Their value fell in line with falling real estate prices. As a result, the banks suffered unrealized price losses, similar to today, and were unable to finance any more properties, so that their prices continued to fall and the default risks of the mortgage loans became ever greater. This vicious circle does not exist this time. Although the banks have suffered losses from their government bond portfolios on paper, there is no doubt that they will be repaid in full on the due date. Due to the support measures in Europe and the USA and the growing risk aversion of many investors, the prices of government bonds worldwide have risen significantly in recent days and interest rates have fallen (charts 12a and b).

This means that the banks' potential share price losses are already falling again and the problem that triggered the crisis has become smaller again.

Nevertheless, the global recession risks are increasing as a result of this crisis. Many banks are currently considering tightening their lending conditions so that fewer loans will flow into the economy. Prof. Schularick, the new head of the Kiel Institute for the World Economy, showed in a study in 2017 that recessions associated with a crisis in the banking sector are significantly longer and deeper than other recessions (e.g. the 2020 recession as a result of the coronavirus crisis or the recessions during the oil crises of the 1970s, source: Bank Capital Redux: Solvency, Liquidity, and Crisis, Òscar Jordà, Björn Richter, Moritz Schularick, Alan M. Taylor, NBER Working Paper Series 23287 http://www.nber.org/papers/w23287). However, the consequences of these developments are not necessarily negative for the capital markets. The US central bank is not only committed to monetary stability, but also to promoting the US economy. Its growth since the end of the coronavirus crisis has been quite high and therefore tends to drive inflation. In the US, an extremely large amount of money was generously printed to combat the coronavirus crisis (chart 11a), which initially ended up in Americans' savings accounts as they were initially only able to spend it to a limited extent from March 2020 (chart 11b). In the meantime, however, the surplus savings are gradually dwindling, flowing into consumption and thus leading to a level of consumption that is higher than income. Until the coronavirus crisis, savings had a volume equivalent to around 50% of US national income. They will have fallen to this level by the start of 2024. After that, consumption will only be fed by income, meaning that the level of consumption, which is very important for the US economy, will weaken over the next 12 months.

The sharp interest rate hikes since the beginning of 2022 also served to cool down the US economy. The current crisis is therefore immediately giving the US central bank what it wanted to achieve with further interest rate hikes. The capital markets are therefore rightly assuming that there will be significantly fewer interest rate hikes than previously thought. This expectation is already driving up government bond prices and should soon lead to a rise in the multiples on the cash flows of stock corporations (chart 7b), which have fallen sharply in recent months, because government bonds have become much less attractive again.

Another dampening factor for the US economy is the current decline in residential construction investment, which has always led to or exacerbated a recession since 1970 (chart 12). The current significant decline in construction activity would be the first not to occur during a recession.

In the eurozone for over 20 years, a real contraction in the money supply has been an indication of a subsequent recession (chart 13). However, this indicator is not yet as tried and tested as the interest rate structure in the US (chart 9), which has been functioning for 70 years and is significantly older than the eurozone.

In summary, we can say that the current banking crisis will not develop into a global financial crisis like the one in 2008 because the central banks and governments acted much more quickly and prevented the crisis from spreading by securing all deposits with the state. Furthermore, the focus of this crisis is not on questionable mortgage loans, but predominantly on short-dated government bonds, which there is no doubt will be repaid in full on the due date. Nevertheless, it will have an impact in the coming months, when we will move from an environment of high and rising inflation to one of high but falling inflation. Under these conditions, which after 1995 were only present in times of a weak economy, equities have not generated any positive performance in these phases, with the exception of the cyclically resistant healthcare and consumer staples sectors (chart 8b). The probability of a recession is also currently increasing, particularly in the USA. However, this should no longer weigh too heavily on the equity and real estate markets, as the banking crisis in the US and Europe (Credit Suisse) has greatly reduced the risk of further significant interest rate hikes. However, these were already the reason for significant share price losses in the third quarter of 2022 and for a trend reversal on the German residential real estate market. Even well below the current inflation rates of 6% in the US and 8.5% in the eurozone, interest rates can hardly rise significantly without triggering further turbulence in individual countries or sectors. Bonds and savings accounts are therefore unlikely to be an alternative to global equities or residential real estate, which are not unattractive in Germany in the long term (see capital market report from February 2023, which you can find here ), even after the crisis-related fall in interest rates. Equities from the healthcare and consumer staples sectors in particular should achieve good results in the future.

Capital market review: March 2020, which you can find here

In future, we will provide the key statements from our Capital Market Outlook from 3 years ago here so that you can get a feel for the quality of our long-term forecasts. The first FINVIA Capital Market Outlook was published on March 19, 2020. In it, we correctly predicted the following:

"As a result, there are very attractive opportunities for long-term investors on the stock market, regardless of whether the low on the stock markets has already been reached or not."

"... apart from cash, gold is now the only remaining medium-term risk-reducing form of investment that, unlike bonds, can also deliver a clearly positive performance in the long term."

"In the long term, both will lead to a more compartmentalized world in which higher inflation rates are likely to prevail."

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You can also download the capital market outlook here.