Economy, exchange rates, real estate and equities

Things look hopeless in Germany. Politics, bureaucracy, the economy, energy prices... - There are no recognizable solutions anywhere. Should we give up and emigrate, at least with our savings?

A look at the economic policy uncertainty index for Germany (chart 1, green line) does indeed look bleak. Even during the terrorist attack in New York in September 2001, the financial crisis in 2008, the euro crisis in 2011, the election of Donald Trump as US president, Brexit in 2016 and finally the coronavirus crisis from 2020, uncertainty in Germany was lower than it is today. In other major industrialized countries such as the USA, Japan and the UK, people are much less anxious. However, there are some indications that the situation is viewed too negatively in Germany and possibly too positively elsewhere.

Chart 2 shows the ranking of the Corruption Index in the major industrialized countries. This is where Germany can score the first points, as it is clearly in the lead here, although it does not quite reach the top of the class, Denmark (which has been in first place for years, chart 3). In a global comparison, all major industrialized countries perform quite well, while countries such as Russia, China and Hungary have been suffering from growing corruption for 30 years. Corruption goes hand in hand with a relatively low standard of living (Figure 4).

If we look at the economic outlook as measured by the OECD's Leading Economic Indicator (LEI, chart 5), Germany, the US and the UK in particular are on the rise again following the dip in sentiment in September 2022. In Japan, the economic outlook has not improved since then, but it had not fallen before either. The stock markets obviously believe in these forecasts, as they have risen sharply to date following the price declines until fall 2022 (chart 6). The German share index DAX, for example, has risen by 50% since September 26, 2022 (DAX at 12,114) to a level of over 18,000 today. A low in sentiment can therefore be a good time to invest.

In the USA, the fairly good economic outlook is a component of confidence on the stock market. Chart 7 shows the rather close correlation between the OECD LEI and the stock market in recent years; the correlation, which can range between +1 (clear correlation) and -1 (clear opposite correlation), was quite high at +0.63. In the years before that, however, it was much weaker with a correlation of only +0.24 (chart 8). In previous years, however, it was much weaker with a correlation of only +0.24 (chart 8). The OECD LEI is therefore only a weak argument for optimism on the stock market, especially as it is based more on qualitative (surveys) than quantitative data.

In contrast, the LEI of the US research firm The Conference Board (TCB), which was founded in 1916, consists of measurable data for the US economy that is ahead of economic developments. Examples include the US stock market, incoming orders in the consumer and capital goods industry, building permits for residential buildings, initial applications for unemployment benefits or the difference between short-term and long-term interest rates (interest rate structure). This TCB-LEI shows a slightly negative correlation (-0.05) for the last 7 years - especially since fall 2022, when the US stock market began to rise while the TCB-LEI continued to fall (chart 9). However, since this leading economic indicator had a much greater correlation with the stock market than the OECD LEI for 50 years from 1969 to 2018 (+0.73, chart 10), its sharp decline in recent years should be given more attention.

The TCB-LEI should also be taken into greater consideration when considering how reliable the leading indicators of the US economy are for future economic development. Chart 11 again shows the OECD's Leading Economic Indicator (LEI) for the US economy. Initially, this makes a good impression, as the red line before each grey bar, which represents the period of a recession, went downwards; recessions were therefore recognized in advance. Unfortunately, however, there were also several cases in which the LEI fell more sharply than before some recessions, e.g. in 1982 or 2008, without a recession following (chart 12, white bars). There were a total of 6 false signals, most recently in the fall of 2022, so the reliability of the OECD LEI is not particularly high.

The Conference Board's LEI for the US economy is much less hectic (chart 13). With the exception of the 1959 recession, it correctly predicted each of the 8 recessions from 1971 to 2020 with a decline of at least 4% before the start of the recession (chart 14). In contrast to the OECD LEI, there have otherwise only been 3 weak declines in the TCB LEI of a maximum of 1.8%. Since December 2021, however, this fairly reliable LEI has already fallen by a massive 14.1% by May 2024, without a recession having yet occurred.

The explanation for the astonishing resilience of the US economy lies mainly in the enormous national debt in the US, which rose from below 60% to over 120% of national income between 2000 and 2023, while the eurozone has been much more cautious, with national debt growing from 71% to 90% (chart 15). In the USA, government debt as a percentage of national income has been on average 5.4 percentage points higher than in the eurozone over the last five years (chart 16). This level of debt cannot be maintained in the long term. As a result, the US economy faces the considerable risk of a reduction in government deficits and thus a recession.

When a country becomes indebted abroad, e.g. the USA since the start of the financial crisis (chart 17), foreign lenders or investors have initially sold their own currency and bought US dollars in order to grant loans to US borrowers or buy assets in the USA. Accordingly, the exchange rate of the US dollar rises in purchasing power-adjusted terms during the net debt phase (rise in the blue line from 2006 onwards in chart 18). In such times, everything looks very good. The economy is growing because a large proportion of foreign credit is being spent domestically, the dollar exchange rate is rising and attracting more investors from abroad to buy US assets. If there is also an exciting story to be told (the armament of the US army to defeat the Soviet Union in the early 1980s, the internet developed primarily by US companies in the late 1990s and artificial intelligence today), the procyclical inflow of capital leads to high debt (charts 15 - 17) and an overvalued currency (charts 18 and 19; the euro, which is currently undervalued by around 16%, should appreciate by around 3% a year against the US dollar over the next 10 years - horizontal arrow in chart 19). The Japanese yen is also heavily undervalued against the euro and therefore also against the US dollar (chart 20). The same applies to the British pound (chart 21).

Finally, we examine whether real estate and equities in the major industrialized countries are correctly valued. Looking at house prices (chart 22) does not answer this question. Whether British residential real estate, which has achieved the highest increase in value in US dollar terms since 1970, is overvalued can only be determined if the development of per capita income is taken into account. Then a clear overvaluation of British residential real estate does indeed emerge, as, unlike in the USA, Germany and Japan, it has risen significantly more than the respective incomes (chart 23).

As the Americans have been collecting interesting data much earlier than other countries for many decades, there are numerous informative statistics on the US real estate market that provide a detailed picture of the real estate market. For example, based on actual purchases, house prices are currently at a record high (chart 24) and therefore not very attractive in terms of per capita income (chart 23), but in terms of the Affordability Index (chart 25). Since 1981, this index has measured house prices in relation to income, rents and mortgage interest rates and thus the feasibility of buying property, and was only lower than today in the 1980s when mortgage interest rates were significantly higher. Even before the severe real estate crisis in the USA from 2006 - the only period in which US house prices have fallen significantly in the last 50 years (chart 24) - the Affordability Index was not as low as it is today. However, the big crash should not be expected either, as the housing vacancy rate is close to its record low since 1957.

Real estate can be valued using the feasibility index; however, this is only available for the USA. In all cases, there is a measurable correlation between the costs of a property and its expected income. In the four countries surveyed, this is that when mortgage interest rates rise, the expected income also rises, which everywhere consists of the current rental yield and the expected rental growth. This is obviously formed from the average inflation of the last 10 years, as this results in a statistically close correlation with R² values between 0.66 and 0.86 (R² can lie between 0 (= no correlation) and 1 (exact correlation)).

A real estate market is overvalued if the current point for 2024 is below the dotted line, as in the USA and the UK. Accordingly, the mortgage rate in the USA is likely to be only 4.2% instead of 6.95% if the 45-year correlation still applies at the current yield expectations of 6.4% (3.6% rental yield plus 2.8% average inflation over the last 10 years) (chart 27). In the UK, the mortgage rate is even 3.6% too high (chart 29). In Germany, the real estate market is fairly valued (the red dot is almost exactly on the dashed line, chart 28), but considering that average inflation in Germany over the last 10 years was only 2.4%, this figure is too low as an estimate for future rental growth. The much-lamented housing shortage, the high number of immigrants and the almost 4% rise in real wages in the first quarter - the highest figure recorded since this time series began in 2008 (source: Destatis, June 2024) - suggest significantly higher rent increases, meaning that the German residential real estate market is likely to be undervalued. Japan is also fairly valued according to this valuation approach (chart 30). However, Japanese real estate has not been sensitive to interest rates below a mortgage rate of 4.6%; during the period of deflation following the 1990 stock market crash, real estate prices fell regardless of the low interest rate level until 2007 and then stagnated (chart 23, orange line). This market is likely to be very resistant to interest rate rises.

Chart 31 summarizes the overvaluation of British and American residential real estate, while in Germany the valuation is fair and in Japan very favourable.

Chart 32 shows that, with the exception of the USA, equities are more attractive than government bonds in the other countries.

As with real estate, the Americans also provide interesting data on equities that is not available anywhere else. Chart 33 shows the proportion of equities in the liquid investments of American private households. The US central bank in St. Louis has been storing this data since 1947. The share of equities is currently at a 77-year record high; even during the telecoms and internet bubble at the turn of the millennium, optimism was not as high as it is today. The return expectation for the next 10 years is correspondingly low, namely -4% p.a. with a rather high R² value of 0.68 (chart 33).

The earnings expectations shown in chart 32 are derived from our standard models for forecasting 10-year share performance, which is derived from the change in share prices relative to the change in dividends, gross earnings (cash earnings) and book values (companies' balance sheet equity). It is easy to see that the US equity market is valued almost as highly as at the turn of the millennium, while the other equity markets are valued below average and therefore have significantly higher earnings expectations (charts 32 and 35 to 38).

Conclusion:

The high level of economic policy uncertainty is understandable given the weak image of the German government and the difficult geopolitical situation in Europe (Ukraine war), but is exaggerated compared to the other countries under review, which also have problems (e.g. Trump candidacy in the USA). Germany is doing comparatively well in one key area, namely low corruption.

The economic outlook is probably less rosy everywhere than is generally portrayed, if you look at the Leading Economic Indicator (LEI) from The Conference Board, which has been very reliable in the US for 70 years. The LEIs calculated by this research company for Germany, the UK and Japan point to a further economic slowdown, just as in the US (source: The Conference Board, June 2024), albeit to a lesser extent. The special problem in the USA is the high level of new and total government debt, the reduction of which will place a considerable burden on the economy.

Accordingly, the currently overvalued US dollar should depreciate against the euro, the pound sterling and very significantly against the yen over the next 10 years.

On the real estate market, Japanese residential real estate is cheap and German residential real estate is fairly valued after years of falling prices and subsequent stagnation. Taking into account the very low level of new construction activity, high immigration and demographically induced strong wage increases, German residential real estate may even be undervalued. Residential real estate is too expensive in the USA and the UK, although prices in the USA are not about to plummet because the vacancy rate remains close to decades-long lows.

The picture on the stock market is similar to that on the currency market. US equities are very highly valued, while the equity markets in Germany, the UK and Japan are undervalued. Taking exchange rates into account, US equities and residential real estate are therefore currently unattractive for German investors. If you want to emigrate with your capital, you should at least not move it westwards at the moment.

‍

As usual, we will provide the key messages from our capital market outlook from 3 years ago here so that you can get a feel for our long-term forecasts.

You can find the capital market outlook from June 2021 here. As we did several times in 2020, we highlighted the generally underestimated inflation risks and came to the conclusion that share prices will nevertheless perform well because the high level of government debt should prevent interest rates from rising too sharply. In fact, the global stock markets have risen by 24%, European stocks by 12% and healthcare stocks by 25%. As a reminder, the war in Europe only began in February 2022.

‍

You can also download the capital market outlook here.