War and capital - then and now

Even if the Putin war is not yet over, there are increasing signs of how it will end. First of all, we can see from the financial data that Russia will be one of the losers. Even a military victory would be bought with such high human and economic losses that it would be tantamount to defeat.

During the Second World War, the prices of the government bonds of the losing states collapsed - losses amounted to almost 100% (see chart 1a below left). Since fall 2021, the start of the Russian troop deployment on the Ukrainian border, the prices of long-term Russian bonds have already almost halved.

‍

Since then, Russian shares have lost 87% in € terms (chart 2) until trading in Germany was halted on March 4, 2022. Coincidentally, this corresponds exactly to the share price losses of the three losers of the Second World War - Germany, Japan and Italy - at the end of 1945 (chart 1b). The stock market has therefore already spoken its verdict.

There is also growing evidence of Russia's military failure. The study "How the Weak Win Wars" by Ivan Arreguin-Toft (Harvard College and MIT, 2001), which is well worth reading, uses 197 wars since 1800 to show that and why wars are increasingly being won by the weaker side.

The main reason for this is that the stronger party sets the strategy and the weaker party can choose the appropriate response. In the case of the strategy chosen by Russia of a direct attack on the Ukrainian capital Kiev, the response of the far inferior Ukrainians to wage a guerrilla war was exactly right, because they are fighting in their own country, the entire population supports their own people and modern portable weapons systems give guerrilla fighters a fairly high fighting force. The Russian soldiers are much less motivated because they don't know exactly why they are waging war against Ukraine. In addition, the stronger side is often hampered by the fact that "public opinion" (in democracies) or the "elite" (in dictatorships) pushes for an end to the conflict if the war is not progressing satisfactorily; unlike the weaker side, war is not necessary for the other side's survival.

In any case, the Putin regime lacked any legitimacy long before the war. In 1992, after the dissolution of the Soviet Union, Russia, with its vast reserves of raw materials, was the richest successor state to the Soviet Union and its former satellite states in terms of per capita income in US dollars, ahead of Hungary and Estonia. 28 years later, prosperity has at least doubled in all states that have subsequently joined the EU (see chart 4 below), while the majority of wealth accumulation in Russia has obviously taken place among the "elite" oligarchs in the form of yachts and luxury villas abroad. There is therefore a certain probability that Putin will lose the support of the population, without which even a dictator cannot manage in the long term. The collapse of the Russian economy as a result of the war will massively weaken his position in the future.

Russia's military spending is only high in relation to its economic output (chart 5a), which was already only twice as high as Switzerland's before the war: in absolute terms, even Germany will surpass Russia after the implementation of the target of spending 2% of national income on defense. In any case, the country cannot keep up with the world powers USA and China (Figure 5b); after this war, it will have to cut defense spending. The Soviet Union's attempt to keep up with NATO's rearmament following the Red Army's invasion of Afghanistan in 1979 led to the economic collapse of the Eastern Bloc from 1989 onwards. For Russia, one can only hope that Putin will not repeat this mistake.

The only moderate price losses on the international stock markets to date correspond to the share price development during most wars that were dangerous for the Western energy supply (chart 6 below, example USA). Only the first oil crisis in 1973 led to a sharp fall in share prices worldwide (USA, Germany over 40% loss, UK even over 70%). However, the reason for this was more the surprise effect and the high interest rates at the time, as well as the fact that, after a slight slowdown in growth in the late 1960s, many countries experienced a slump in economic output for the first time since the Second World War.

More important are the global political structures, which have a favourable effect on globalization and thus inflation when a single business-friendly world power dominates. This was the case with Great Britain after the Napoleonic Wars until around 1880 (see chart 7). International trade declined (deglobalization) when the USA, and later Germany and Russia, surpassed Britain's economic power and adopted their own global policies (multipolarity), which led to the First World War (1914 to 1918) and only ended after the Second World War (1939 to 1945).

Multipolarity not only means higher government spending on armaments, but also suboptimal supply chains with increased development of production facilities within the economic bloc to which one belongs. This creates state and private investment as well as additional demand for intermediate products and labor, which are already in short supply. Their price rises, but in return there is more certainty that the required products will be available. This development leads to higher inflation rates in phases of multipolarity.

After the end of the Second World War, there was a gradual increase in globalization, followed by an accelerated increase after the opening of China in 1978 and the collapse of the Eastern Bloc in 1989, combined with a decline in inflation rates that was only interrupted by the oil crises of the 1970s.

Since the weakening of the USA and Europe as a result of the financial crisis and the rapid rise of China, a new phase of multipolarity began in 2009. Since then, China has been creating its own sphere of influence in the Far East and beyond (Silk Road project). Since Putin came to power, Russia has also been pursuing a militarily supported power policy with the aim of building up a belt of dependent satellite states, but this has not met with approval from its neighbors due to the economic incompetence and corruption of the Russian regime. As a result of the coronavirus crisis, the US and European governments had to sharply increase the money supply in order to avoid company bankruptcies and unemployment as far as possible. Due to the sudden difficulties in obtaining all the necessary raw materials and supplier products such as chips at all times, companies had already made significant changes to their supply chains before the war. Now, particularly in Europe, it has become necessary to switch energy supplies, which means a renewed push towards deglobalization and further increases in inflation rates for several years.

The incentive for Europe to make inflation-driving changes to supply chains, accelerate the energy transition and increase arms spending would be less strong if it could rely on the US as an order-creating world power. In fact, the US government has so far behaved strategically and tactically cleverly in the Putin war, but in view of the polarization of political forces taken to extremes by Trump (see chart 8), unfortunately no one can rule out the possibility that a similarly structured figure or even Trump himself will win the presidency again in two years, especially as President Biden also has domestic political problems due to inflation.

However, the two world wars and the subsequent Cold War have greatly reduced the differences in basic political convictions; the USA was a reliable partner for Europe for decades. The Putin war has also had the same effect; the Republicans suddenly support the Democratic President Biden with a large majority. So if the long-term scenario of a cold war between the USA/Europe/Japan, Australia, South Korea and New Zealand on the one hand and China with Russia and some smaller states on the other becomes a reality, America is likely to become the reliable partner it has become used to.

We now look at the consequences of this sudden change in the global political situation for the capital markets. The sharp rise in oil prices and the higher prices for other commodities and supplier parts such as chips have caused producer prices in Germany (the prices of the products that companies have to buy in order to manufacture their goods) to rise by a record 30% (see chart 9a), i.e. a fifth of the oil price increase. In previous phases of rising oil prices, their impact was significantly weaker than in 2022 (see chart 9c).

Consumer prices are following producer prices, whose sharp rise has triggered the surge in inflation from below 0% in the second half of 2020 to currently 7.3% (chart 9b top center).

Food prices have also been strongly influenced by the development of energy costs, as represented by the oil price, for decades (see chart 10a and b) and have recently risen sharply.

In addition to the rise in petrol and diesel prices, this is having a particularly noticeable impact on consumers' wallets, so it would be illusory to assume that wage increases will remain weak. The trade unions are likely to enter the next wage increase negotiations with demands that, as usual, will be higher than the inflation rate (see chart 11a). This means that, after the USA, another driver of inflation in Germany, namely the difficult to combat wage-price spiral, will soon be a reality, even if oil prices fall again after the end of the Putin war.

In addition, the political situation in the poorer parts of the world is likely to deteriorate even after the end of the war due to the sharp rise in food prices (see chart 11 b). Sowing in Ukraine, the former "breadbasket of Europe", which is now an important supplier to North African countries, is failing in large parts of the country this spring.

In addition to the inflationary pressure caused by oil price and future wage increases, the growing government demand for military equipment, particularly in Europe, is also having an impact (chart 12 a). Companies whose machinery has reached a record age since the period after the Second World War (chart 12 b) due to weak investment in recent years - not only in Germany, but also in former crisis states such as Greece and Italy - must also increase their investment spending. However, this will not only stimulate inflation, but also economic demand.

A decline in national income in two consecutive quarters (recession) is not yet likely, at least in the US. With the exception of 1966, an inverse interest rate structure (short-term interest rates > long-term interest rates, see the red circles in chart 13) has always preceded a US recession by an average of 13 months in the last 70 years. In the eurozone, such a development is only imminent if imports of Russian energy commodities are stopped completely.

‍

In addition to the non-permanent rise in energy prices, the following factors are now having a lasting impact on inflation:

- Increasing shortage of labor due to the aging population, which will also further increase government debt and reduce the ability of central banks to fight inflation (see capital market outlook from March 2022, which you can find here )

- Deglobalization through multipolarity

- Accelerated energy transition and upgrading, growing need for investment by industry (stronger in Europe than in the USA)

- Wage-price spiral

‍

Inflation expectations on the capital market in the USA are 2.9% p.a. for the next 10 years. Due to the long-term inflation risks resulting from the changed global political situation, we are now again setting our global inflation expectations at 3.5% p.a., which is higher than the average expectation on the capital markets. In Europe, there is also the increased need for investment in upgrades and the energy transition, meaning that the inflation rate across Europe should at least match the US figure in future.

Moreover, the ECB's ability to combat inflation by raising interest rates is much more limited than that of the US central bank, even though the US has very high government debt (chart 14 a). However, equally highly indebted eurozone countries such as France and Italy already spend 62% (France) and 57% (Italy) of their national income on public spending. These figures, known as the public spending ratio, mean that these countries already have to pay very high taxes on private households and companies; tax increases are virtually impossible. The Americans, on the other hand, manage with 46% (Figure 14b); they could therefore still raise taxes considerably and have to spend less on armaments and the energy transition.

Sustained high inflation rates have a positive effect on gold and residential real estate, but not immediately in either case.

For residential real estate, the yield expectation for the next 10 years is in the upper single-digit range (Figure 15) as long as real interest rates remain negative, i.e. the government bond interest rate in Germany (currently 0.68%) remains below the inflation rate (currently 7.3%).

In the short term, house prices could react negatively to the sharp rise in mortgage interest rates in recent months. A model calculation for an average apartment with a price of € 400,000 in March 2019 compared to the same apartment in March 2022 (price € 525,000), each financed with € 120,000 equity, results in an increase in the monthly burden from € 1,050 to € 1,690 today and thus an additional burden of € 115,000 extrapolated over 15 years (source: Manager Magazin online, April 2022). This may currently deter buyers, but in March 2019, wage increases were around 2% (chart 11a) and inflation was not an issue. Even if the wage increase over the next 15 years is only 4%, the cumulative total income over this period will be €127,000 higher than with an annual increase of 2%. In the short term, the rise in interest rates disrupts the residential real estate market, but in the long term, the effect of high inflation via wage increases is stronger than the current rise in interest rates.

In the case of the gold price, the clearest statistical correlation between inflation and the trend-adjusted gold price is found when the average inflation rate of the last 7 years is used. Investors therefore obviously regard this figure as the best estimate for future inflation (chart 16 b).

Even with an inflation rate of 3.5% p.a. over the next 10 years, the price of gold could therefore continue to rise significantly (chart 16a).

Overall, gold will clearly benefit from inflation rates that are likely to be significantly higher than in the past in the long term. For equities and residential real estate, the decisive factor is whether interest rates remain significantly below the inflation rate over the next 10 years, which we believe is the most likely scenario. If this is the case, the return expectations for these investments shown in Figure 17 are rather too conservative. As usual, private equity funds will perform significantly better than equities in such an environment, especially as the loans that fund managers work with remain cheap.

As long as investors' inflation expectations for the next 10 years remain unrealistically low at 2.9% p.a. in the USA and 2.5% p.a. in the eurozone, one should limit oneself to the inflation-linked variant of bonds. Normal bonds will certainly produce significant losses in real terms.

‍

‍

You can also download the capital market outlook download it here.