Politics, the economy and the capital market - the current situation in the major regions

"They never come back" supposedly applies to the world champions in heavyweight boxing. With one exception, this rule also applies to world powers. The exception is China. The country has already been ousted from the top spot by Rome, by the Mongols and most recently by the USA (see chart 1a), but each time the Chinese have managed to work their way back up to become the leading power. This time we examine the question of whether the Chinese will succeed in overtaking the USA and Europe, including on the capital market.

China's rise over the last 50 years has been due in part to a successful focus on education in the fields of mathematics and science (see chart 1 b). This has enabled China to catch up technologically with the western industrialized nations.

Now, however, there are increasing signs of fatigue. A few years ago, the Communist Party began to further restrict the already limited freedoms of the Chinese (Figure 2 a). The government is presumably increasingly afraid that it will no longer be able to keep its pact with the population. This consisted of the fact that the Chinese were happy to forego their right to have a say as long as their prosperity increased sharply year on year.  

However, since the 2008 financial crisis, this has only been increasingly successful because the share of the construction and real estate industry has often reached 30% of national income, a figure that only Spain achieved in the two years before the financial crisis. In Germany and the USA, this figure always remained well below 20%, usually barely more than 15% (see Capital Market Outlook from November 2021, which you can find here ). Construction work increases national income particularly strongly in the short term, but only in the long term if the buildings are also needed and generate income. With 65 million vacant apartments and an even larger number of apartments that have been sold and paid for but not completed (see capital market outlook from September 2022, which you can find here ), this condition is not met. Vacant properties will cause the construction industry to shrink for years and debt in China to rise. As a result, the gigantic cement consumption in China (see chart 2 b) is likely to fall sustainably. As cement production is very energy-intensive, China has accounted for more than 50% of global energy consumption for years (chart 3 a). In future, China's declining demand for energy raw materials could have a dampening effect on their price level.

This development would help the European economy. It is already particularly energy-efficient - with 1 gigajoule of energy, Europe generates four times as much national income as China (see Figure 3 b). However, Europe is suffering particularly from the energy crisis caused by the war due to a lack of its own reserves of energy resources and an insufficient number of plants for generating renewable energies.

This will not last forever. Shortly after the start of the war, we explained in our capital market outlooks from March(here) and April 2022(here) why Putin's war may well end in a Russian defeat (see chart 4), but will at least massively weaken Russia in every respect. Gradually, the Russian elites and population seem to be realizing this. In any case, the probability of peace within the next 12 months is increasing. Europe would be the big economic winner. If a new Russian leadership opens up to the West again, Russia would also benefit. Perhaps this actually banal realization will soon mature there too.

The Putin war has also brought about a turnaround in the hitherto particular political and strategic weakness of the Europeans compared to China and the USA, who plan for the long term. After the Russians' first war against Ukraine in spring 2014, the latter strategically recognized that Ukraine had to be prepared for further attacks and implemented this with training and armament. The Europeans, on the other hand - with the Germans at the forefront - have become even more dependent on Russia in complete strategic blindness, against the advice of the Americans. To Putin's surprise, however, the Europeans changed their tune within a few days after February 24 and decided on considerable sanctions against Russia and arms deliveries to Ukraine. Fortunately, Europe is no longer a strategy-free zone.

Falling gas prices are also helping European equities, especially German equities, which were particularly hard hit until August. Their strong underperformance compared to US equities ended with the turnaround of the gas price explosion in August (chart 5 a, note the reverse scaling of the red line). The fall in gas prices also heralded the end of the euro's weakness (chart 5 b).

Despite this slight recovery, the euro is still undervalued by 18% against the US dollar compared to the purchasing power trend since 1980 (chart 6 a) and is likely to appreciate by an average of 4% p.a. over the next 10 years. A stronger euro makes European equities attractive for US investors and is likely to generate corresponding demand. However, one should not make the investment strategy too dependent on the European gas price, as this has certainly also fallen due to the relatively warm weather in Europe, which has had a decisive influence on gas consumption to date (chart 6 b).

However, as other important commodities and costs have already fallen significantly from their peak prices, such as the oil price, which has already fallen again by 25% (chart 7 a), the copper price, which has also fallen by 25% since the start of the war, or the container freight cost index, which has fallen by as much as 70% and has been followed by the US inflation rate with a four-month time lag for several years (chart 7 b), the situation on the inflation front is likely to ease further. Europeans in particular will benefit from this. This is also good news for the economy and the capital markets in the USA and China, where the inflation rate has fallen back to 2.1%.

This brings another current European advantage into focus, namely the low level of interest rates. The European Central Bank raised short-term money market interest rates significantly later than the US Federal Reserve (see chart 8 a). As a result, interest rates for long-term mortgage loans are also lower in many European countries, e.g. Germany, than in the USA. The reason for the low interest rates is not lower inflation rates. These are far higher in the eurozone at 10.6% or in the UK at 11.1% than in the USA at 7.7%. However, high money market interest rates can do little to counter high energy prices, which the ECB has correctly recognized. The highly indebted Italian state or the even more indebted French economy as a whole are also less able to cope with high interest rates than the US economy.

The Americans had pumped far larger sums into the economy to support the economy during the coronavirus crisis than the Europeans (chart 9 a). This resulted in a massive boom in consumption in the US, while government funds in the eurozone were only able to prevent a major slump (chart 9 b). In the future, consumption in the USA could be significantly weaker than in the eurozone, where there is more of a need to catch up.  

Europe has also done too little compared to the US in terms of corporate investment in equipment (chart 10 a) and military spending (chart 10 b). The need to catch up in these areas also has a growth-promoting effect.

In the USA, on the other hand, there is considerable pent-up demand in the residential real estate sector. Little has been built since the financial crisis (chart 11 a). As a result, the average age of US residential real estate is as high as it was last in 1945 (chart 11 b), when investments had to be made in armaments instead of residential construction due to the Second World War.

In Sweden, on the other hand, a great deal has been invested in new buildings (chart 11 a), so that the real estate market has reacted quite strongly to the interest rate increases (chart 12 a). Unlike in China in particular (or in Sweden), the real estate market in the USA and the eurozone will not have a lasting negative impact on the economy. Due to the low level of new construction activity in both regions, vacancy rates are also extremely low, meaning that rents will continue to rise in line with the higher wage increases caused by inflation and support the currently somewhat declining prices.

One of Europe's structural weaknesses is its much higher government spending ratio compared to the US (chart 12 b), which stands in the way of higher economic growth in Europe due to the usually inefficient government spending. It is no longer possible to measure China's government share precisely, as many companies are under increasing state influence and foreign companies now also have to provide premises for members of the Communist Party. These are preferred for negotiations with government agencies; a very dangerous development for the attractiveness of China as a business location. Demographic trends are also very negative in China, slightly negative in Europe and only positive in the USA in the long term (see capital market outlook from February 2022, which you can find here ).

The outlook for the stock markets is very mixed in this environment. Due to the sustained slump in the residential real estate market in China and significant interventions in the business models of Chinese internet giants (Alibaba, Tencent, Ping An) and other companies, e.g. in the education sector, the Chinese stock market has lost around 40% since last fall, although it was not expensive at the time. In addition, China's rigorous coronavirus policy has damaged the economy. One of the reasons for the frequent lockdowns in China is the refusal to use Western vaccines, e.g. from Biontech, which are more effective than Chinese vaccines. This means that there is a greater risk of considerable economic damage and strain on the population than admitting that Western companies have developed a better product.

As recently as last fall, 74% of future 10-year returns could be explained by the price/book value ratio (chart 13 a). Since then, however, the performance of Chinese equities has been far lower than predicted by the model. In October 2022, the average annual return over the last 10 years was just under 4% p.a. instead of over 10% p.a. (chart 13 b, bottom red dot). Chinese equities were therefore over 40% lower in October 2022 than they would have been under unchanged conditions. The changed factor is China's hostile economic policy. China's economic weakness is also having an impact on interest rates, which barely moved even in 2022, when interest rates on 10-year government bonds rose sharply in Europe and the US (chart 15 a). Chinese interest rates are therefore now lower than US interest rates (chart 15 b) and barely higher than in most eurozone countries. The sharp rise in the interest rate differential between the US and China has weakened the yuan's exchange rate against the dollar by over 10% (chart 15 b). As the strains on the Chinese economy will continue, particularly in the important real estate sector, while the outlook for Europe is brightening, the yuan could also weaken against the euro over the next few years.

European equities are valued on average (chart 14 a) and thus achieve expected returns of almost 9% p.a. (chart 14 b).

US equities are highly valued, but not extremely expensive (chart 15 a), with expected returns of 6.5% p.a.

Overall, China is only in third place in many areas of the economy and particularly at the political level. Instead of purely politically motivated and incalculable interventions in the economy, China would once again need reformers of the caliber of the father of the Chinese economic miracle, Deng Xiaoping, to work its way out of its major problems. Xi Jinping is now the wrong man for China's future. Although earnings expectations on the Chinese stock market are quite high, the predictability of Chinese stocks is very low. Military adventures would be another huge burden for China, but even Xi Jinping should draw the right conclusions from Putin's experience.

The USA, which was hardly affected by the energy crisis, is doing quite well overall. Although the above-average interest rate level is a burden, it is also a sign of a certain strength. In the long term, the strength in the technology sector will help, as will the current incentives for industrial investment due to the new Inflation Reduction Act.

Europe will benefit considerably if the current burdens in the energy sector can be resolved, which is quite likely in the medium term. The other conditions for positive development are good.

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