Recessions, capital markets and inflation

First came the surprising rise in inflation a year ago, then the Putin war, resulting in even more inflation and a significant rise in interest rates for the first time, and now there is also a threat of recession in many countries. At first glance, this does not look like a good environment for equities, but at second glance it does. We dare to take a second look here.

Fear of a recession is currently rising significantly (see chart 1).

In the US, which, unlike some European countries, has no war-related energy supply problems, fears of sharp interest rate hikes by the US central bank are increasing due to the rise in inflation to 9.1% in June. The interest rate structure (the difference between the interest rates on 10-year and 1-year US government bonds), which has been a particularly reliable early indicator of a recession for 70 years, has announced all 10 recessions in the US economy with an average lead time of 13 months (see chart 2). Only in the mid-1960s was there a false signal. In July 2022, the yield curve turned negative again at minus 16 basis points, as short-term interest rates rose sharply but long-term interest rates have already fallen again by 70 basis points since mid-June.

This raises the question of what reasonably reliable information is available on the impact of a recession on the capital markets, especially on the equity markets, which are particularly dependent on economic cycles.

To do this, we first show the schematic sequence of a recession (see chart 3). A recession usually begins with rising inflation rates due to a strong economy, which the central banks combat by raising interest rates, so that long-term interest rates also begin to rise and bond prices start to fall. This makes loans more expensive, which weighs on demand for goods. As a result, companies' sales suffer and at the same time their borrowing costs rise. As a result, profits become weaker. In addition, the attractiveness of bonds increases, so that more investors sell shares and buy bonds, which weakens share prices. Companies then reduce their capital expenditure and hire fewer workers. Increased fear of losing one's job causes consumption to fall further, so that eventually inflation rates fall due to falling demand and national income declines; a recession begins.

In practice, the trend is almost always comparable (see charts 4 a to c, where the average values of 5 recessions since 1974 in the USA and Germany and 3 recessions since 2008 in the eurozone are included). Initially, bond prices are weak, then the stock markets reach a low point before the economy reaches its low point a few months later.

The low price losses on the bond markets are due to a number of recessions that were not caused by economic factors (2nd Iraq War in 2003 or the coronavirus crisis in 2020) and were therefore not triggered by rising interest rates. What all recessions have in common, however, is that the stock markets rise again even before the economy reaches its low point and, from their low point to the economic recovery in the three quarters following the economic low point, have generated price gains of 23% to 64%, on average 45%, in less than 15 months (chart 5).

It is therefore not advisable to sell shares in view of the current difficult economic situation, especially as there are a number of indications that inflationary pressure will ease (see also the June 2022 Capital Market Outlook, which you can find here ). The inflation rate falls significantly before and during a recession (see charts 6 a to c, which show the inflation rate per quarter).

On average, the annualized inflation rate falls by more than 3 percentage points during a recession (see chart 7).

We are therefore already in a particularly interesting part of the economic cycle for equities (see chart 3). The first interest rate hikes by central banks have already been enough to trigger fears of a recession, even in the US (see chart 2), which does not have the energy problem of some European countries. As a result, many investors have started to buy "safe" government bonds since mid-June, although interest rates everywhere are still far below the current inflation rate. Accordingly, bond prices are already starting to rise, in the eurozone also because the ECB considers Italy's financial stability to be at risk even at an interest rate of just over 4% for government bonds and has started to consider renewed bond purchases.

Share prices have already fallen sharply. However, even if a recession were to occur, the price opportunities for equities are very good even before the economy reaches its low point (charts 4a - c, chart 5), especially as bonds with negative real interest rates of 6.5% in Germany and 6.3% in the USA remain extremely unattractive and do not represent any competition for equities. This is because equities are very cheap in Germany and Europe (see charts 8a, b) and in Europe, with significantly lower gas supply risks compared to Germany, they offer high expected returns of 10% p.a. (chart 8b). German equities have even become so cheap due to the risks of high dependence on Russian energy commodities that they have even higher expected returns of 12.5% p.a. (chart 8 d), although the quality of the forecast model is only average.

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Investors around the world are also very pessimistic; as in May, the managers of the major equity funds held a higher proportion of fund assets in cash in June 2022 (6.2%) than at any time in over 20 years. The professionals' great pessimism was followed by an equity performance that was more than 6 percentage points above average in the 12 months since 2000 (see also the June 2022 Capital Market Outlook, which you can find here ).

In the USA, in addition to the risk of recession due to interest rate hikes, there are other inflation-reducing developments. The European Central Bank is much more hesitant to raise interest rates than the US central bank, which has made the dollar more attractive. The dollar is also appreciating against the yuan. In China, interest rates are not being raised at all. There is a reason for this. The Chinese real estate market is extremely expensive and has the lowest rental yields in the world (chart 10).

The Japanese also inflated their real estate market in the 1980s (chart 11 a, see also the reasons for this in the Capital Market Outlook from October 2020, which you can find here ). The collapse in real estate prices from 1990, around the year when the proportion of the working-age population peaked, was exacerbated by the sustained decline in this population group, which forms the overwhelming majority of property buyers. In China, the number of potential property buyers is also beginning to fall; the real estate market there will cause major problems for years to come - developments similar to those in Japan after 1990 cannot be ruled out (Figures 11 b and 12 a and b).

Using Japan as an example, the following charts show the pressure on government debt and interest rates following the bursting of a real estate bubble up to the present day. After losing the Second World War, Japan largely got rid of its national debt through rapid, brief hyperinflation (see chart 12 a). By 1990, the peak of the real estate bubble, government debt had risen again to a level of 60% of national income, which was also the case in the USA at the time. In 1990, interest rates on 10-year government bonds in Japan were 7.5%, the last time they were at a similar level to those in the USA (8%, see chart 12 b). Japan's government debt then exploded from 60% to 260% of national income because the state had to bail out the banks. The banks had financed masses of overpriced real estate with rental yields that were often less than 10% of interest costs. The borrowers constantly needed new money to pay the interest on the loans, as there was hardly any rental income. In line with the rule that a highly indebted state needs and receives low interest rates, interest rates fell below 2% as early as 1997 and below 1% from 2012, to practically zero since 2016.

In the meantime, Japan's debt-related inability to raise interest rates has led to a significant increase in the interest rate differential with the US, causing the dollar to appreciate by 20% against the yen since February 2022 (chart 13).

However, as inflation in Japan has been much lower than in the US over the last 12 months, the yen should have appreciated. As a result, the yen is now undervalued by a record 40% against the US dollar (chart 14 a). The US central bank's very moderate interest rate hikes in relation to inflation have therefore caused the yen to fall sharply alongside Italian government bonds.

The € has also lost 10% against the dollar since the outbreak of the Putin war, the British pound over 10%, the Chinese currency 6% etc.. This strong appreciation of the dollar is having a deflationary effect on the US economy and will soon give the US central bank pause for thought.

In the longer term, however, the Japanese yen (chart 14 b) and the € should appreciate against the US dollar, for example; investments in € or yen will therefore become more attractive.

Conclusion

Overall, the probability of a recession is now just over 50%, even in the more robust USA. Nevertheless, the future prospects for equities are already quite good for the next 1-2 years, as the best time to buy shares is not at the low point of the economy, but a few months before. Now could be such a time because investors worldwide are very pessimistic and equities are valued accordingly low, which also points to good long-term prospects for equities.

The sharp rise in inflation over the past year has also worried investors. However, there are growing indications that inflation rates are likely to have peaked soon. Inflation has been driven in particular by the sharp rise in energy commodity prices (oil, gas), but a high oil price has in the past been accompanied by falling oil prices in the long term, because in such a situation consumers, companies and the state take measures to sustainably reduce demand, and these have always been successful. In addition, a recession would be another inflation-reducing event.

After all, fears of drastic interest rate hikes by central banks to combat inflation are currently receding. Problems are beginning to emerge in the highly indebted global financial system. The ECB became nervous in June when the interest rate on Italian government bonds rose above 4% and announced measures to combat excessively high interest rates in the weaker eurozone countries. Since then, long-term interest rates in Italy have fallen by 70 basis points. Interest rates have also fallen by a similar amount in other European countries and the USA. Only highly indebted Japan had to leave long-term interest rates close to zero. As a result, the exchange rate of the Japanese yen collapsed. The euro and even the Chinese currency also fell significantly against the US dollar. This is likely to increase the strength of the dollar in the US, weighing on the economy and depressing inflation. The US central bank will have to keep an eye on this development in its interest rate policy.

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You can also download the capital market outlook here.