Recessions, debt and capital markets

The risk of a recession is increasing from the fall of this year, particularly in the US. Employees of the US central bank are now also expressing this opinion (source: Bloomberg, 13.4.2023). Europe is not safe from a recession either. In this environment, government debt will continue to rise. This will further reduce the already limited willingness of governments and central banks to combat inflation through high interest rates. The long-term impact of these developments on the capital markets is today's topic.

In March, the crisis triggered by rising short-term interest rates at a number of smaller regional banks in the USA and the demise of the major Swiss bank Credit Suisse triggered a significant fall in interest rates for short-term government bonds worldwide. The central banks and governments in Switzerland and the USA had bailed out the creditors of the affected banks with hundreds of billions of euros, thereby halting the spread of the crisis. It was then generally expected that the current interest rate hikes by central banks would soon come to an end in order to eliminate the cause of the banking crisis. With the expected end of interest rate hikes, many believed that the risk of recession would also diminish. In last month's Capital Market Outlook, which you can find here, we explained why we continue to expect a recession from fall 2023 and have increasingly focused the equity allocation in our client assets on cyclically resistant equities.

Since then, short-term interest rates in the USA have once again risen more sharply than long-term rates and the interest rate structure in the USA has moved even deeper into inverse territory (chart 1). Short-term interest rates exceeded long-term rates for the first time in July last year (red circle on the far right). For 70 years, this has been followed by a recession on average 13 months later (exception: 1966).

For at least 50 years, a recession in the US has led to rising government debt (chart 2), as the US government, like Japan or the European states, has mitigated every economic crisis since then through financial government aid. This generosity was increasingly facilitated for the state by the fact that interest rates had fallen to 0.5% by 2020, when 25% of national income was spent on corona-related financial aid (source: BCA, Dec. 2021) (chart 3).

However, this money is not returned to the treasury after crises, which means that debt continues to rise. In 1981, the USA had a debt of USD 1,016 billion or 31.7% of national income (see chart 2) amounting to USD 3,207 billion (source: www.macrohistory.net, database by Prof. Schularick, 2023). In March 2023, debt had risen to 30 times its 1981 level, namely USD 31,500 billion, while national income had only risen 7.6 times (source: Trading Economics, 2023). Overall, the financial aid has therefore cost far more money than the economy, which grew again after the crisis, has brought in in tax payments, also because, unlike until 1945 (end of the costly Second World War), the top tax rates have even been reduced slightly since 1982 as government debt has risen (chart 4). At 7% of national income in 1945, corporate taxes also made a significant contribution to the restructuring of public finances; currently, corporate taxation is surprisingly low at 1.1% of national income (chart 5).

These developments are the reasons for the sharp rise in national debt in the US. In the long term, US tax rates for companies and top earners will have to rise.

The national debt is likely to generate enormous interest costs in just a few years' time. So far, the interest costs for the gigantic mountain of debt are surprisingly moderate, namely less than 2% of US national income in 2022 (blue line in chart 6, figures directly from the US Federal Reserve). Interest costs also remained below 2% of national income in 1980. By 1985, however, they had already risen to 3% of national income. The new government bonds required to finance the new debt and to redeem older government bonds that had fallen due had to be issued at higher interest rates due to the high interest rates at the beginning of the 1980s (chart 3). If the interest rate level of US government bonds (4.8% for 1-year bonds, 3.6% for 10-year bonds, i.e. currently around 4%) remains constant over the next few years, interest costs will rise to an unprecedented 5% of national income (chart 6, bottom blue dot). If an interest rate of 7% is allowed to combat inflation, interest costs would rise to an unsustainable 9% of national income in a few years (chart 6, upper blue dot). The difference to today's interest costs (just under 2% of national income) would correspond to twice the value of total US military expenditure in 2021 (3.5% of national income, source: SIPRI Military Expenditure Database). During World War II, the US national debt had risen to similar levels as today (chart 7), but interest rates were consistently kept at around 2%. This means that interest costs as a percentage of national income could hardly have been higher than 2%, as the national debt only briefly exceeded the 100% mark and had already fallen back to 78% by 1951.

Even with interest costs of 3% of national income, government debt in the US grew faster than national income from 1982 onwards (chart 8, red line). From 2000, debt growth was under control for a few years; the reason for this was the US stock market boom at the end of the 1990s, which led to high tax revenues from realized capital gains and thus enabled surpluses in the national budget for a few years (chart 9). Since this brief episode, government debt has once again risen much faster than economic output. Rising interest costs will accelerate this trend in the future.

The fundamental problem of the heavy burden on public finances due to high government debt, even at moderate interest rates, can be illustrated particularly well using the example of the USA, as the best statistics are available there. We will face similar problems in Germany (and many other countries). From 2019, Olaf Scholz, in his role as Finance Minister, has hardly allowed any longer-dated German government bonds to be issued during the period of negative interest rates (chart 10), meaning that a significant proportion of bonds with negative interest rates are already maturing and will have to be replaced by newly issued bonds at much higher interest costs.

However, the risk of rising tax rates is lower in Germany than in the US for the time being, as German corporate tax rates are quite high by international standards (Figure 11) and the top income tax rates are also significantly higher than in the US. Even with a gross income of € 62,810, approximately 1.5 times the average income, you pay 42% tax in Germany, from € 277,826 45% (source: Wikipedia), including the solidarity surcharge it is then almost 48%.

The following charts show the growing importance of the debt problem. Firstly, we see the debt of the major economies in 1980 (chart 12) at the end of the phase of rising interest rates (chart 3). In the meantime, debt has risen massively everywhere (chart 13).

It is particularly worrying that in the very highly indebted countries of Japan, France and, more recently, China, debt growth in the last three years, i.e. the period of various crises (coronavirus, inflation, war in Ukraine, growing decoupling of Western nations from China and Russia), has amounted to between 30% and 45% of national income (chart 14). Interest rates were extremely low everywhere until the beginning of 2022 (for example in the USA, chart 3, or in Germany, chart 10). Other countries overcame the crises with a comparatively moderate increase in debt of around 15% of national income.

The decisive conclusion of these figures for the capital markets is that the rise in interest rates in conjunction with the high and growing mountain of debt will ensure that in future, more and more highly indebted countries will no longer be able to cope with rising interest costs without the help of their central banks.

There is also a growing risk of recession in the eurozone. The European Central Bank (ECB) calculates money supply growth for eurozone members back to 1981. The eurozone money supply had never shrunk until the beginning of 2023, but this has changed since January 2023 (chart 15a). The real money supply (adjusted for rising consumer prices) is even shrinking massively (chart 15b). There have already been three slight declines in the real money supply, each time followed by a recession.

However, the situation in the eurozone is significantly less dangerous than in the USA. Eurozone governments have spent significantly less money during the coronavirus pandemic than the US (chart 16).

This is another reason why government debt in the eurozone as a whole, at 91.5% of national income, is significantly lower than in the USA (129% of national income, source: Trading Economics). This means that the risk of rising interest rates for government budgets in the eurozone is much lower than for the USA (chart 6), because in addition to government debt, interest rates in the eurozone are also lower than in the USA (for 10-year government bonds at the end of March 2.5% instead of 3.5%, on the money market 3.5% instead of 5%, source: Refinitiv). The lower level of government debt is one reason why banks in the eurozone are now much more solid than US banks. They have been able to reduce their bond holdings considerably, while US banks have bought more bonds (chart 17). Price losses (due to rising interest rates) on bonds held by banks were the cause of the crisis at some small banks in the US in March. Another reason for the lower risks in the eurozone banking sector is the stricter regulation compared to the US, which has meant that the core capital ratio of banks (an extended definition of equity) has risen much less in the US than in the eurozone since the financial crisis from 2008 (chart 18).

In view of the long-standing shortfall in tax revenues (charts 4 and 5) and the huge expenditure during the coronavirus crisis (chart 16), the US has had to borrow more and more abroad since 1990 (chart 19). Here, too, higher interest costs will be a considerable disadvantage in the future, as more and more money will flow abroad as a result.

Against this backdrop, the US dollar, which is currently still 14% overvalued against the euro (chart 20), is likely to depreciate against the euro over the next 10 years (chart 21) by around 3% p.a.

This should also put an end to the strong outperformance of the US stock market, whose prices have risen two and a half times as much as the European stock market in € terms since 2007. For 16 years, US equities have benefited from a strong dollar (chart 22), but the boom in technology stocks has also made a significant contribution to US outperformance.

As a result, however, the valuation of US equities has risen much more sharply since the financial crisis (chart 23) than the valuation of European equities (chart 24), namely to three times the 1974 value (in Europe only two times). Accordingly, our expected return in the USA is now only 3% p.a. (chart 25), compared with 8% p.a. in Europe (chart 26).

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In view of the potential economic problems, we should continue to be overweight in the cyclically resilient healthcare and consumer staples sectors (see capital market outlook from March 2023, which you can find here ). As the companies in these two sectors also have above-average balance sheets, they should also be largely immune to rising interest costs. In general, a neutral equity allocation should be maintained at present, with the US equity market significantly underweighted in favor of Europe and the emerging markets in particular.

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Finally, our key statements in the Capital Market Review of April 23, 2020, which you can find here :

• Bond investments remain unattractive and will no longer function as risk reducers
• Shares remain attractive, possible price slumps are not sustainable due to lack of alternatives
• Retail and office properties are being permanently weakened by online retail and working from home
• Gold will develop positively

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You can also download the capital market outlook here.