Capital market outlook 12/2024

Risks and opportunities of liquid investments in 2025

30.12.2024

Executive Summary:

Despite a number of geopolitical turbulences (war in Ukraine and the Middle East, changes of government in Germany, France and Syria, as well as the questionable economic plans of the new US president-elect), the US stock markets, particularly the major technology companies, US residential real estate prices and the dollar exchange rate are only heading in one direction, namely upwards. The fact that the US economy also has problems, which may even be exacerbated under the new president, is of no interest at the moment. However, it was the same 35 years ago in Japan, which was supposedly the leading technology nation at the time, but which was also leading the way in debt accumulation, and until 2011 in the emerging markets, which were rushing away from the Old World (USA, Europe) in the wake of (debt-driven) booming China. People are enthusiastic about price gains and do not want to acknowledge the debt behind them.

However, there are a number of liquid investments that are not inflated (equities in the US outside the technology sector such as healthcare or consumer staples companies, almost all other equity markets except India and gold) and that certainly offer the prospect of adequate gains over the next decade. So there are also many opportunities. There could even be some improvements in the political arena in Europe.

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Risks

There is a lot going on geopolitically at the moment. In Syria, the dictator has fled, in Germany the finance minister has been fired and the chancellor has lost the vote of confidence, in France the prime minister has had to go and in the USA Donald Trump will take over the presidency in a few weeks. The wars in Ukraine and the Middle East are not over; a conflict between Israel and Iran cannot be ruled out. As Syria has been mired in chaos for many years, Germany has not governed for 20 years but only reacted, and President Macron in France can at best remain in office until 2027, the economic policy plans of the future US president, who can undoubtedly be categorized as a populist politician, are of particular importance to the global economy.

Chart 1 shows that even the Americans are now getting a little nervous, albeit much less so than the Europeans. At least in the discipline of economic policy uncertainty, the Germans have been the undisputed leaders for the past three years. Reacting instead of governing was enough in the geopolitically calm times of Chancellor Scholz's predecessor, but a new political style would have made sense since 2022. Now the country must be steered through difficult times. In order to stabilize growth rates and be less affected by international turbulence, more investment in education, infrastructure, technology and defence is needed. A constant expansion of social benefits is simply wrong and negligent, actually also a negative form of populist economic policy, only without the shouting.

The extent of the lack of concern, particularly on the US equity market, is impressive in view of the economic policy uncertainty in the US (index value currently at 236, a rather high value for the US). Chart 2 shows that the US S&P 500 share index had lost an average of just under 6% by the month in which this value was exceeded due to one of the events mentioned in the chart. Only before the euro crisis, which only unsettled Americans for a very short time, and before the first election of Donald Trump were there moderate price gains (but never a price increase of 32% like this time, red bar).

In a study on the performance of populist governments - characterized by the division of the population into "the elite" and the "people" represented by the populist politician - the authors show that this style of politics (chart 3), which has been on the rise over the last 40 years, has significantly weakened the economy for over 100 years (chart 4). The key elements of populism - closing off the domestic economy to free trade in goods and immigration and abolishing the independence of the central bank from politics - are reflected in the ideas of the new US president and have been the causes of considerable economic weakness for over 100 years (see the November 2024 Capital Market Outlook, which you can find here ).

The decisive factor for the course of the economy in 2025 will be whether the aforementioned prescriptions of Donald Trump, who is at best moderately successful as an entrepreneur, were merely campaign slogans or will actually be implemented. In the latter case, considerable risks are likely to arise, and not just for the US economy. Tariffs, like the mass deportation of working immigrants, have a direct inflationary effect and are likely to push up US interest rates, as was already seen in December following warnings from the head of the US Federal Reserve. This could have a negative impact on the already ailing housing sector and later on the economy.

The real prices of US residential real estate fell by 7% during the rise in mortgage interest rates from 1970 to 1981 (chart 5). However, since their low point in 2011, after the housing crisis, they have risen by 63% while interest rates have also risen significantly. However, as the income of employees in the US has risen significantly less than the US national income over the last four decades - the proportion has fallen from 57% to 51.8% (source: US Federal Reserve Bank of St. Louis) - the feasibility of home purchases has deteriorated sharply (chart 6). As a result, the number of housing starts, which has fallen by 28% since April 2022 (source: US Federal Reserve Bank of St. Louis), is unlikely to improve. According to an analysis by the Bureau of Econonic Analysis, an agency of the US Department of Commerce, this indicator has pointed to an impending recession since 1947 in the event of a decline (red bar in chart 7).

These risks are currently not being taken into account on the capital market; small businesses in the US have suddenly become optimistic after the Trump election (chart 8, red circle on the right: sharpest rise in 50 years; the other red circle shows the rise after Trump's first election victory in 2016). You can only see the idea of a planned massive deregulation, which at first glance seems favorable for the economy. According to a statement by the recent Nobel Prize winner in economics Acemoglu in the Swiss newspaper Finanz und Wirtschaft in mid-November, this will not only be positive, but will also lead to an expansion of fraudulent or simply bad products and services, especially if it is implemented by politicians for whom the common good is less important than their own advantage. In any case, the conflicts of interest of the multi-entrepreneur Elon Musk are obvious. For example, he could abolish the authority that regulates the licensing of autonomous electric cars. The further reduction of corporate taxes, which are already at an inappropriately low level given the high level of US national debt, is also clearly not a good idea (see Capital Market Outlook from November 2024, which you can find here ).

A considerable lack of concern is also evident in the market for US corporate bonds. For decades, total debt (government, corporate and private household debt) in the US was very low (chart 9). During this period, the yield premiums of corporate bonds over government bonds were also low at an average of 125 basis points (chart 10), presumably due to the fundamentally greater stability of an economy with little debt. From 1981 onwards, total debt began to rise from 131% of national income to more than double this figure today. The average yield premium also rose sharply. However, it is currently at a level that has only been slightly lower in a few individual months in the last 40 years. The potential risks arising from Trump's populist ideas are therefore not being taken into account. If the economic data in the USA deteriorates or interest rates end their downward trend soon - either of which is likely to happen - corporate bonds will suffer noticeable price losses.

There is even a certain euphoria on the US stock market. Although the Leading Economic Indicator of the US research firm The Conference Board has been declining sharply in the US - as well as in China and the eurozone - for over two years, share prices are rising sharply, contrary to the usual behavior (chart 11, see also the capital market outlook from November 2024, which you can find here ). The valuation of the stock market based on the development of share prices compared to the development of fundamentals has now risen again to its highest level in 50 years, which was reached at the turn of the millennium during the internet and telecoms bubble (chart 12). The resulting earnings expectations for the next 10 years are correspondingly very low (chart 13).

Such a high valuation of equities and corporate bonds is dangerous in view of the economic risks that already exist and are exacerbated by Trump's possible populist policies, and is likely to lead to a setback on the US equity and corporate bond market in 2025. The two other phases of very high equity valuations (early 2000 and 2021, chart 12) were also followed within a few months by significant price declines of 46% and 25% respectively (source: Trading Economics).

The moderately optimistic forecasts of the equity strategists of the major US financial companies regularly surveyed by Bloomberg in December, who expect an average share price increase of 7.5% for 2025 (right bar in chart 14), should not be relied upon. Two years ago, for the first time since the survey began in 1999, the professionals predicted a slight fall in share prices and last year the second-lowest price gain (red bars in chart 14). However, this was followed by the two largest price gains since 1999 (green bars in chart 14). The statistical analysis of forecast and realized result yields an R² value of 0.013 (chart 15). This figure is very close to zero, which means that there is practically no correlation between the forecast and the realized value.

In the eurozone, too, the leading economic indicators, which have been falling sharply for over two years, are being ignored on the stock market (chart 16). However, the valuation of European equities is almost 40% more favorable than in December 1999 and 16% more favorable than in 2021 (chart 17), so that the expected return of 5% p.a. is not very high (chart 18), but significantly higher than for US equities and also higher than the long-term interest rate level, which is around 3% in Europe. The price losses after the valuation peaks amounted to 53% in Europe from 2000 and 15% from 2022.

The interim conclusion is that the risks to the economy in the world's major economic areas (USA, China, eurozone), which have been apparent for some time based on the Leading Economic Indicators, will not be eliminated by Donald Trump's inauguration. In China and the eurozone, both of which would be negatively impacted by the tariffs, the risks are likely to increase further. New economic risks are also emerging for the US economy as a result of inflation risks due to tariffs and mass deportations, which are likely to prevent further interest rate cuts. As geopolitics has by no means calmed down in the last three years, the sharp rise in economic policy uncertainty is easy to understand, but the unchecked rise in share prices, particularly in the US, is not. US residential real estate is also likely to suffer from the weakened expectations of interest rate cuts.

Opportunities

Despite the various uncertainties, the stock market also offers opportunities. Many investors are currently favoring IT stocks, not only because of the fantasy surrounding artificial intelligence, but often also simply because these stocks, like US stocks as a whole, have risen particularly strongly over the past 15 years (chart 19). Healthcare stocks, on the other hand, which have delivered almost equally good value growth, are less in demand. The performance of healthcare stocks is much "healthier" than that of the US or IT stock market. Chart 20 shows that the black line has been roughly constant for 10 years, but also since 1995; healthcare stocks have not risen more than their fundamentals (dividends, gross profits and book values). However, IT stocks were 30% cheaper 10 years ago than in 1995 and are now 80% more expensive. The other equity markets have not become more expensive (chart 20).

If we compare the historical data of the last 30 years with our forecasts for the next 10 years, we see a similar picture in most equity submarkets, but a very different picture in the area of US and IT equities, which have performed particularly well to date (chart 21). Chart 22 shows that not much is likely to be earned there in the next decade (see also charts 12 and 13).

This may seem unrealistic at first, but it is in line with the picture that equities, real estate and currencies very often show when they rise far more than their fundamentals over longer periods of time (see in detail the comparison of these three asset classes in Japan before 1990 and in the US in 2024 in the November 2024 Capital Market Outlook, which you can find here ).

Below we show another example from the recent past for those who do not remember the Japanese bubble 35 years ago. In 2010, there was one area of the stock market that enjoyed enormous global popularity, namely emerging markets (chart 23). This was triggered by the unchecked economic and construction boom in China, which led to rising commodity prices (see chart 28) and dragged many commodity-producing emerging markets with it. The "old" world (USA and Europe) was left behind, having suffered two severe crises, namely the collapse of the IT sector from 2000 and the financial crisis originating in the USA from 2008. IT shares were no longer attractive, although their valuation had become much more favorable. The comparatively higher valuation of emerging market equities did not bother anyone.

From 2010 onwards, US and IT stocks began their triumphant run (chart19) and the share prices of emerging markets lagged far behind; the capital markets once again had a new favorite. A change of favorites is also to be expected now, from which many other stock markets, but also other sectors in the US, will benefit.

The collapse of residential construction in China (chart 25) is weighing heavily on the Chinese economy and is the main reason for the significant and, for China, completely new contraction in leading indicators (chart 26). However, this means that the Chinese government and central bank need to stimulate consumption and investment in other areas through interest rate cuts and further easing measures. The long-term interest rate has visibly fallen to a historic low since the end of November (chart 27).

This suggests some possible positive developments. Since 2011, activity in Chinese residential construction had been rising only slowly before the recent collapse. A similar trend was seen in commodity prices, which may now also soften and counteract the inflationary pressure that will soon rise again due to Trump's misguided policies. Lower interest rates in China will support consumption and thus help the export economy in Europe. As falling interest rates make fixed-interest securities less attractive for Chinese investors, they are likely to turn increasingly to gold.

The crumbling credit ratings of various countries provide additional support for the gold price (chart 29). France's rating was already lowered by the rating agency S&P before the government crisis there last summer, with Moody's following suit on December 14, 2024. In the US, the government lost its top AAA rating from S&P back in 2013, and Moody's has also been considering an initial downgrade since November 2023. In particular, Trump's planned further tax cuts for companies, but also tax exemptions for tips and the extension of the temporary tax cuts from Trump's first presidency are increasing the government deficit and the likelihood of a reduction in credit ratings. Investors looking for a safe investment will increasingly turn away from government bonds and towards gold.

The costs of the war in Ukraine are also gradually becoming a problem for the aggressor Russia. Russia's military expenditure, as determined by the Swedish peace research institute Sipri, increased almost as much during the first attack on Ukraine in 2014 as it did from 2022, the second attack (Figure 30, values up to 2023). The overall economic damage was considerable from 2014 onwards (Figure 31). Since the first attack, Russia and the hard-pressed Ukraine have fallen far behind economically compared to other Eastern European countries (Figure 31). The willingness to enter into peace negotiations is therefore likely to increase; Trump will exert corresponding pressure.

This means that Europe's political risks could be assessed somewhat more favorably, at least temporarily. If Europe, which did not want to hear the first shot (Russia's attack in 2014) - see the unchanged low defence spending of European countries in chart 30 - were to hear the second shot and significantly increase its defence spending, as Trump is not entirely wrong to demand, the political risks would even have been permanently reduced. Rebuilding Ukraine could help European economic growth.

There has also been a structural improvement in monetary policy in the eurozone. Since the 2008 financial crisis, the eurozone's share of global economic output has fallen much more sharply than in European countries with their own central bank, e.g. Switzerland or the UK (chart 32). The most important reason for this lies in two serious mistakes made by the European Central Bank. While the US central bank had already cut interest rates sharply before the Lehman bankruptcy in September 2008 because it saw the growing problems on the domestic real estate market, the ECB - at that time still heavily influenced by the German Bundesbank - even raised interest rates in the summer of 2008 because oil prices had risen and an inflation risk was derived from this (chart 33). The fact that a number of European countries (Spain, Portugal, Ireland, but not Germany) also had inflated real estate markets was not recognized and interest rate cuts then had to be hastily made. Because the ECB reacted too late and too weakly - it hardly printed any fresh money to contain the crisis (chart 34) - financial problems arose in Ireland and Portugal from fall 2010, resulting in a rescue package for these two countries. This was followed in 2011 by rising interest rates for Italian and Spanish government bonds, where creditworthiness problems were also identified. However, the ECB did not lower interest rates, but actually raised them twice and once again did not print any fresh money (Figure 35) - for whatever reason. The result was a recession that only occurred in the eurozone, as can be seen from the rapid decline in relative economic output from 2010 to 2015 only in the eurozone (Figure 32). The ECB had now learned its lesson. When the Americans raised interest rates during Donald Trump's first term in office from 2016, the ECB quite rightly remained inactive. With rising inflation rates from 2021, it even acted more cautiously than the US central bank, but it reacted just as quickly when interest rates were cut in 2024. Since the end of the euro crisis, the eurozone's share of global national income is no longer falling faster than that of other European countries

It can therefore be assumed that the ECB will focus on domestic inflation trends and the economy in future and will therefore not be impressed by an upward turn in the inflation trend in the US caused by Trump's strange policy mix. This could be another relative advantage for Europe in the coming years and direct capital flows away from the US and its IT sector and back into cheaper stocks in other regions and sectors.  

Conclusion:

The US equity market, residential real estate and the US dollar are ignoring the considerable risks arising from Donald Trump's inflation-increasing ideas (tariffs and mass deportations). However, the head of the US central bank has these risks in mind, meaning that the danger of interest rates rising again soon in the US is growing. This increases the likelihood that the heavily overvalued parts of the US equity market, as well as the residential real estate market, will fall in 2025. The risks are also being ignored in the US corporate bond market, which is also at risk of a setback. The optimistic forecasts of US equity strategists should not be given much credence.

US equities outside the technology sector will benefit from an upcoming change of favorites, as will many stock markets in Asia and Europe. China's problems will force the government to support consumption, which will help Europe with its strong exports. The gold price will also benefit from interest rate cuts in China, as well as from the growing creditworthiness problems of many industrialized countries. The geopolitical situation in Europe could improve in the short term as a result of an end to the war in Ukraine, which has led to enormous losses and costs on both sides, and in the long term if European countries increase their defense efforts. Finally, the ECB's monetary policy has learned from some of the mistakes it made in its youth and should help quickly and effectively in future crises.

Finally, our key statements from the December 2021 Capital Market Outlook, which you can find here can be found here:

Three years ago, we analyzed the effects of possible interest rate increases worldwide - the rise in inflation rates had begun. As a result, we expected interest rate increases that would be significantly lower than consumer price increases, which also materialized in both the US and Europe from 2022. Interest rate increases only reached half of the inflation rates. We did not expect a sustained fall in property prices, as higher inflation and a moderate rise in interest rates are more likely to lead to a further increase in value in the medium term. However, as inflation and interest rates rose very quickly after the Russian attack on Ukraine, residential property prices came under pressure. They have been rising again slightly since December 2023, but the falls in value have not yet been offset. On the equity market, we assumed that the European equity markets would suffer less from rising interest rates than the US markets due to their lower valuation. This was exactly the case; by September 2022, US equities had fallen by around 25% and European equities by only 15%.

You can also download the capital market outlook here.

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