Real assets, interest and inflation

Due to the Putin war and the associated consequences for inflation rates (see capital market reports from March and April, which you can find here and here ) and interest rates, it is unfortunately necessary to re-analyze the impact on real assets such as equities, real estate and gold.

The two charts below show, using the USA and Germany as examples, that the majority of the rise in inflation had already begun a year before the outbreak of war. After that, a further significant rise in inflation only took place in some European countries that are heavily dependent on Russian energy supplies, such as Germany. Inflation had little impact on long-term interest rates until February 2022. After that, however, they shot up by 1 percentage point in both countries.‍

Residential real estate

Share prices often anticipate developments in the real economy, such as during the financial crisis from 2007 or the coronavirus crisis from the beginning of 2020 (see charts 2a and b).

But often does not always mean. The American Nobel laureate in economics Paul Samuelson (1915 to 2009) once said: "The stock market has successfully predicted 9 of the last 5 recessions. This insight is also likely to apply to the current slump in residential real estate share prices and the probable future development of residential real estate prices in Germany. The rise in interest rates since the start of the war on February 24 has pushed down the prices of residential real estate shares in Germany sharply (see chart 3). While the inflation rate had risen by 5.4 percentage points and interest rates by 0.5 percentage points between December 2020 and February 2022, the price declines of real estate stocks remained moderate during this period, with losses of between 7% and 15% (average of the 4 stocks: -11%). However, the subsequent rise in the inflation rate by 2.3 percentage points and interest rates by 1 percentage point after the start of the war depressed the prices of real estate shares by a further 20% on average (between -17% and -29%).

Although an increase in interest rates for 10-year government bonds in Germany from 0% before the start of the war to 1% led to a somewhat stronger increase in mortgage interest rates with a 10-year fixed interest rate from 1.4% to 2.6% today, this does not sufficiently explain a 20% slump in the price of real estate shares in these barely 3 months, especially since the Association of German Pfandbrief Banks simultaneously reported a price increase in residential real estate of 10.7% in the first quarter of 2022 compared to the same quarter of the previous year (FAZ of 11.5.22), calculated from the evaluation of real estate transactions. The rise in interest rates does not appear to have affected residential purchases.

The reason for the weak performance of listed apartments, in addition to the standard reaction of investors to react to interest rate increases by selling shares, is likely to be the minimum standards for the energy efficiency of buildings, a planned directive of the EU Commission that has become more relevant due to the war-related energy price increases. By 2050, 200 million homes in the EU must be climate-neutral. Vonovia, for example, has stated that it has renovated 3% of its housing stock each year to date. This would mean that the company would almost reach its target in 28 years. With a current dividend yield of 5%, the costs of refurbishment could even be covered if they amounted to 100% of the value of the apartments to be refurbished. On the other hand, given the shortage of tradesmen - throughout Europe, not just in Germany - and the exploding prices of building materials, it is likely to be much more difficult for many owners of a few or just one property to carry out an energy-efficient refurbishment. In the long term, a growing number of unrenovated properties that can no longer be rented out due to high ancillary costs will lead to a shortage from which owners of large residential real estate portfolios such as Vonovia will benefit.

Another aspect that sellers of real estate shares may have overlooked is the future development of rental income. These will grow more strongly than in the past in view of the stronger rise in wages and salaries due to a sustained higher inflation rate. This is because employee compensation has influenced per capita rents by 98% since 1991 (chart 4a and b).

In view of high inflation - and also due to the shrinking number of employees in many industrialized countries - significantly higher wage increases than in the past are to be expected in the coming years.

This will create significant potential for rising rental income over the next few years, particularly in the part of the housing stock that has undergone energy-efficient refurbishment. Overall, the attractiveness of apartments (without a refurbishment backlog!) has not suffered as a result of the rise in interest rates over the last three months, as the following two charts show.

Last year, property buyers were satisfied with a rental yield of 3% at an interest rate of 0.6% for 10-year mortgages (top left). However, when the mortgage rate was over 11% in 1981, the rental yield was barely higher at 3.3%. The enormous difference between rental income and mortgage interest costs (7.7% of the purchase price per year!) did not deter buyers. The reason was that the real estate market includes not only the current rental yield but also future rental growth, which is obviously derived from the average inflation rate of the last 10 years (Figure 6b: If you add the inflation rate to the rental yield, 82% of the sum of both variables can be explained by the respective mortgage interest rate. You can read why it makes sense to add the rental yield and the expected long-term rent increase in the Capital Market Outlook from December 2021, which you can find here ). Currently, with a rental yield of just under 3% and our expected inflation of 3.5% p.a., investors can expect an annual return of 6.5% over the next 10 years (chart 6b, orange dot); historically, however, they would be satisfied with 5.2% (horizontal orange arrow), i.e. with 25% higher property prices. Residential real estate is therefore undervalued even after the rise in interest rates and will rise in price as soon as investors realize that inflation rates will be significantly higher than before in the long term.

Conclusion for residential real estate

Higher inflation rates and the demographically induced shortage of labor will result in significantly higher wage increases and thus also rent increases for years to come. However, interest rates will remain below the inflation rate in the future (see chart 12 and the following text). This means that residential real estate without a renovation backlog continues to offer good earnings potential even after the recent rise in interest rates; the slump in real estate share prices in Germany is - this time - not a reliable early indicator of falling house prices in the future.

Shares

In order to illustrate the behavior of equities, but also other important forms of investment such as bonds, residential real estate and gold in different phases of inflation (high, low, rising, falling), we have assigned their performance in quarterly periods to the respective inflation regime. First of all, chart 7a shows the overall performance compared to the consumer price index, which all forms of investment outperformed during this period. However, equities lagged far behind in the 1970s, when consumer prices rose significantly. Simply outperforming inflation with equities over the long term will still be possible in the future, but it will require some pretty strong nerves. Chart 7b shows the quarterly performance of the asset classes over the entire period.

The following chart 8 shows the respective performance in the four sections of high falling, high rising, low falling and low rising inflation. Equities have performed particularly well in times of low and falling inflation (bottom left section). Gold and residential real estate, which are considered good inflation protection, have lived up to their reputation since 1970 (top right area), while equities have suffered particularly from high and rising inflation.

This is reflected in the trend since the jump in inflation in recent months (see chart 9). Equities have fallen significantly, while gold and real estate have risen.

Since the end of 2019, real assets such as equities, real estate and gold have weathered the double crisis of pandemic and war remarkably well. If we had correctly predicted both crises at the end of 2019, we would certainly not have dared to forecast that all three forms of investment would achieve an annual performance of over 10%.

The two charts below show how the overall performance of equities is composed. The company earnings, shown here with the internationally and over different time periods well comparable cash flows, have developed quite well in the rather unfavorable times for the overall share performance (chart 8, top right) of high and rising inflation (chart 10, top right). For the average company, high inflation also means higher sales. Although costs also rise more sharply, the average company usually makes a profit, so the cost block is smaller than sales, which is why profits can develop better with inflation.

When share prices stagnated in the inflationary 1970s despite rising cash flows, interest rates on 10-year government bonds had risen to 14% in the USA and 8% in Germany by the end of 1979, in each case 2% points higher than the corresponding inflation rates. Then even rising cash flow is of no use to companies because government bonds become irresistible competition for shares.

This is shown in the following chart. Due to high interest rates, the price/cash flow ratios (comparable to the multiplier on rental income for an apartment building) fell so significantly in the 1970s with high and rising inflation (top right-hand box) that share performance was only just positive despite rising profits (cash flows) (chart 8, top right-hand box). Investors sold shares despite rising cash flows in order to invest the money in high-yield bonds.

The key difference between today and the 1970s is (government) debt, which was very low everywhere back then (around 35% of national income in the US and even lower in Germany, see chart 12b). In order to combat inflation, governments everywhere could afford double-digit interest rates above the inflation rates (chart 12a), so that saving became more attractive than consumption again.

Transferred to today, the interest rate in the USA would have to be over 10% and in Germany over 9% (see chart 1a and b).

However, this will not happen. Total global debt, i.e. not only government debt but also the debt of companies, private households and the financial sector, has now reached a record 355% of global national income. The British business newspaper The Economist has calculated that a rise in global interest rates of just 2 percentage points would increase the global interest burden by 50% to an unsustainable 18% of global national income. A massive recession and debt crisis would be the inevitable consequence (source: Handelsblatt, 11.2.2022). The central banks are also aware of this, which is precisely why they are only raising interest rates very cautiously.

Accordingly, the risk of recession in the USA remains low, as the so-called yield curve (the difference between the 10-year and 1-year interest rates for government bonds) shows (chart 13). With one exception in the 1960s, a recession only occurred after an average of 13 months when the 1-year interest rates rise above the 10-year rates (red circle in the chart).

Conclusion for shares

In an environment of high inflation rates, company profits may well continue to rise significantly. If interest rates rise to a level above inflation rates, as they did in the 1970s, equity performance will be low or negative. However, given the extremely high level of global debt, we are certain that interest rates will not even come close to inflation rates, so the outlook for equities with earnings expectations in the mid to upper single-digit range remains positive.

Conclusion for gold

The price of gold rose sharply in the 1970s amid high inflation (chart 7a, chart 8), although interest rates were in double digits everywhere at the end of this period. In today's environment with interest rates far below inflation, gold will again be able to generate high returns over the next 10 years.

Despite the war and coronavirus, real assets remain attractive because the high level of government debt means that there are strict limits to the fight against inflation by raising interest rates.

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