Rising inflation, but also rising interest rates: a dangerous scenario for real assets?

In recent weeks, it has become clear that the sharp rise in inflation rates on both sides of the Atlantic in recent months will only partially recede next year. The US Federal Reserve, among others, has therefore announced interest rate hikes. We are now examining the consequences of higher inflation rates and interest rates for the individual forms of real asset investments (equities, corporate investments, real estate and gold; the reasons for sustained increases in inflation rates can be found here in our Capital Market Outlook from June 2020).

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At first glance, the rapid, sharp and, for many, surprising rise in inflation rates does not appear to be a problem for the stock markets (see Figures 1a-b) and the market for residential real estate in Germany is still "humming". We will come back to this later.

During the last inflationary phase in the 1970s, things were very different. In this decade, the stock markets reacted with nominally stagnating share prices. In view of the high inflation rates, this resulted in exceptionally sharp price losses of up to 50% in real terms, as the following figures 2a-b show.

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In view of the high inflation rates, this resulted in exceptionally heavy price losses of up to 50% in real terms, as shown in the following figures 3a-b.

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The key difference between the 1970s and today lies in government debt. At that time (USA: below 40% of national income, see Figure 4a), this was very low in all industrialized countries. High interest rates were therefore not a problem for public finances, and the central banks were able to successfully break the inflation mentality with double-digit interest rates.

However, when the US national debt was almost as high as it is today after the extremely expensive Second World War, interest rates were pushed below inflation rates for years with bond purchases by central banks and massive incentives for institutional investors, even though the economy was booming. Government debt alone can explain 60% of the interest rate level for almost 90 years (Figure 4b). Today, government debt is even higher and growth prospects are significantly weaker than in 1945, so that interest rates have had to be pushed down even further (Figure 4a).

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In view of the growing burden on national budgets in the future due to the ageing population and the need to combat climate change, a reduction in the level of debt, as was the case after 1945, is completely unthinkable. Low interest rates are likely to remain with us for many years to come. As many major investors (and also the central banks, hence the ECB's reassuring comments) are becoming increasingly aware of this connection, long-term interest rates have hardly reacted to the rise in inflation so far (Figures 5a-b).

It will be of great importance for the future performance of real asset investments whether sustainably higher inflation rates will only have a minor impact on interest rates in the future.

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A certain upward movement in interest rates can no longer be ruled out since the US central bank has recognized that the inflation risks, particularly in the USA, are by no means of a temporary nature. The economy there has been extremely strongly stimulated by the government (Figure 6), with the result that demand for consumer goods has increased particularly strongly.

In conjunction with the global supply problems and the growing shortage of labor due to demographic factors, wages are also rising particularly sharply in the US; there is a risk of a wage-price spiral (wages rise, many companies then have to raise prices, then employees demand higher wages again, etc.). In view of the rise in the inflation rate to 6.8%, moderate interest rate hikes in the US are likely from 2022.

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Against this background, we would now like to statistically analyze the susceptibility of real asset investments to interest rate increases in an environment of higher inflation rates using historical data.

A look at the German residential real estate marketin the decades since 1975 provides an indication of how property buyers factor interest and inflation rates into their price expectations (price as a multiple of rental income). The following two charts show that the rental yield of owner-occupied apartments has been only slightly dependent on interest rates over the last 46 years (Figure 7a). The rental yield fluctuated between 3.3% and 4.6% with a mortgage interest rate of 4% to 11%. Only at very low mortgage rates of less than 4% did the rental yield fall. Prices therefore rose significantly faster than rents (Figure 7b). This means that the statistically measured correlation between interest rates and rental yields only makes economic sense at very low interest rates (low interest rates enable high purchase prices and therefore low rental yields).

With a double-digit mortgage interest rate, however, a low single-digit rental yield is too low. This means you can only finance a small part of the interest and no repayment. Were the buyers foolish back then or did they calculate differently?

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The calculation can only work out if property buyers include a second factor, namely the future growth in rental income. In recent decades, this has been estimated by the average home buyer and seller on the basis of the inflation rate over the last 10 years, as the chart below shows. Its value, 1.40% in the current year, was then added to the rental yield (2021: 2.98%) (mathematically correct, see the two figures after next 9a-b). This results in a value of 2.98% + 1.4% = 4.38% for December 2021. In the high-interest year 1981 - 11% mortgage rate! - the rental yield was barely higher than in 2021 at 3.32%, but average inflation was 5.25% and the sum of both figures was 8.57% (see Figure 8, which shows that the mortgage interest rate level for 46 years explains 82% of the respective rental yield + inflation rate of the previous 10 years, the best estimate of the yield required by property buyers - the green arrows and the dot will be explained later).

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The next two figures 9a-b show why the addition of rental yield and future rental growth rate makes sense. On the left, we see the rental income of 2.98% growing at 1.40% in the long term. The horizontal orange line shows a constant cash flow of 4.38% (=2.98%+1.40%) as an investment alternative. Visually, the green line appears to be the clearly better alternative.

However, you have to bear in mind that in a world with positive interest rates, income that is due soon is more valuable than income that is due later, as you can invest the money at interest in the meantime. But then, at a certain interest rate level, the higher income from the fixed-interest investment until 2049 offsets the higher income from the growing rent payment thereafter. This interest rate level is exactly the sum of the initial rental yield and its future perpetual growth rate (see Figure 9b; the area between the two lines and the zero line is the same and therefore both cash flows are equivalent).

Rental yield + growth rate is therefore a fairly good indicator of the long-term profitability of capital invested in residential real estate.

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We can now attempt to estimate the impact of rising inflation rates and interest rates on the price development of condominiums. Figures 5a-b show that when inflation rates in the USA or Germany rose sharply by more than 5 percentage points, interest rates only rose by around 0.5 percentage points in each case. The two reasons already mentioned above for this weak reaction so far are:

1) The extremely high level of public debt in many countries forces interest rates to remain low in the long term. Governments can only cope with moderately higher interest rates if inflation rates are quite high and wages and tax revenues are rising strongly as a result.

2. many investors believe that inflation rates have only risen temporarily and therefore (and due to legal investment regulations for institutional investors) hold on to their fixed-interest investments, such as government bonds. However, in the event of sustained higher inflation, more investors will sell their bond holdings, which will result in falling prices and thus rising yields, unless the central banks put the brakes on this rise in interest rates by buying bonds.

We can therefore assume that only half of any sustained rise in inflation will be reflected in interest rates. So if, in the valuation model (Figure 8), the inflation expectation (= estimated future rental growth rate) rises by 1.6 percentage points from the current 1.4% to 3% and the mortgage interest rate reflects half of this increase and rises from 0.59% to 1.39% (green arrow), then the expected return from rental yields (2.98%) and their growth (3%) rises to just under 6% (green dot). According to the model, however, investors would be satisfied with an expected return of 4.7% (the sum of rental income + growth rate matching the 1.39% mortgage interest rate, see the green arrows in Figure 8); they would therefore only demand a rental yield of 1.7% with 3% perpetual rental growth. Real estate prices would have to rise accordingly.

This allows us to calculate an estimate for the total return on condominiums (rent + appreciation) next year. We conservatively assume that the inflation rate will fall again next year from 5.2% to 2.5% and that the government bond interest rate will nevertheless rise from -0.4% to +0.1%, because inflation expectations in Germany are still only around 1.5% and the interest rate could match 50% of this rise in inflation to 2.5%. This puts the real interest rate at -2.4% (0.1% interest rate minus 2.5% inflation) and the performance forecast at 11% (see Figure 10). The result of this forecast model matches that of the valuation model (Figure 8); in any year with negative real interest rates of less than -2%, a double-digit total return would be possible.

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Real estate and inflation:

A rise in interest rates should therefore not be a problem for German residential real estate over the next few years, provided that our well-documented basic assumption that inflation rates will rise faster than interest rates over the next few years is correct.

On the major stock markets, cash flow, a gross profit adjusted for write-downs and write-ups, is particularly suitable for forecasting purposes due to its greater stability compared to net profit. Accordingly, the cash flow yield of shares, the equivalent of the gross rental yield of condominiums, provides good indications of the interest rate sensitivity of shares. The relationship between the global interest rate level and the cash flow yield appears to be completely logical from a business point of view; when interest rates are lower, investors are satisfied with lower returns on equity investments (see Figure 11 below, comparable with Figure 8). The correlation also appears to be quite close, as interest rates explain over 70% of the cash flow yield. However, the cloud of dots on the left-hand side of the graph at interest rates below 6% looks somewhat "chaotic", and there is a particular reason for this.

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In the long term, falling interest rates can only lead to falling returns on shares or real estate (i.e. higher prices or real estate prices), as shown in Figures 8 and 11, because investors can then finance higher loans and thus pay higher prices for real estate or loan-financed share or company purchases. In the case of real estate, which is very often loan-financed and therefore dependent on interest rates, the correlation is therefore also consistent (Figure 8).

In the case of equities, however, there is a decade in which this correlation was reversed, as you can see in Figure 12 below. From 1970 to 1999 and from 2009 onwards, all was well with the world. The correlation between equities and interest rates was strongly negative at -0.69 and -0.70 respectively, meaning that falling interest rates were mostly associated with rising equity prices (or falling cash flow returns on equities) (the extreme value would be -1.0, in which case equities and interest rates would always move in exactly the opposite direction).

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Between 1999 and spring 2009, however, the correlation was strongly positive at +0.86 - when interest rates fell, share prices also fell, which actually makes no economic sense. However, after the near bankruptcy of Russia in the fall of 1998 and the resulting bankruptcy of the USD 125 billion hedge fund LTCM (managed by two Nobel Prize winners in economics), there were fundamental fears as to whether a strong deflation like that of 1929 to 1933 could no longer be ruled out due to a general wave of bankruptcies (Dow Jones share index down 89% at the time). As a result, many investors immediately fled into "safe" government bonds when share prices fell in the following 10 years, causing their prices to rise and interest rates to fall too. During this period, the correlation between equities and interest rates was positive. Almost 10 years later, however, after the Lehman bankruptcy in September 2008, the US central bank showed that it would consistently oppose any deflation or wave of bankruptcies by printing money on a large scale. This restored confidence in the fundamental stability of the financial system and therefore also the stock markets. Since then, they have reacted normally to interest rate cuts - with the minor exception of the coronavirus crash in March 2020.

Until 2009, interest rate sensitivity on the European equity market corresponded to that of the global equity market. After that, however, the slightly sharper fall in interest rates in Europe no longer led to share price increases above the trend. The reason for this is that the global equity market, 60% of which consists of US equities, has a much higher proportion of technology stocks than the European market.

These react particularly positively to falling interest rates, as they are particularly likely to see further increases in cash flows in the long term. Figure 9b shows that interest rates have an increasingly strong influence on the current value of cash flows as they move further into the future. So far, many European stocks have benefited much less from this than technology stocks, such as German carmakers, which some investors see as being strongly threatened by Tesla. However, if these companies not only survive, but also succeed in their current efforts to become manufacturers of the software required by modern cars in the future, they will have considerable upside potential. This applies to all companies with low valuations today, especially if they become increasingly digitalized.

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In retrospect, equities in Europe, but also in emerging markets such as China, have therefore benefited significantly less from the decline in interest rates over the past 11 years than the global equity market as a whole (which is dominated by US stocks). Accordingly, interest rate rises will have less of a negative impact.

This is also reflected in this excerpt from our current forecasts for the equity markets, which are quite positive for Europe and China. (Figures 14a-c).

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Conclusion Shares and inflation:

If our basic assumption of rising inflation rates with barely rising interest rates is correct, equity returns will be higher everywhere anyway than shown in Figures 14a-c above. Companies, like governments, will also benefit from continued low interest rates on their debt, faster rising sales due to inflation and - if digitalization is successful - a smaller block of personnel costs.

Similar to residential real estate, the inflation rate in recent years also plays an important role in the pricing of gold. We have carried out the analysis since 1968, when the USA first restricted the export of gold to foreign creditors due to the high costs of the Vietnam War; in 1971, then US President Nixon finally abolished the gold backing of the dollar. Since then, the average inflation rate over the last 7 years can explain almost 80% of the trend-adjusted gold price (Figure 15).

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Assuming that this quite logical correlation also applies over the next 10 years, the gold price in our base scenario of an inflation rate of 3% p.a. should rise to USD 4,300 by 2032 and to USD 5,400 with 4% inflation per year (Figure 16).

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Conclusion Gold and inflation:

Gold therefore remains attractive as a hedge against inflation.

P.S.:

And the new superstar of inflation protection, Bitcoin? It hasn't worked in the first major inflationary spike in the 12 years since its creation (see Figure 17)

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