Surprises in the recent past and in the future

In order to recognize the special features on the capital markets since the outbreak of the coronavirus pandemic in the first quarter of 2020 and to make them usable for forecasting purposes, it is worth taking a short trip back in time, namely to December 2019. At that time, a very good year for equities had ended worldwide with price gains of over 20%, including in Germany and Europe. Long-term interest rates had fallen further - to 1.69% in the USA and below 0% in Germany - and the word "corona" was mainly familiar to medical professionals (coronary arteries) and astronomers (corona = a ring of light from the sun that is only visible during a solar eclipse).

Anyone who would have correctly predicted the course of the coronavirus pandemic for the following two years at this point was able to pat themselves on the back three months later. The expected global closures of industrial and service companies caused share prices to plummet by 30% (see Figure 1). The sudden slump in the global economy - the sharpest since the Second World War - raised fears of deflation, with the result that even inflation-linked government bonds fell by 10% and many real estate experts expected residential property prices to fall in the face of soaring unemployment. The crisis metal gold behaved as expected and rose by 20% in the following three quarters. The perfect coronavirus forecaster could also have predicted that the states and their central banks, which were already heavily indebted before the pandemic began, would spend a lot of money to help the economy and the affected workers.

From the 2nd quarter of 2020, however, there were some astonishing movements. Long before a stabilization of the economy was foreseeable, a record rise in share prices began in March 2020 and lasted for 7 quarters until the end of 2021 (see Figure 2), although the economy was far from returning to the performance of 2019 at that time. In our first Finvia Capital Market Outlook from March 19, 2020, which you can find here, we pointed out the low valuation and high earnings potential of the equity markets, but also the rising inflation risks.

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In addition, the deflation that seemed certain in March 2020 did not materialize. Instead, consumer prices began to rise sharply at the start of 2021. Inflation-linked bonds and residential real estate - not only in Germany - have each delivered total returns of just under 20% since March 2020 (see Figure 1).

Even more surprising for many investors and even the perfect coronavirus forecaster was probably the fact that the sharpest rise in inflation for almost 40 years (Figure 3) took place with virtually no rise in interest rates, as the following two Figures 4a-b show.

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However, this was precisely the decisive reason for the astonishingly good performance of equities, residential real estate, gold and inflation-linked government bonds. The strong, global rise in inflation, which we had not predicted to this extent, but at least in terms of the trend as early as 2020 (see Capital Market Outlook from June 2020, which you can find here ), has so far taken place with virtually no rise in interest rates (Figures 4a-b).

The reasons for our inflation forecast, which was well above the consensus at the time and remains unchanged to this day - even in the future without a significant rise in interest rates - were valid for at least the next decade:

- Lack of independence of central banks due to high government debt. In the 1970s, high inflation could be combated through high interest rates, as government debt of well under 40% of national income could be easily serviced even with high interest rates, which is no longer the case today with government debt of 130% (see Figure 5 using the USA as an example).

- High money supply growth

- Populism. By this we mean socio-political gifts with high costs but no benefit for those really in need. Examples include mothers' pensions, skilled workers' pensions and the political inability to make unpleasant decisions to solve urgent problems. For example, both climate protection and the fight against the housing shortage are being massively hindered and made more expensive by the unlimited opportunities for residents and environmental protection associations to object, something that the new Economics Minister Habeck has at least recognized as a problem. One example from the recent past was the government of the early Weimar Republic, which did not oppose the high wage demands of the trade unions or the desire of companies for low taxation, thereby driving up inflation and national debt until 1923.

- demographics (see Figures 6a-c), which will result in high wage increases due to a sustained decline in the working-age population and growing burdens on state budgets due to the increase in the retirement-age population. This trend has also been very evident in China for some years now

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For the outlook, we therefore need to look at what future surprises are to be expected in terms of inflation rates and interest rates. The generally circulated economic and interest rate forecasts are not relevant here (in fall 2020, the International Monetary Fund (IMF) expected inflation of 1.1% for the eurozone in 2021).

Here is just one example from the past that many of you may remember: in September 2008, the US investment bank Lehman Brothers went bankrupt. The reason for this was the politically motivated boom in new residential construction in the USA. This was based on particularly loose mortgage loans for low-income Americans and embellished ratings for mortgage bonds that were collateralized by these loans. When house prices began to fall, these mortgage bonds ("subprime" securities) collapsed and with them Lehman Brothers, which had speculated heavily on them. Share prices fell worldwide and many companies reported that they were suddenly no longer receiving any orders. In mid-November 2008, the "wise men" in Germany were still only forecasting that the German economy would stagnate in 2009. It was not until the end of December that the then chief economist at Deutsche Bank, Prof. Dr. Norbert Walter, ventured to predict an economic slump of 4% in Germany. By then, share prices had already fallen by over 40%, so this forecast, which was the best at the time, came far too late. The economic slump in 2009 actually amounted to over 5%.

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It is highly likely that the inflation rate will be surprisingly high in the coming years, particularly in the USA, but also in Germany. The US Federal Reserve has long recognized that an inflationary wage-price spiral is looming. In view of the extremely high number of job vacancies (see Figure 7a), companies are having to offer high wages in the difficult search for workers. As a result, many companies, not only in the US, have to raise prices in the face of rising wages and other costs (raw materials, electricity, etc.), which reinforces the trend towards higher wage demands. The US central bank has therefore already made it clear that interest rates will be raised slightly.

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In addition, Americans who have been unemployed since March 2020 have received a high level of financial support from the state, but have only been able to spend part of it due to the coronavirus pandemic. As a result, household savings have risen sharply and will fuel demand strongly in the future (see Figure 8a). The sharp rise in house prices (Figure 8b) and share prices (Figure 9) is also boosting demand, as many Americans, unlike Germans, own both houses and shares and experience shows that they spend more money when they become richer.

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The number of job vacancies is also high in Germany (Figure 7b). The particular problem here, however, is that Germany has the lowest unemployment rate in the eurozone (Figure 10a).

For the responsible central bank, the ECB, however, the average value for the eurozone is relevant and this is considerably higher. The influential countries of France, Italy - recently governed by former ECB President Draghi - and Spain have even higher values and will vehemently oppose any significant interest rate hikes.

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This explains why ECB head Christine Lagarde (from France) has already ruled out interest rate hikes for 2022, even though the (German) ECB director Prof. Isabel Schnabel recently almost doubled the inflation forecast for the eurozone to 3.2% in 2022, incidentally also with reference to the sustained rise in energy prices in connection with climate protection policy.

High inflation in Germany - currently 5.3% - is therefore unlikely to be combated for the time being, even in the event of a wage-price spiral, which we had not actually expected until 2024/2025. Interestingly, the ECB is even threatened by a wage-price spiral within its own organization. The planned wage increase of 1.3% will no longer protect the 3,500 ECB employees from inflation, according to the responsible trade union Ipso (Wirtschaftswoche, 7.1. 2022, p. 41). Only the use of even more industrial robots, in which Germany is the leader in the eurozone, could alleviate wage pressure (see Figure 10b).

Another international inflation risk comes from the sharp rise in food prices. One of the main causes of this is exploding fertilizer prices. The production of ammonia, the basic ingredient in fertilizer manufacture, is very energy-intensive and its price directly follows rising energy prices (see Figures 11a-c).

Fertilizers have become too expensive for more and more farmers in developing countries. As a result, food production is declining.

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This increases inflationary pressure and the risk of political unrest, particularly in poorer countries where people have to spend a much larger proportion of their income on food (see Figure 12).

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Finally, we will now show the consequences of higher inflation rates in the coming years for the earnings expectations of equities, residential real estate and gold.

Inflation is considered detrimental to equities. In the 1970s, when annual price increases in the USA climbed from 6% to well over 10% p.a. and in Germany from 3% to 6% p.a., and in the meantime even 7%, share prices lost 50% in real terms (Figures 13a-b).

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This time, however, share prices are also moving upwards as inflation rates rise (Figures 14a-b).

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In view of the extremely high level of government debt, which is increasingly included in the discussion in economists' texts with the equally euphemistic and incomprehensible term "fiscal dominance" (the central bank must take greater account of the serviceability of high government debt than inflation rates), this time, unlike in the 1970s (see Figures 4a-b), the enormous rise in interest rates that ended inflation at the time and had a massive impact on the stock markets must not occur. In 1981, when the largest company in the world - IBM - paid 16% for a 5-year bond and the Federal Republic of Germany, with less than 40% government debt as a percentage of national income at the time, paid 11% for 10 years, there was no need to speculate with shares in order to achieve double-digit returns. Today, with a far worse credit rating and interest rates at a ridiculous 0%, many investors will still discover shares.

This is because the performance expectations of German government bonds are unfortunately of very high forecast quality (92% of the returns on German bonds over the next 10 years can be explained by the current interest rate level of 10-year German government bonds, Figure 15) at 0.6% p.a., far below the inflation we expect for the next 10 years, as the following chart shows.

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By contrast, the earnings expectations for global healthcare stocks, for example, look much better at 9% p.a. with the same good forecast quality (Figures 16a-c).

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And German residential real estate will also generate annual returns in the upper single-digit range in the coming years, in which interest rates are likely to remain below the inflation rate for the reasons mentioned and the real interest rate will therefore be negative. Figure 17 below shows the corresponding correlation.

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Figure 18 below shows the expected annual returns and the forecast risk for key parts of the equity market - regions and some sectors - as well as German government bonds, residential real estate and gold. Equity funds (private equity), which have historically generated annual returns around 5 percentage points higher than equities, will continue to generate several percentage points higher returns than equities in the future, particularly because they suffer significantly lower losses in times of double-digit losses on the equity market for sustainable reasons.

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Overall, wealth with an investment focus on equities and investment funds, supplemented by (residential) real estate and gold, will (is) doing well in an environment of higher inflation and continued low interest rates.

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