Which trends will break soon

Inflation rates are falling significantly in the USA and the eurozone. Will they really fall to 2% on a sustained basis, as the central banks and capital markets expect? Will China stimulate the weakening global economy? Are the international stock markets too highly valued in view of the current and future problems?

Some unusual developments can currently be observed on the capital market. These include the sudden disappearance of the correlation between the price of gold and the yield on inflation-linked US government bonds (chart 1). These are competition for gold, as they offer good protection against inflation. Unlike normal government bonds, they are not repaid at 100%, but the investor also receives the entire increase in consumer prices during the term. For example, if inflation is 2% per year over the next 10 years, the bondholder will not be repaid 100%, but rather 120%, to put it simply. In the past, investors have only accepted a gold price as high as in recent months if the yield on inflation-linked bonds was below zero (above the dashed blue line in chart 1), as was the case until February 2022 and between December 2011 and May 2013. Since then, these bonds have again offered a positive yield of 1.5% and the aforementioned inflation protection. Despite this, the gold price is not falling because the central banks bought more gold in 2022 (1,136 tons net) than at any time since 1968 (chart 2). Are the yields on inflation-linked bonds unrealistically high?

To do this, we need to examine how the yield on inflation-linked government bonds is formed, which is currently ignored by gold buyers. The distance between the lower and upper line in chart 3 is exactly the inflation rate that investors will need over the next 10 years in order to achieve the same return with inflation-linked bonds as with normal bonds. This distance - the blue line in chart 4 - is therefore the inflation expectation of all capital market participants.

Any investor who expects inflation to exceed 2.3% p.a. over the next 10 years - the current value of the blue line in chart 4 - and owns normal US government bonds would have to sell them and exchange the proceeds for inflation-linked bonds. As a result, their prices will rise and their yields fall; the opposite effect would occur with normal bonds. Only when the resulting increase in the yield spread corresponds to the higher inflation expectation will there be no further exchange. Unfortunately, however, the expected inflation rates in the past did not correspond to the actual inflation rates over the next 10 years, as the different trajectories of the blue line and the gold line in chart 4 show; the statistically measured correlation is practically zero; the inflation rate expected on the capital market is completely useless as a leading indicator for the actual inflation rate over the next 10 years.

In contrast, there is a close correlation between these inflation expectations for the next 10 years and the oil price (chart 5); the statistical analysis (chart 6) shows a high R² value of 0.68 (zero = no correlation, 1 = exact correlation).

At first glance, this correlation between inflation expectations and the oil price is entirely plausible. Everyone associates falling oil prices with falling inflation and vice versa. Investors are therefore selling their inflation-linked government bonds because they believe they no longer need the inflation protection. This causes their yields to rise. They then buy normal bonds, which now become more attractive as inflation falls, causing yields to fall. As a result, the yield differential and therefore inflation expectations fall. The mistake investors make is that they are looking at the inflation rate over the next 10 years. For this period, however, it can be shown that falling oil prices tend to lead to rising inflation rates in the following 10 years, because lower oil prices have been followed by higher oil price increases, at least in recent decades (charts 7 and 8), which undoubtedly do not contribute to falling inflation. This correlation can be seen directly in chart 8.

The explanation for the fact that the effect of the oil price on inflation is very different in the short term than in the long term lies in the effect on supply and demand. A sharp rise in the price of oil, as in the 1970s, causes demand to fall because saving energy suddenly becomes financially attractive. At the same time, supply increases. Only when oil prices were high, for example, did the expensive oil drilling platforms in the North Sea become profitable. As a result, oil prices fell sharply until 1998 and contributed to low inflation rates.

The capital markets' low inflation expectations of 2.3% for the next 10 years are therefore not justified by anything, especially not by the fall in oil prices in recent months. The inflation rate in the USA, currently 3%, will nevertheless continue to fall for the time being (chart 9). One of the early indicators of this is the container freight cost index, which has fallen sharply since January 2022, making US imports cheaper.

The ECB and the US Federal Reserve would like to permanently lower the inflation rate to 2%. However, they have shown in recent years that they - just like the capital markets - do not have useful forecasting models for the future inflation rate. They did not even recognize the considerable inflation risks from 2021 onwards (see the capital market outlook from June 2020 on future higher inflation rates, which you can find here ) and only reacted after more than 12 months with increases in the money market interest rate (charts 10 and 11). Inflation rates are now falling significantly and, at 2.97%, are already approaching the inflation target of 2% again in the US.

However, if investors deduce from this that their inflation expectations of 2.3% p.a. until 2033 are confirmed by the central banks' inflation target and that the inflation rate will soon reach the 2% mark again and remain there, they will be in for a very unpleasant surprise in a few years' time. The US inflation rate will indeed reach the 2% mark, partly because the probability of a recession in the US and the eurozone is quite high (see the May 2023 Capital Market Outlook, which you can find here ). An inverse interest rate structure (the short-term interest rate is higher than the long-term interest rate, chart 12) has been a very good early indicator of a recession in the US for 70 years.

However, it will then become clear that inflation cannot remain permanently low.

Chart 13 shows what is probably the most important factor influencing the future inflation rate, namely the structural break in demographics, which has become increasingly noticeable in all industrialized countries, but also in many developing countries since 2010. Until 2010, the number of workers grew everywhere, meaning that wage increases and therefore also inflation rates were low (chart 13, blue bars). Since then, however, more and more countries have seen stagnation and soon a decline in the working-age population. This development is particularly dramatic in China (chart 14). Here you can see the increase in the number of workers until around 2010, followed by stagnation and the massive decline expected by the UN Population Division. In 2019, this was estimated at around 400 million workers, meaning that just under 600 million workers were still expected in 2100. Just three years later, the new forecast showed a decline to less than 400 million workers. After 15 years of a boom in the real estate market, this poses particularly serious problems for China's economic development (see capital market outlooks from June 2023, which you can find here , September 2022, which you can find here, and November 2021, which you can find here ). The shrinking labor supply for decades to come (not only in China) will not allow inflation rates to fall to the usual 2% in the long term due to rising wage costs.  

The second long-term cost-driving factor is the repatriation of primary products from countries such as China or Russia, which are no longer considered "friendly". Although this development supports the economy in industrialized countries (for example in the USA, chart 15), the production costs for these products are higher there than in China, for example, otherwise they would have always been produced domestically. This means that the astonishing similarity between the inflation trend in the US since 2014 and the trend since 1967 (chart 16) could continue for the time being - initially a further decline, which will soon be favored by a recession as in the mid-1970s (the light grey bar on the far left in chart 17). This is likely to be followed by a renewed rise in inflation rates if demand and wages increase significantly after the recession. Like every recession since 1970, this not only had the (desired) consequence of falling inflation rates, but also regularly led to an (undesired) increase in government debt (chart 17).

This brings us to a particular challenge that is looming for the US in particular over the next few years. Until around 2007, US national income rose faster than the national debt (chart 18: red line above the dashed red line) when interest costs as a percentage of national income (blue line) were low, and vice versa. From the early 1980s to the mid-1990s, interest costs rose to around 3% of national income. During this period, the red line fell below zero for the first time; government debt grew faster than economic output. This happened again at the start of the financial crisis in 2007, even though interest costs were low. The US government took on massive amounts of debt to mitigate the consequences of the financial crisis. Now the debt is much higher than in the 1980s and interest rates have risen to around 4%. This means that the interest costs for the US national debt will rise to a record 5% of national income in just a few years; an increase of over 3 percentage points compared to 2022. Either the US will soon slide into a recession - in which case interest rates would fall but the mountain of debt would rise faster (chart 17) - or the recession will not materialize, which will drive up the mountain of debt by further increasing interest costs.

The US equity market will neither be happy about further interest rate hikes in the absence of a recession nor about a recession, even if this leads to significant interest rate cuts. The valuation of US equities is close to the record levels of the last 50 years (chart 19). This means that the average price increase of US equities over the next 10 years will be 0% (chart 20).

In 2000, when US shares were even more expensive than they are today, there was euphoria about the future prospects of telecoms and internet shares. China was still small and supplied the world with cheap goods and Russia had narrowly avoided national bankruptcy in 1998. America was the undisputed sole world power and the economy had been booming for several years. Investors saw no problems, especially geopolitical ones. In 2021, US equities were valued almost as highly as in the early 2000s. Inflation had risen significantly in the meantime, but so had company sales and profits. Moreover, it was generally seen as temporary and interest rates remained at zero (see chart 11). Bonds were therefore not an alternative for equity holders. There was also no war in Ukraine yet. Now, in July 2023, a recession is by no means ruled out - and not just by us. Only 19% of the participants surveyed by Bank of America in its monthly Global Fund Manager Survey do not expect a recession in the next 18 months (survey of July 18, 2023). Moreover, the geopolitical situation is indisputably far more problematic than it was in 2000 or even in 2021, and next year will see the election of the next president in the USA.

This economic and geopolitical situation is not matched by the once again very high valuation or the optimism of US private investors (chart 21), who are also predicting price gains on the US equity market of 0% p.a. until 2033 (chart 22). For 76 years, there has been a close correlation in the US between the proportion of equities in the portfolios of US private investors and price changes over the next 10 years (chart 22). However, this is not as investors would like it to be, because whenever they are optimistic, i.e. have a high proportion of equities in their portfolios, the price gains in the following 10 years are very meagre. In the 17 years from 1974 to 1990, on the other hand, the proportion of shares was a low 15% or even lower. People were pessimistic, but the price gains in the following 10 years averaged 340% (equivalent to 16% p.a., see golden line in chart 22).

Unfortunately, the current very low unemployment rate of 3.6% (source: US central bank in St. Louis) in the US does not allow for a more positive forecast. Here, too, we find the correlation between optimism, which is by no means absurd with a very low unemployment rate, and subsequently weak gains on the stock market, while periods of high unemployment rates mean high share price gains in the future (chart 23, green bar). Since 1953, the average share price performance with an unemployment rate of less than 4.5% only reached 2.2% p.a. in the following 10 years (chart 23, red bar). If the boom of the 1950s is excluded, the expected price gain is again 0% p.a. until 2033 (chart 24, red bars).

To conclude these not particularly pleasing expectations for the coming years, there is now some positive news. Only US equities have weak earnings expectations. All other equity markets we monitor have high earnings expectations that are well above interest rates. Examples include Europe (charts 25 and 26) and Japan (charts 27 and 28).

Europe is also likely to experience a recession; Germany already had a slight contraction in economic output in Q4 2022 and Q1 2023 (source: Trading Economics, July 2023). However, unlike US equities, European equities have not experienced a boom in technology companies, which are increasingly seen as providers of artificial intelligence, and are valued on average but not highly. The expected return is therefore 9% p.a. until 2033 (charts 25 and 26).

Japanese equities are even significantly undervalued (chart 27). Nevertheless, the expected return of 7% is not particularly high (chart 28). However, it must be borne in mind that a forecast model trained with data since 1997 produces only moderate expected returns because the Japanese equity market has generated less than 50% of global equity performance in this period, at 3.3% p.a. Japanese equities are therefore likely to perform better than expected, especially as the sharp rise in global interest rates has not taken place in Japan. Short-term interest rates remain below 0%, while long-term interest rates are extremely low by international standards at 0.45% (source: Trading Economics, 24.7.2023). Unlike in the USA, where long-term interest rates of almost 4% are well above the expected returns on the stock market, government bonds in Japan are absolutely no alternative to equities.

In summary, the following future trend breaks will surprise many investors:

• Inflation rates in the US and the eurozone will soon have fallen to 2%, as expected by the average investor and the central banks. However, the expectation of the capital markets and central banks that inflation will hardly be higher in the entire period up to 2033 is unfounded. Inflation will be significantly higher on average over the next 10 years.
• China will grow much more slowly in the future than in recent decades. In addition to particularly weak demographics, the country has many other structural problems (see capital market outlooks from June 2023, which you can find here, September 2022, which you can find here, and November 2021, which you can find here ).
• After years of strong outperformance, the US equity market will perform poorly over the next 10 years. In contrast, the equity markets in other industrialized countries, but also in the emerging markets, will generate high single-digit price gains per year on average over the next 10 years.

Finally, our key statements from the Capital Market Outlook from July 2020, which you can find here:

• Shares in particular, but also residential real estate, enable real wealth preservation in the long term, even in an inflationary environment, even if regular withdrawals are made.
• Equities will come through the current coronavirus crisis well because they are becoming more robust thanks to cost-cutting programmes and digitalization.
• In the real estate sector, preference should be given to residential real estate.
• Gold remains interesting, but bonds are also very unattractive in the long term

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You can also download the capital market outlook here.