Who is afraid of the spectre of inflation? Nobody!

There have been some changes in recent weeks that confirm the expectation of rising inflation risks that we outlined back in spring 2020 - that is the bad news. However, the conclusion based on this that the price that is decisive for the economy and the capital markets, the long-term interest rate level, will react only slightly to higher inflation rates has so far also proven to be correct, which is good news.

The significant jump in the US inflation rate, which is also reflected in the core inflation rate (excluding energy and food prices, see chart above), which is not affected by the rising oil price, has hardly had any impact on the long-term interest rate for US government bonds. This is particularly noteworthy because the US government has provided the largest sums in an international comparison since 2020, at 25% of national income, to support the economy and compensate for corona-related income losses (see chart below).

For the next 12 months, this disregard for current price increases is probably even justified. Following a sharp rise, timber prices have recently fallen again significantly because demand for construction timber in the USA has fallen due to price factors and sawmills have increased their production. China is beginning to depress prices by selling strategic reserves of important industrial metals. The price of oil has risen by over 150% since April last year and was only slightly more expensive than today for a short period in the last five years in the summer of 2018; a further price increase at this rate is extremely unlikely. This is also the view of the central banks, which is why they are emphasizing that they are not paying attention to the sudden rise in inflation.

In our Capital Market Outlook from May 2021, which you can find here, we described the factors that will contribute to significantly higher inflation rates in the longer term, i.e. over the next decade. Here is the summary again:

• In recent decades, many countries have run up debts, particularly for high social benefits, without taking into account that this expenditure would not generate corresponding tax revenues in the future; the growing national debt was therefore deliberately accepted. In future, too, politicians will not abandon the path of least resistance in the face of demographically induced sharp increases in social benefits and will continue to increase debt
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• Governments were able to rely on the help of their central banks, particularly after the financial crisis, which have always ensured falling interest rates through government bond purchases whenever investors have lost confidence in a debtor country (most recently in Italy during the coronavirus outbreak in February 2020)
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• The future global demographic trend of a declining workforce as a proportion of the total population increases the potential for inflation, as there are fewer productive workers and more pure consumers. In addition, the rapidly growing number of older people is causing high and constantly rising healthcare costs, most of which will have to be borne by the state. The following chart shows the influence of demographics in the years 1970 to 2010 (blue bars), when the entry of baby boomers into the workforce, increased female employment and the opening up of China and the former Eastern bloc reduced annual inflation in 22 countries by an average of 2.9% p.a. The orange bars show the expected increases in annual inflation rates up to 2050 due to the declining proportion of the workforce (average value up to 2050: +3.4% p.a.). There is therefore no question of the frequently expected deflation due to the ageing population.

• Increasing de-globalization and growing regulatory zeal on the part of politicians (the former Berlin rent cap and perhaps soon a nationwide rent cap) are reducing supply and are already making production more expensive. Higher tax burdens for entrepreneurs ("rich") would also have an effect
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• The failures of German politicians of all parties to design or reform the overpriced and low-return funded pension scheme (Riester pension) will require higher pension payments at the expense of the state coffers in future
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• The extremely large economic stimulus programs to combat the consequences of the coronavirus, but also climate change, despite the already extremely high national debt, could trigger a general inflation mentality as 55 years ago (politicians spend a lot of money, which increases wages and costs, which generates further demands for wage increases, etc.).

Now that interest rates have so far resisted the short-term outbreak of inflation, the question is whether a sustained rise in inflation will have little impact on interest rates or whether a sharp rise in interest rates could cause the stock and real estate markets to collapse. The next charts look reassuring in this respect.

First of all, you can see that the slide in interest rates, here using the USA as an example, from up to 14 percentage points at the beginning of the 1980s to the current 1.45% was by far the biggest fall in interest rates in 221 years since the beginning of industrialization.

However, there is only a weak correlation between this sharp fall in interest rates in the USA and inflation (bottom left chart) (bottom right chart). Thus, with inflation rates barely falling, as was the case between 1984 and 2021, long-term interest rates could fall sharply without precedent.

The explanation for the fall in interest rates is provided by another, much more powerful influencing factor compared to the inflation rate, namely government debt in relation to national income (see chart below for the example of the USA).

The sharp increase in government debt after the global economic crisis and particularly as a result of the Second World War was accompanied by interest rates that were lowered to their lowest level since 1800 - largely through extremely low money market interest rates controlled by the US Federal Reserve and permanent purchases of government bonds. The second great orgy of debt began in the early 1980s with tax cuts and a sharp rise in military spending, was interrupted in the mid-1990s by the economic and stock market boom driven by the US technology sector, resulting in high tax revenues on share price gains, and was finally driven to new record levels by coronavirus-related government spending from 2020. This time too, the central bank ensured falling interest rates with a growing range of measures.

The chart below left shows how strongly government debt has influenced the biggest fall in interest rates of all time; 80% of the interest rate movement can be explained by rising government debt alone (chart below right). This leaves little room for other influencing factors, such as inflation.

We should therefore expect that a phase of higher inflation rates in the coming years, in which government debt will certainly not fall (demographic change with rising healthcare costs and pension spending, combating the consequences of the pandemic and climate change, ...), will at best be characterized by weak or non-rising interest rates. Of course, this does not only apply to the USA. All of the aforementioned developments are also the most likely scenario in other industrialized countries and increasingly also in China in a similar form.

This means that the environment for the equity market remains slightly positive in principle, as interest rates have a strong influence on valuations and therefore also on the future performance of equities, as will be shown below, initially for the global equity market and later for some sectors and regions.

The two charts below show that the ratio of share prices to cash flow (KCFV) on the global equity market is the most important factor influencing the performance of the equity market over the next 10 years. It explains 76% of future performance (and

currently suggests slightly negative total returns for the next 10 years (left chart). The significance of the long-term interest rate level can be seen in the right-hand chart, as it determines 65% of the KCFV.

Rising interest rates therefore require rising cash flow yields. These arise either when share prices fall or when companies' cash flows increase. In an environment of rising interest rates, however, the global economy with highly indebted countries, real estate markets and companies (China, France, ...) is unlikely to allow for generally rising corporate profits. For this reason, it is preferable to invest on the stock market in sectors or regions whose earnings situation is as independent of the economy as possible (so-called quality stocks) and / or which are valued low in relation to interest rates and for which a rise in interest rates is therefore not risky.

According to a recent study by the American asset manager GMO, quality stocks, and among these especially the low-priced value quality stocks, have mostly outperformed the overall US market in times of inflation rates of over 5% p.a. for 90 years.

Overall, quality stocks outperformed the overall US equity market by 20% points and value stocks by 39% points during the inflationary periods.

Over the past 26 years, two sectors of the global stock market have proven to be significantly more stable in terms of returns than the market as a whole. Shares in the consumer staples sector - companies such as Nestlé, Procter & Gamble, Walmart or Coca-Cola - have a business model that is not very cyclical (their products are constantly bought or, like Walmart, they cover basic consumer needs). Accordingly, the share prices and also the cash flows of these companies fall significantly less in times of crisis (2002 to 2003, 2007 to 2009, 2020) than on the stock market as a whole (see charts below). In addition, they mainly produce branded goods, which continue to be bought even if the price is raised slightly. The companies are therefore less susceptible to inflationary trends. Despite the lower risks, the share prices of these companies have outperformed the stock market as a whole.

In addition, share returns in this sector can be predicted quite well over the next 10 years if you look at the current price/cash flow ratio. At the current value of 15.6, this indicates an annual performance of 5% p.a. with a high forecast quality (70% of returns over the next 10 years have been explained by this since 1995). That is 7 percentage points p.a. more than the global equity market (see p. 4 bottom left, expected return -2% p.a.)

Even more attractive is the healthcare sector, whose largest companies are Johnson & Johnson (USA, pharmaceutical and medical technology manufacturer, one of the few US companies with an AAA credit rating), United Health (USA, health insurance) and Roche (Switzerland, pharmaceutical manufacturer). The share price and, in particular, earnings stability are also good there (see charts below).

Particularly convincing in this sector is the high predictive power of the price/cash flow ratio (92% of 10-year returns have been explained by this ratio since 1995, see chart above) and the only average valuation in a period of extremely low interest rates. So if, unlike the global equity market (see price/cash flow ratio and 10-year performance scatter plot above) or consumer staples stocks (see above), low interest rates have not led to very high valuations, rising interest rates will not trigger falling valuations for healthcare stocks either. It is more likely that permanently low interest rates will drive healthcare stocks higher. In addition, the healthcare sector is already characterized by historically above-average earnings growth, which will continue to be above average in the future due to future global demographic developments. For these reasons, FINVIA's equity portfolios are not overweighted in equities overall, but the healthcare sector is significantly overweighted within the equity component.

Among the regions, Europe is currently an example of a not particularly high valuation (see chart below left) with a resulting fairly good earnings expectation of 5.5% (see the green arrows showing the price/cash flow ratio after the corona-related slump in earnings is probably fully recovered towards the end of 2021). The forecast quality is also quite high at 77%.

After all, European equities have benefited little from extremely low interest rates (see charts below). When the cash flow yield (currently 8.6%) fell below 10% for the first time almost 25 years ago, interest rates were still at 4 to 6%, and currently at 0%. A moderate rise in interest rates is therefore unlikely to have a negative impact on European equities for the time being.

To summarize , inflation should average at least 3% per year in the eurozone and the USA over the next 10 years, with slightly lower rates in the next 5 years and higher rates thereafter. The main reason for this assumption is the demographic trend in industrialized countries worldwide, which is easy to forecast in the long term.

However, the high level of government debt will ensure that interest rates can hardly react to this.

This means that the environment remains positive in the long term, particularly for those parts of the equity market that have benefited little from the fall in interest rates in recent years and that are less susceptible to general price increases. These include consumer staples stocks, healthcare stocks and, as a region, European stocks.

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