Economy, exchange rates and securities

The geopolitical tensions have various causes, for example the growing populism in the western industrialized nations - US President Trump (2016 to 2020) has made an important contribution to today's tensions with his trade war against China -, the number of democracies, which has been falling again for 10 years (chart 1), and the growing self-confidence of the major emerging economies (BRICS countries of 2022, chart 2), which has increased since 2000 as their economic power has grown significantly.

Last year, they even held a conference at which the introduction of a common digital currency linked to gold, silver and various commodities was discussed (source: Der Standard, 15.7.2023) in order to replace the US dollar as the world's most important currency. Even if the development of economic output since the turn of the millennium indicates a significant decline in the importance of Western industrialized countries, this has not yet been reflected in the structure of global currency reserves (chart 3).

The US dollar has been able to increase its share of global currency reserves since December 1995, as has the euro since 1999. Only the share of the yen has fallen slightly since then, from 7% to 5.5%, while the currency of China, the great economic climber of the last 30 years (chart 4), has only managed to achieve a share of 2.4%. In the case of the democratic industrialized countries USA, Eurozone, Japan, UK and Switzerland (0.2% of global currency reserves), the ranking of the share of the currency in global currency reserves corresponds to the share of the respective country in global economic output (chart 4). However, the importance of the Chinese yuan as a reserve currency is negligible compared to China's economic output. As long as the Chinese currency is not freely tradable, i.e. China renounces this important component of a liberal economic order, the yuan will remain of secondary importance.

The change in a country's relative economic performance, i.e. in comparison to global economic performance, also appears to be related to the exchange rate in the long term. During the 130 years from 1820 to 1949, i.e. from the global start of industrialization to the period after the Second World War, the share of British economic output in the global economy was around 10% (+/- 2 percentage points, chart 5). The exchange rate of the British pound against the US dollar was also largely stable. However, the outbreak of the First World War in 1914 marked the beginning of the first fluctuations. After the end of the Second World War, which was very costly for the UK (national debt in 1946: 270% of national income, source: www.macrohistory.net), the pound began a sustained decline of almost 75% from 1947. Since then, the country's relative economic output has fallen by 71%.

Only the UK is suitable for a very long-term analysis of economic performance and the exchange rate against the US dollar, as the country hardly recorded any higher consumer price increases than the USA (chart 6), whose national debt in 1946 only reached 119% of national income (source: www.macrohistory.net), despite the enormous financial burden of the two world wars from 1914 to 1946. In the other large countries that were involved in the war and had to cope with extremely high financial burdens, the decline in the purchasing power of the currencies and thus the exchange rate was much greater, so that corresponding comparative calculations are not meaningful. For example, consumer prices in France rose a hundredfold, while inflation was even higher in the other countries (chart 6).

By contrast, the fluctuations in relative economic output since 1980 are linked to exchange rate changes in several countries, including China. The increase in relative economic output from 2005 to 2015, which was well above the trend, also led to an increase in the value of the Chinese currency. In 2005, it took 8.18 yuan to buy one US dollar; in 2015, 6.29 yuan was enough (chart 7). In the meantime, the value of the yuan has fallen again by more than 10%, and it now takes 7.10 yuan to buy one US dollar.

Figure 8 shows that the correlation over the last 28 years since 1995 is quite close; the value of the R² figure, which can range between 0 (no correlation) and 1 (perfect correlation), is almost 0.9.

The correlation between relative economic performance and the exchange rate is also evident in Japan. During the rise of the Japanese economy up to 1994, the yen appreciated sharply. Instead of 226 yen in 1980, at the peak of Japan's relative economic performance in 1995 (see chart 9 and chart 4), only 94 yen was needed to buy one US dollar. With the gradual decline in Japan's importance, the yen has depreciated again to 141 yen per US dollar to date. The exchange rate change in Japan's boom phase and in the years between then and 2006 was significantly stronger (chart 10) than in the subsequent phase of relative decline (chart 11).

The aforementioned correlation also exists in the eurozone and the USA - growing relative economic output goes hand in hand with a rising value of the currency (charts 12 to 15).

The question now arises as to whether economic output influences the exchange rate or whether it is the other way around. The two components of real national income are the population (chart 16) and real national income per capita (chart 17). Population growth is very steady. In Germany, recognizable slumps were a consequence of the two world wars; in the UK, they occurred due to Ireland's independence (1921) and in India due to independence from the UK (1947) with the secession of the newly founded Pakistan.

Real per capita national income is subject to greater fluctuations. In the USA, the global economic crisis from 1929 to 1933 caused the sharpest slump, while in the UK and Germany the declines were particularly severe during and after the two world wars. Japan also recorded massive income losses during the Second World War. China experienced a major famine around 1960 with considerable consequences for the economy. The same slumps can be seen in the countries' real national incomes. Real per capita income is therefore responsible for the short-term fluctuations, while the long-term trends are generated by both components (Figure 18). The relative decline of China and India until around 1980 was characterized by weak demographics and stagnating per capita income, while the rapid rise since then has been driven by both components (chart 19). The relative rise of the US economy until 1945, but also the only moderate decline since then, were also caused by the steady growth in population and per capita income.

The USA has also performed better than the eurozone, the UK and Japan over the last 43 years (chart 20) when looking at real national income. If, on the other hand, the economic performance of the countries is measured in terms of exchange rates and everything is converted into a single currency, e.g. the US dollar, the picture looks somewhat different (chart 21). The major trends - the rise of China and India, the slight relative decline of the USA and the more pronounced decline of Europe and Japan - remain the same, but the medium-term fluctuations become more pronounced.

Chart 22 uses the example of the US to show what caused these medium-term fluctuations. Whenever the US economy was particularly strong compared to Europe, capital flowed into the US dollar and weakened the euro or, before 1989, the DM; in other words, fewer dollars were needed to buy one euro (rising blue line in chart 22 indicates a strong dollar). The share of the US economy in the global economy, measured in US dollars, rose correspondingly sharply (red line in chart 22). However, in all three cases this was a false boom. From 1983 to 1986, then US President Reagan accepted average annual government deficits of 5% of national income (source: US Federal Reserve Bank of St. Louis) in order to keep the then still-existing Soviet Union at a distance militarily after its invasion of Afghanistan by increasing military spending. US goods became too expensive due to the inflated dollar exchange rate. Investors became aware of this from 1985 and the euro appreciated sharply in the following years (chart 23). In 2000, the internet boom of the 1990s was thought to be a permanent phenomenon. This was not sustainable either; the US dollar, which had risen in the meantime, fell significantly in the following years. Currently, the AI (artificial intelligence) fantasy, but also the enormous new debt of the US governments (since 2019 an average of 9% of national income p.a., source: US central bank St. Louis) - are clearly brightening the picture compared to the paralyzed Europe - however, such high borrowing is also not sustainable. As was the case in the mid-1980s and late 1990s, the US dollar is overvalued and will again fall significantly over the next 10 years in line with the close correlation between the future exchange rate and the valuation (chart 23). The relative economic performance of the USA will then also fall (chart 15).

In Japan, real economic output as a percentage of global economic output (orange line in chart 20) rose slightly during the boom of the 1980s, but the share measured on the basis of the dollar exchange rate rose sharply from 11% to 18% (orange line in chart 21), because the yen had risen from 235 yen per US dollar in 1985 to 94 yen per US dollar 10 years later (chart 9). The reason for this was the boom in share and real estate prices over the years (chart 24), which attracted massive amounts of foreign capital. At its peak, the Japanese central bank proudly reported in its 1990 annual report that the 1.6 km² site of the Japanese Imperial Palace was worth more than all the real estate in California. The stock market was equally absurdly overpriced with a dividend yield of 0.4% in December 1989 (source: MSCI) - never before and never since has a country's stock market had such a low yield. However, the subsequent loss of importance of Japan, whose share of global economic output measured against the Japanese currency has shrunk from 18% to 4% in the last 30 years, is also record-breaking (chart 21). The much more moderate decline from 11% to 5% in terms of real economic output (chart 20) is probably somewhat closer to the truth, as the Japanese currency is currently massively undervalued even against the euro, which is cheap in relation to the US dollar (chart 23), and has a high upside potential over the next 10 years (chart 25).

After the 2008 financial crisis, China made the big mistake of artificially inflating economic growth through lavish construction activity in the real estate sector, which far exceeded the residential real estate boom in the US until 2006, which had caused the severe global financial crisis from 2007 onwards (chart 26). In September 2022, the US investment bank Morgan Stanley estimated the number of vacant apartments at 65 million. Unlike the clever Americans, who had sold a large proportion of the mortgage loans to European and Asian investors with poor credit ratings ("subprime"), the loans for the empty apartments in China were financed almost exclusively by Chinese savers. A global financial crisis is therefore not to be feared. However, the Chinese have lost confidence in the future. One indication of this is the collapse in the birth rate compared to Germany - not exactly known for its particularly good demographics - or the USA (chart 27). Most vacant apartments will probably remain empty.

Consumer confidence in China has also fallen massively since February 2022 (Figure 28). At the same time, foreign companies began to reduce their direct investments in China from USD 101 billion in Q1 2022 to USD 38 billion in Q2; in Q3 2023, they withdrew more capital than they invested for the first time (chart 29, for China's major problems, see the capital market outlook from November 2021, which you can find here , and from June 2023, which you can find here ).

China's weak demographics will permanently reduce its long-term growth potential. In 2019, the UN estimated that the number of Chinese of working age would fall from the current 1,000 million to 585 million in 2100. Just three years later, this estimated figure was massively reduced to 380 million due to the further collapse in the birth rate. Added to this is an already very high level of debt (307% of national income), which, with the exception of France (338%), is unmatched by any other major European country or the USA (source: Bank for International Settlements, November 2023). To alleviate the real estate problems, the government will have to greatly expand its debt over the next few years, as all countries have done after an exaggerated real estate boom. Chinese interest rates will also be very low by international standards in the future. For example, from 1990, the peak of their equity and real estate boom (chart 24), the Japanese had to cut their money market interest rate from 6% to 0% by 1999, where it still stands today, in order to stabilize the interest costs of exploding government debt (1990: 70% of national income, 2024: 264%, source: Trading Economics, January 2024). This mixture of low interest rates and extremely high government debt is likely to be the main reason for the low valuation of the Japanese yen, alongside Japan's weak demographics. The Chinese currency is therefore likely to face a long-term downward trend, meaning that China's economic importance is also unlikely to increase any further.

Similar to the economic importance of a country, its stock market is also significantly influenced by exchange rates. Using the example of the US and European stock markets, chart 29 shows that a fall in the blue line (phase of a strong US dollar - you need fewer US dollars to buy one euro) is accompanied by a rise in the red line (phase of a stronger US stock market compared to the European stock market) and vice versa. The correlation is quite close with an R² value of 0.66 (chart 30).

We also find this correlation in the relative performance of US equities compared to Japanese equities, except between 1996 and 2009. The two charts below show that as the purchasing power of the US dollar increases (then you need more yen to buy a US dollar), US stock prices rise relative to Japanese stock prices and vice versa.

To summarize, we can say that the long-term trend of an economy compared to global economic performance (chart 20) is determined by population development and productivity growth. However, if we evaluate the national income of countries in one currency, e.g. the US dollar, the relative economic performance of individual countries and regions is subject to greater fluctuations (chart 21), which are caused by exchange rate movements but do not dominate the fundamental trends. The clear decline of the eurozone, whose economic output in US dollars was as high as that of the USA in 1980 and 2008, is exaggerated by exchange rate movements. The euro was overvalued against the US dollar by around 30% in both 1980 and 2008, but is now undervalued by around 15% (chart 23, blue line). However, the over- or undervaluation of a currency has been a reliable early indicator of future exchange rate developments since the 1970s. There is therefore a high probability that the euro and the yen will appreciate against the US dollar, whose phases of overvaluation in the past have been accompanied by an unsustainable fake boom in the US economy. The relative economic performance of the eurozone and Japan will move somewhat closer to that of the US over the next 10 years. China's relative rise is likely to come to an end due to numerous significant structural problems.

This study also supports our thesis that the European and Japanese equity markets will outperform the US equity market over the next 10 years (see Capital Market Outlook from December 2023, which you can find here), as stronger currencies lead to capital inflows and thus to stronger equity markets (charts 30 -33).

Finally, our key statements from the Capital Market Outlook January 2021, which you can find here :

The political forecasts in the January 2021 Capital Market Outlook were only partially correct. The expectation that the massive coronavirus rescue measures, supported by the ECB, would improve the cohesion of the EU and the eurozone and that no members would leave has proven to be correct to date. The assumption that China's increasingly hostile economic policy would have a negative impact on its economy in the long term has also proved correct. This sounds banal today, but three years ago it was not a consensus. By contrast, the assumption (or hope) that Donald Trump's election defeat could herald the decline of populism was wrong.

The expectation of rising share prices due to low interest rates was also correct, with the global equity market gaining 19% (in €), but not the expectation that the very highly valued US equity market could underperform. Valuations only provide a good indication of future returns in the long term.

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You can also download the capital market outlook here.