Turning times

This time we would first like to take a long-term look at the performance of shares, bonds, residential real estate and gold since 1914. This year, in which the First World War broke out, marked the end of the previously prosperous, less indebted world with an inflation-proof gold currency. Since then, there have been various other turning points, the last of which was caused by the coronavirus crisis. Which asset classes have coped with this and which have not? What do the valuation and forecasting models say?

The year 1914 not only marks the beginning of the First World War, but also the end of the precious metal-based currencies used in Europe and the USA for many centuries. Before 1914, inflation only occurred during a few major wars (the Seven Years' War from 1756 to 1763, the Napoleonic Wars until 1815), after which there was iron-fisted austerity and prices fell again. Data for England dating back to 1661 shows an inflation rate of 0.13% p.a. up to 1830 - in 169 years, prices rose by only 25% overall. Inflation data is also available for Sweden since 1830 and, like the English data, shows that prices hardly rose at all until 1914 (chart 1). From 1914 onwards, however, inflation was the rule rather than the exception worldwide.

Right at the beginning of the First World War, some governments abolished the gold backing of their currency in order to be able to print unlimited amounts of money; however, consumer prices also rose by 100 to 170% in other countries until inflation stabilized from 1920. Germany, on the other hand, experienced hyperinflation, which completely destroyed the purchasing power of the German currency by November 1923. The global economic crisis from 1929 led to falling prices everywhere and forced most countries to finally abandon the gold backing of the currency in order to support the economy with government spending. With the start of the Second World War in 1939, consumer prices began to rise again worldwide, a trend that continues to this day. After the USA became the last country to end the pegging of its currency to the price of gold between 1968 and 1971 due to the costly Vietnam War, there was now the possibility of unlimited money creation everywhere. In this respect, 1970 marked another turning point in international finance.

Since 1914, it has been possible to increase the standard of living in the USA (without taking taxes and withdrawals into account) with shares, but also with residential real estate; the asset growth required for this in these asset classes significantly exceeded the growth in per capita income (see chart 2a), while government bonds and gold did not generate sufficient total returns. Per capita income is a better measure of the performance of an asset class than the consumer price index. If the development of wealth only reached the consumer price index, a wealthy family in 2023 would only be able to buy 1/6 of the goods and services they could afford in 1914 compared to the development of per capita income, the income of an average earner (chart 2b). The relative standard of living would have fallen sharply.  

There were only slight differences in the average annual increase in shares and residential real estate as well as in per capita income before and after 1970, while gold and government bonds benefited significantly from the removal of the gold backing for the dollar after 1970 (chart 3a). However, one cannot conclude from this that government bonds would benefit permanently from the unlimited possibility of printing money. Their positive development was historically unprecedented, as interest rates on 10-year government bonds had reached an extremely high level by the end of the 1970s (chart 3b). By 2020, interest rates had fallen to a historically unprecedented low of around 0% due to the ability of governments to print money to buy government bonds in times of crisis such as the 2008 financial crisis and, most recently, the coronavirus crisis from 2020 onwards. During these 40 years, holders of government bonds not only received interest, but also unusually high price gains.

At first glance, everything seems quite simple. You allocate wealth mainly to shares (and the comparable private equity funds) and invest a smaller portion in residential real estate for security. Then the wealth will automatically grow much faster than the per capita income; you will gradually become rich.

However, this pleasant development only applies to investors or families who do not have to pay taxes for over 100 years and do not make a living from wealth . As we will see, the French economist Piketty (Thomas Piketty: Das Kapital im 21. Jahrhundert, 2014) is wrong in his thesis that with returns greater than economic growth, the rich would have an ever greater share of the national wealth. Only if wealthy families do not withdraw anything in the long term, not even for tax payments, is the thesis correct for owners of shares and residential property (Figure 2a), otherwise it does not apply to most regions, forms of investment and time periods.

Even the initial withdrawal of 1%, which was adjusted in the following decades in line with the growth rate of per capita income and thus rose from 1 dollar in 1914 to 187 dollars in 2023, was not sustainable for a wealth that was invested 100% in government bonds (consumption of wealth in 1977) or gold (consumption in 1960) (chart 4a). By contrast, an investment in shares or residential real estate would have generated a 1% initial withdrawal with the above-mentioned growth on a sustainable basis (chart 4a). But even an initial withdrawal of USD 1.85, which would have risen to USD 347 by today, could only be made until 2022 with an investment in residential real estate wealth . In May 2023, the wealth would no longer be available (chart 4b). Equities, on the other hand, would enable a withdrawal of as much as USD 3.8 initially and could easily continue to represent the withdrawal that rose to USD 713 in 2023, as the equity portfolio would have grown from USD 100 in 1914 to USD 18,900 today despite the withdrawals and the USD 713 withdrawal would represent 3.8% of the portfolio (as in 1914).

But even at this point, the all-clear cannot be given. You had to have invested in the right country in 1914. In 1914, this was the USA, the actual winner of the First World War. There, the initial withdrawal of 3.8 dollars could be earned well beyond 1970 if you had invested your money in shares, as chart 4c shows. This would not have worked in Germany and Japan, which suffered high human and material losses in the First and/or Second World War.

The direct comparison of charts 5a and 5b shows the huge difference for equities and government bonds between the USA and the two war losers, initially without withdrawals. Even after the First World War, the stock markets in Germany and Japan failed to generate any significant growth, so that the wealth invested in equities was already used up during the global economic crisis in 1932 with an initial withdrawal of 3.8%, growing in line with per capita income (chart 5c). The wealth invested in government bonds had already met this fate a few years earlier. Real estate or gold would probably not have fared much better for the following reasons. In Germany, an era of state discrimination against property owners began in 1923 with a rent cap, which was a considerable burden for landlords during hyperinflation (house interest tax from 1924 to 1943, when a one-off payment of ten times the previous annual amount had to be made, burden equalization in 1953: 50% of the property value, payable in 30 annual instalments, source: Wikipedia 2023). In addition, most cities were destroyed. Gold was also unsuitable, as its possession was prohibited in the Third Reich.

In this comparison, it is striking that per capita income in Germany and Japan developed even better from 1914 to 1970, increasing 21-fold in US dollar terms (chart 5b) than in the USA (increase of 13-fold, chart 5a). This is due in particular to the strong economic growth of the two war losers from 1945, when reconstruction began, but also to the fact that a war causes massive government spending, which drives up economic output. This is also shown by the development in the USA during the two world wars (charts 6a, b).

Since 1970, all asset classes have outperformed per capita income in both the USA and Germany (charts 7a and 8a). Nevertheless, it would not have been possible to withdraw more than 3.2 dollars in the USA in 1970 and increase withdrawals annually by the growth in per capita income. This is the only way that a wealth invested in shares would have just grown in line with per capita income despite withdrawals and could have financed the continued growth in withdrawals for many decades to come (chart 7b). In the case of gold, this would only have worked because the price of gold had risen extremely sharply at the beginning of the period under review and the withdrawals would therefore hardly have burdened gold assets at the beginning despite the lack of current income. The significantly weaker performance of residential real estate in the 1970s, which even delivered a slightly better overall performance than gold without withdrawals (chart 7a), would have meant that the growing withdrawals in the 1970s and 1980s would have weighed so heavily on real estate assets that wealth would have gradually shrunk from 1989 onwards and been used up in 2010 (chart 7b).

The situation was very similar for a German investor. After all, a wealth invested solely in equities would have initially generated €2.6 in sustainable withdrawals, which grow in line with per capita income (chart 8b). This is not very much, because under today's tax law, the performance of shares since 1970 (just under 8% p.a.) would have been subject to 26.4% flat-rate withholding tax, which is around €2 at the outset. That leaves hardly anything left over for lavish private withdrawals.

Furthermore, although investing the entire wealth in shares is particularly profitable in the long term, it is unfortunately also very susceptible to fluctuations. In chart 2a, you can see a sharp decline in the US equity market from the "4" of the year 1924. This event, which took place a long time ago, does not look particularly impressive. In practice, however, it was quite different. From its high in the summer of 1929, the Dow Jones Index fell by 89% to its low in 1932. Investors had to have very strong nerves to hold on. In Germany, a sharp slump began in March 2000, which only came to an end in March 2003 after a 75% drop (chart 8a).

The vast majority of investors cannot withstand such fluctuations, especially if they have to make a living from this wealth . This is where the idea of risk diversification comes from. Even if you only invest 60% in equities and 40% in less profitable asset classes, wealth will grow just as strongly as pure equity assets in the long term, but the fluctuations will decrease significantly (chart 9).

The agonizingly long phase of weak stock market performance from 1970 to 1983 (€100 became €77 after withdrawals, while per capita income had already risen to €245) is much more bearable with the mixed portfolio (green line in chart 9). Although the maximum loss from March 2000 to March 2003 still reached 59% (instead of 75%), the psychological burden was lessened by the fact that gold, residential real estate and government bonds had risen in value during this period.

The question now arises as to which phase of the past the future will most closely resemble.

The golden age of globalization, which began with the transformation of China's socialist economy into a market economy with growing entrepreneurial freedom at the end of the 1970s and was accelerated by the fall of the Berlin Wall in 1989 (chart 10a), will unfortunately not be, because some large countries (China, Russia) have finally lost their way to economic and political freedom in recent years (chart 10c). This can already be seen in the development of inflation rates in the USA and Germany, for example (chart 10b), which were very low until 2020 and have risen not only, but also because of China's rigorous coronavirus policy and Russia's war of aggression.

Other factors that will structurally contribute to higher inflation in the coming years, perhaps even decades, are demographics and the high level of debt (see the capital market outlook from March 2022, which you can find here can be found here). The era of globalization and an abundant global supply of labour came to an end in 2020 at the latest with the outbreak of the coronavirus crisis, when there was a sudden lack of supplier parts in many areas of the economy and an increasing shortage of labour became apparent. This represents a structural break for the capital markets. In the previous 40 years, total returns on government bonds were well above average (chart 11). Equity performance was also relatively good. Gold, on the other hand, performed poorly.

The scenario we are looking for in the future therefore consists of slightly below-average returns for equities, well below-average returns for government bonds and significantly above-average returns for gold. Residential real estate returns are likely to be average.

The current return expectations for equities correspond to the probable future scenario both on the US equity market with a return forecast of 5.5% p.a. until 2033 (charts 12a, b, c) and for European equities with a return forecast of 8% p.a. until 2033 (charts 13a, b, c); the values are significantly below average in the USA and slightly below average in Europe.  

The expected performance of government bonds in the USA (chart 14a, expected return p.a. until 2033: 3.9%) and in Germany (chart 14b, expected return p.a. until 2033: 2.5%) also fits the scenario of significantly below-average returns described above.

The price of gold has risen by 7% per year since the gold backing of the US dollar was lifted in 1968 (chart 15a). However, there was a significant deviation from the trend growth in 1980. These deviations are explained quite well by the average inflation rate in the US over the last 7 years (chart 15b). The average inflation rate of over 9% in the years 1973 to 1980 triggered strong gold buying, as investors obviously expected this multi-year average inflation to continue in the future. Currently, the gold price should be slightly higher than it currently is due to average inflation since 2016 (3.4% p.a.) (chart 15b, the red dot is slightly below the target value). If trend growth remains unchanged, the gold price increase should therefore be around 10% in US dollars and around 7.5% p.a. in euros. These figures also fit the picture of an expected above-average performance of gold, as the long-term price gain in the US has been 4.2% p.a. since 1914 and 6.2% p.a. in DM or € since 1970.

Average residential properties in Germany are not overpriced in the long term. The increase in house prices is only relevant in connection with the development of per capita income. Since 1970, per capita incomes in Germany have risen more than twice as much as house prices up to 2008 (Figure 16a). Only in the last 14 years has the rise in house prices been greater. However, per capita income has risen by 46% more than in 1970. Taking into account the still favorable financing conditions compared to previous decades, German residential real estate is inexpensive by both historical and international standards (Figure 16b).

For almost 50 years, the income expectations of condominium buyers have been based on rental yields and the long-term future growth of rents, derived from the average inflation of the last 10 years (Figure 17a). Accordingly, condominiums are currently fairly valued. Investors have a return expectation of around 5%, formed from the current rental yield of 3% and the future perpetual rental growth derived from the current 10-year average inflation rate of 2.2% p.a. A detailed explanation of the relationship between rental yields, average inflation and mortgage interest rates can be found in the December 2021 Capital Market Outlook, which you can download here here. If inflation reaches 3.5% in the future, condominiums are currently undervalued. The supply of apartments has also been very low for a long time (chart 17b).

In the last few years from 2008 to 2020, German residential real estate generated a total return of 9% p.a.. This will not be achievable in the future, but they will reach the long-term average of 5% since 1970 or moderately exceed it with average inflation of 3.5% p.a.

In summary, we can say that changes in demographics and the decline in globalization, also due to countries such as China and Russia turning away from democracy and a market economy, have made the world more restless and more susceptible to inflation. Added to this is the high level of debt, which limits the scope for political action. The new period of de-globalization since 2020 will be characterized by below-average returns on government bonds, but also other types of bonds, below-average returns on equities, average returns on residential real estate and above-average returns on gold. With the exception of bonds, however, the other asset classes will still deliver returns that are above the inflation rate of 3.5% that we estimate for the next 10 years in Germany. This means that real wealth preservation is likely to be a very realistic scenario for a portfolio invested predominantly in equities, residential real estate and gold wealth .

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You can also download the capital market outlook here.