Turning point

Turning point - Chancellor Olaf Scholz used this word in his speech on February 27, 2022. After many years of refusing to take future-oriented measures (rearmament, old-age provision, ...), German politics has been quickly and thoroughly awakened.

We are not only at the end of a decades-long period of peace in Europe, North America and East Asia. This change has become increasingly likely as political uncertainty has grown over the past 15 years (Figure 1a); we will describe the political causes of this turning point in more detail below.

The historically unprecedented 40-year era of falling interest rates (see Figure 1b) is also likely to have come to an end, as interest rates have fallen below 0% in a number of countries as a result of the coronavirus crisis, which is not economically sustainable and has never happened before in history.

In addition, the massive and generally unexpected rise in inflation rates since the beginning of 2021 stands in the way of a continuation of the interest rate reduction trend (see Figure 2a, for the main causes of the increase in inflation that we predicted two years ago, see the Capital Market Outlook from June 2020, which you can find here can be found here). The 40-year period of low inflation rates has also come to an end. According to a 2018 study by the Bank for International Settlements, the most important reason for this, the declining labor force, will continue until at least 2050 in the 22 industrialized countries analyzed, driving up inflation rates by an average of 3.4 percentage points p.a. (Figure 2b). The Putin war exacerbates this scenario, as Putin has turned Russia into a rogue state that is largely excluded from global trade, at least as long as Putin remains in power.

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The only extremely important trend of the last 40 years that will remain with us for many years, if not decades, is the development that has been visible worldwide since the 1970s, namely that government debt is rising faster than national income everywhere (see Figure 3a). However, the main cause of this will no longer be exclusively "bad" policies, but also the ageing of the population.

In the last 40 years, we can find many individual events that are "bad" policy in that they have caused rising government debt through capital waste without having a positive impact on a state's economic performance. Compared to previous decades, the cause of this is not more irresponsible politicians, but the fact that there is hardly any additional money to distribute everywhere (see Figure 4a).

In addition, the distribution of income has increasingly changed to the detriment of low earners over the last 40 years, as can be seen from the American Gini coefficient (Figure 4b, example USA). A Gini coefficient of 1 means that an American earns the entire US income; a value of 0 is given if all Americans earn exactly the same.

40 years ago, a recipe that was already appreciated 300 years ago was increasingly used worldwide to quickly stimulate the economy, for example to calm the discontented: The promotion of building activity. The economically gifted soldier king Frederick William I of Prussia (1688 to 1740) ordered his wealthy subjects in Berlin without rhetorical subtlety: "This guy has money, let him build!" (Spiegel Special History, March 2007). Today's economists know that the so-called investment multiplier of construction activity is particularly high. The builder usually has to pay for building materials, the land, architects and construction workers with high loans, who can use the money to buy a new car or go on vacation. One euro of taxpayers' money generates several times as much private expenditure and thus stimulates the economy, but also private debt. Rising property prices as a result of state financial incentives attract more builders and property buyers. In the long term, however, the promotion of the real estate market only works as long as the rental income of a new homeowner (or the rent saved by a home buyer) is higher than the interest on the loan in the long term, so that the loan can be repaid gradually without having to cut back on other expenditure. If politicians push the real estate market beyond this point, the initial positive effect on the economy soon fades, ideally only after the next election date; in the end, we are left with higher national debt and highly indebted, often bankrupt homeowners. Then it was "bad" politics, just like the constant invention of new injustices that continue to inflate the inefficient social system, often without any benefit for those really in need (e.g. skilled workers' pensions, mothers' pensions).

In the 1980s, the USA forced the Japanese to revalue their currency in order to limit the American import surplus in trade with Japan. To compensate for this weakening of the Japanese economy, the government allowed companies to write up real estate holdings from their original, often very low values to current values and did not levy taxes on the resulting profit.

Suddenly, many Japanese companies had a very high level of equity and were able to buy more properties, which they later also wanted to upgrade tax-free. In view of the strong price increases (Figure 5a), buyers forgot that interest costs had long since reached a multiple of rental income; at the peak of the boom in 1990, rental yields in the greater Tokyo area were 0.5%, while interest rates on loans were at least 15 times higher, i.e. 7.5%. More and more property owners were driven into bankruptcy by the interest costs; the state had to prop up the banking system for decades and experienced an unprecedented explosion in its national debt (see Figure 5b). Real estate prices have not recovered since then and the Japanese government, which at the same time triggered a huge speculative bubble on the stock market, is now completely overindebted (Figure 5b), but has shown other governments what is possible at the level of government debt, namely 260% of national income.

The attempt to stimulate the East German economy with real estate investments after reunification worked very well from 1991 to 1994. Special depreciation allowances of 50% on the purchase price of an East German property meant an immediate tax saving of around DM 250,000 for a high earner with an annual income of DM 1 million if they bought a property for DM 1 million. Many people did this several times. One of my tasks at that time was to calculate eastern real estate projects for our few clients at the time. I never came anywhere near a positive long-term return expectation for a single project because the rental yields were always below 3%, even after deducting the tax benefits, while the mortgage interest rates were almost 10%. After Helmut Kohl won the federal elections in December 1994, the tax benefits were abolished and the East German real estate market collapsed. The asset losses suffered by investors who had allowed themselves to be dazzled by the state were so great that Germany was the "sick man" of Europe until 2006 due to weak consumption.

From the mid-1990s, the Americans pushed their residential real estate market. In order to distract low-income earners from their below-average income growth in recent decades (see Figure 4b), the government provided particularly loose lending conditions. These loans were later called "ninja loans" - no income, no job, no assets. Investment banks bought these loans from the US savings banks, created a security from numerous loans with poor credit ratings and gave it a first-class rating. This allowed these securities to be sold to foreign - and often German - investors. From 2006, the US real estate market began to fall and the "ninja loans" could only rarely be repaid. This triggered the financial crisis from 2008, which brought the global banking system to the brink of collapse. To save the banks, money printing began in the USA and many other countries.

American real estate investment reached 6% of US national income for a few years before this major financial crisis (see Figure 6a). The Chinese then stimulated their own real estate market from 2009 onwards to combat the crisis triggered by excessive real estate investment in the US to such an extent that by 2020, around 14% of Chinese national income had been invested in residential real estate for over 10 years, of which many millions of apartments are now vacant (see a detailed analysis in the November 2021 Capital Market Outlook, which you can find here can be found here). The aim was also to tackle inequality (see Figure 6b), which had also risen sharply in communist China since the economy opened up in 1978. China will be in serious trouble given the huge volume of capital wasted on real estate misinvestment. The Chinese are in the habit of demonstrating when they lose money. It is possible that China's increasing isolationist tendencies and growing aggressiveness in foreign policy, for example towards Taiwan, are already a populist diversionary tactic.

People like to discover threatening foreign powers (with Putin it is NATO and the Ukrainian "neo-Nazi government", with Erdogan it is the European "fascists", Hitler incited against Jewish big business and Eastern Bolshevism, Trump against the Chinese) that are to blame for domestic economic problems and must therefore be fought at all costs. This behavior has been common for centuries with governments of dubious legitimacy.

This brings us to the unpleasant topic of the increasing number of dictatorially governed and aggressive states. Since 2006, the British business newspaper The Economist has published a democracy index ranging from 0 (pure dictatorship) to 10 (perfect democracy).

The global average index has fallen only slightly since 2006, from 5.52 to 5.37 points, but some large countries (Turkey, Russia, China) are clearly on the decline; Russia is likely to have fallen below the level of China in recent weeks (Figure 7).

In Turkey (inflation of over 50%) and Russia, the aforementioned fears of decline due to low income growth among the lower and middle classes and growing inequality are a reason for growing dissatisfaction. In order for the respective dictator, for whom his private wealth accumulation is far more important than the welfare of the people, to retain his position, he must take away as many freedoms as possible from his subjects, e.g. independent media.

Then you can keep your own supporters, most of whom are not particularly educated, happy with tall tales. Donald Trump, who fortunately did not manage to become a dictator as the lazy child of rich parents, should be praised for his honesty. On February 24, 2016, he stated unequivocally: "I love the poorly educated."

The usual dictator program accelerates economic decline. It consists of increasing isolationism, which is justified by evil neighbors and dark powers. Then there is armament, which is financed either by printing money (Third Reich, Turkey, from now on Russia, soon probably also China, ...) or by cutting social spending (Russia in recent years). This is followed by inflation (Turkey over 50%, Russia is facing hyperinflation) or strict price controls to disguise inflation (Third Reich). Now wars have to be waged as a distraction so that the "investments" in armaments pay off at the expense of general prosperity and the country, supposedly surrounded by enemies, rallies behind its dictator. In China, too, growth prospects are deteriorating significantly after years of high economic growth that has been doped up by bad real estate investments, which explains the growing isolationism and aggressiveness of the leadership there. If the Chinese no longer become richer, the Communist Party will lose its right to sole rule, as it was quite rightly granted this by the population due to the enormous increase in prosperity in China over the last 40 years. However, China's ruling class is also corrupt and does not want to step down under any circumstances; they are happy to have family members involved in the real estate development companies, which probably best explains the real estate boom.

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At this point, the first piece of good news is due so that you don't lose interest in reading on: Putin also planned and executed his completely pointless war, which even if successful would not have benefited Russia at all, incredibly badly. He underestimated the bravery of the Ukrainians and overestimated the quality of the Russian ground forces. However, he was probably most surprised by the sudden unity of NATO - he certainly did not expect the turnaround in German politics - and the effectiveness of the sanctions, which caused Russia's financial system to collapse within a few days. However, the shock is not limited to Putin, but also to Putin fans and supporters of other comparable figures such as Erdogan or Trump. The damage is not only huge for the Ukrainians, who will hopefully soon receive substantial reconstruction aid from the West, but also for the Russian population and is likely to make other nations lose their appetite for this type of politics in the long term. Xi Jinping will also have taken note of NATO's revived unity and willingness to rearm. Erdogan's poll ratings are plummeting as inflation rises, Trump ("Putin is brilliant") is now being prosecuted for storming the Capitol and is likely to be finished as future US president and Marine Le Pen and Eric Zemmour, the two leading right-wing populists in France, are losing votes in the polls for the French presidential election in April. Finally, the British are turning their backs on the notorious liar Boris Johnson because of his various scandals, but also because of the growing doubts as to whether the Brexit, which was narrowly achieved with numerous lies, was really a good idea.

So perhaps we are witnessing the beginning of the end of populists and dictators. The era of peace will therefore probably not be replaced by a warlike phase, but by a new Cold War with NATO and the allied Asian states (Japan, Australia, New Zealand, South Korea) on one side and China with its impoverished vassal state Russia on the other.

We would now like to assess the consequences of recent events for the capital markets. To do this, we will first look at the impact of wars on the capital markets. Figure 8 below shows the consumer price index in England since 1661. Unlike Germany, Italy or France, for example, the USA was not founded until 1776, England has not experienced a currency reform or hyperinflation over this long period and therefore shows the fundamental links between wars and inflation that will continue to apply in the future. In addition, the great significance of the conversion from a precious metal-backed currency to a pure paper currency is clearly visible (see dark line). When the First World War broke out in 1914, the British government suspected that it would be very expensive and would overstretch the British gold reserves, the basis of the currency. The gold backing of the pound was therefore suspended and unlimited amounts of money could now be printed to finance the costs of the war. By the end of 1913, the consumer price index, which stood at 1.32 in 1661, had only risen to 1.39; the annual inflation rate over these 252 years was a barely measurable 0.02% p.a. In the following 108 years, the index, which since then has reflected the price development of a pure paper currency, rose to 124.7 by 2022; this corresponds to an average annual inflation rate of 4.3% p.a. and thus a 90-fold increase in prices. The ability to print money at will therefore has a particularly strong and lasting impact on inflation.

The second most important influencing factor is major wars, which triggered inflation even in the era of the gold standard (the 10-year average value is shown here): 4% p.a. in the Seven Years' War (England against France and Prussia, financially supported by England, against France, Austria and Russia) and 6% p.a. during the war against Napoleon. However, as the debts for these wars were dutifully repaid in stable gold currency, the consumer price index fell back to its initial level in the following hundred years after 1815 until 1913. The two world wars brought average inflation rates of 11% p.a. and 6% p.a. respectively, but the two oil crises of the 1970s, which were triggered by Israel's war against Arab states lasting barely three weeks in 1973 and the expulsion of the Shah of Persia in 1979, even brought about an inflation rate of 13% p.a. by 1981. The effect of paper money became clearly visible.

Wars not only have an inflationary effect due to the high demand for armaments and soldiers in the affected countries, but also because of the drastic decline in foreign trade. Napoleon had largely interrupted trade with England with the Continental Blockade. During the world wars, Germany and the allied and occupied countries were completely cut off from world trade; the result in both cases was hyperinflation, and not just in Germany. In the run-up to the long-planned invasion of Ukraine, Russia reduced its foreign trade, e.g. food imports, and has now been cut off from foreign trade within a few days by sanctions.

This means that both factors that increase inflation risks are also present in the Putin war. With the exception of inflation-linked government bonds, fixed-interest securities have become even less attractive.

By contrast, wars are far less dangerous for equities than for bonds, as the three charts below show:

Wars, even the two world wars, or crises triggered by wars have caused smaller share price losses than the three major speculative bubbles of the last hundred years (see Figure 9, red label). The "golden" 1920s, the boom in technology and telecom stocks up to 2000 and the real estate boom in the USA up to 2006 were followed by the three sharpest price falls of the last 152 years on the US stock market, which is particularly suitable for long-term analyses because the two world wars neither changed the political system nor triggered a currency reform.

Government bonds suffer far more from armed conflicts than equities (see Figures 10a and b). From 1900 to 1984, their total return (price changes + interest) worldwide reached a meagre 0.13% p.a. after deduction of the inflation rate, meaning that in real terms, government bond assets rose from €100 to €116 in 84 years. In the same period, equities managed 4.5% p.a., so €100 became €4,034 after 84 years. This period is certainly relevant for the future, because until 1945 it was characterized by the two world wars and the enormous burden they placed on public finances and then by longer periods in which interest rates were pushed below inflation rates by the central banks in order to make it easier for countries to reduce their debt. Similarly, government debt today is extremely high by historical standards and interest rates have been far below the rate of inflation for a year now, as governments are no longer able to finance high interest rates.

At the end of these 84 years, the owners of government bonds had therefore only paid 1/40th of the wealth of a share owner and thus, alongside the taxpayers, the majority of the war costs.

Conclusion

The end of the decades-long period of peace will have three lasting consequences:

- In the Western world, more will have to be spent on armaments in the long term, but not so much because of Russia, which will be severely weakened at the end of the current war and will remain so for lack of development efforts, but because of the far more powerful and increasingly aggressive China

- The energy transition is accelerating, but the raw materials and labor required for this are already in short supply and will continue to rise in price

- The shrinking workforce will trigger an inflationary wage-price spiral in many countries; increasing deglobalization will also increase costs

More armaments and a faster energy transition have an inflationary effect and require additional government debt. These are already enormously high (see Figure 3a) .

This also marks the end of the era of low inflation rates for a long time, which have already been rising sharply for a year (Figure 2a) and will continue to rise or at least remain high due to the ageing population alone (Figure 2b). Moreover, it will hardly be possible to combat this inflation, as governments must ensure that interest rates remain low in times of extremely high debt (see the example of the USA, Figure 11 and other countries in Figures 3a and b). In order to effectively combat inflation, interest rates must exceed inflation rates so that saving becomes attractive again. Interest rates would therefore have to reach a mid to upper single-digit percentage, which is probably too much for most finance ministers by now. The brutal variant of fighting inflation, namely triggering an economic crisis through high interest rates, will be avoided by all politicians worldwide at all costs.

Even without significant interest rate increases, however, the 40-year era of falling interest rates is over, as inflation rates are already so high that zero interest rates are no longer necessary in the USA (current inflation rate 7.5%, government bond interest rates 1.8%) or Germany (current inflation rate 5.1%, government bond interest rates 0.1%), for example; it may be a little more, especially as rearmament and the rapid energy transition are stimulating the economy and counteracting the negative consequences of higher inflation.

Einstein once said that two things are infinite, the universe and human stupidity; but he was not quite sure about the universe. Reversing this wisdom, we can attribute a probability bordering on certainty to the turning point in global politics, interest rates and inflation rates, but we cannot be quite so sure about the assumption of a turning point in populism based on human stupidity. After all, it springs from an infinite resource.

For the capital markets, inflation rates that are higher than the inflation rates of 3% expected for the next 10 years mean that we will also see slightly higher interest rates, although these are unlikely to exceed 2% in the eurozone and 3% in the USA. Gold will also yield higher returns than previously expected, partly because capital market participants still have long-term inflation expectations that hardly exceed 2%. Inflation-related cost increases will certainly put some pressure on corporate profits, but this will be offset by additional sources of income from higher military spending and investments in the energy transition. With real interest rates remaining very negative, many investors will therefore find their way out of "safe" investments such as bonds or savings accounts and into shares, company investments, gold and real estate, possibly more quickly than previously assumed if the Putin war hopefully ends soon.