Germany - or North Korea?

It is always difficult to make a precise statement about the future - and there have already been enough financial analysts who were way off the mark. Nevertheless, we need to talk about how share values will develop over the next few years and the dramatic role that corporate taxation will play in this.

It is not only in Germany that there are discussions about growing inequality, fueled by the record highs on the international stock markets despite the unresolved coronavirus crisis. The rich are getting richer, the poor are getting poorer and politicians need to do something about it. At the same time, investors are extremely optimistic, as can be seen from the record share of total turnover on the New York Stock Exchange accounted for by call options purchased by retail investors (see chart below). At the height of the tech bubble in the early 2000s, speculation was also far lower than it is today, fueled by virtually free trading apps (Robin Hood, ...) and social networks.

In the following, we examine the extent to which these contrasts - on the one hand, growing government intervention in the economy, the debate on inequality and possible tax increases, and on the other, exuberant optimism and a willingness to speculate in anything that "smells" of technology (Bitcoin, Tesla) - will influence the stock markets in the coming years. We would like to find out whether the rather low earnings expectations of our forecast models based on the analysis of historical data are confirmed if we also consider these contradictions.

First, let's take a look at the current results of our long-term forecast models (see the charts below). These result in a performance expectation for global equities of only 3.5% p.a. until 2031. This not exactly lavish figure is still 2.5 percentage points above the future returns of bonds, but it does signal certain risks, which we see particularly in the area of technology stocks, where the conspicuous speculative excesses are also taking place. Overall, the return expectations for the US market are below average and for the rest of the world, which accounts for less than half of the global equity market, above average and still in the upper single-digit range.

For example, European equities would be able to generate 4% p.a. performance until 2031 on the basis of the companies' current cash flows; however, if the corona-related slump in profits is soon made up for, which we expect to happen in the further course of the year, the annual return figure is more likely to be 7% p.a. (see below). Expectations for US equities are significantly lower; with current cash flows, earnings expectations for US equities are minus 3% p.a. and plus 2% p.a. once the earnings slump has been made up for (see chart after next). In March 2020, US equities were also very attractive with earnings expectations of 9% p.a., but the boom in many technology stocks has made the entire US equity market very expensive.

The price/cash flow ratio, which was used to explain approx. 77% of the subsequent 10-year performance of the European equity market from 1973 to 2011, means a performance expectation of 4% for European equities until 2031 (+7% p.a. if the cash flow from 12/2019 before corona is achieved again)

The price/cash flow ratio, which was used to explain approx. 88% of the subsequent 10-year performance of the US equity market from 1975 to 2011, means a performance expectation of -3% p.a. for US equities until 2031 (+2% p.a. if the cash flow from 02/2020 before corona is reached again)

The development of interest rates is also more problematic for the highly valued US equity market than in the rest of the world. Interest rates have risen by 0.80 basis points in the US since last summer and by 0.10 basis points in Europe and Japan.

Following this brief data-based forecast, we will examine other factors that will influence the stock markets in the coming years. First of all, you will see a summary of the key factors that make up share prices:

1. wages and taxes

The main factors influencing share prices

The discussion on inequality mentioned at the beginning has been losing its foundation for some years now, as the following chart shows:

An important cause of populism, namely the divergence between corporate and property income, is increasingly being addressed by higher wage increases, including minimum wages. Demographics will exacerbate this trend, which will affect profits

In Germany, there was a significant imbalance between falling wages and sharply rising corporate and property income until 2007. Since then, however, wages have risen so sharply that the difference, which now stands at 40% points, has been almost completely offset, even though the demographically induced decline in the workforce is only just beginning. In the US, the share of wages and salaries in national income had fallen significantly from 53.8% to 49.4% by 2015; however, it has since increased again by almost 2 percentage points. The new government will ensure that this trend continues through minimum wage increases, among other things. The wage side will therefore stand in the way of a further significant increase in company profits once the coronavirus-related slump in profits has been made up for in many countries.

The tax rate on corporate profits, for example, which has fallen sharply in the US in recent decades, will also end its downward trend (see below). The new US government

In the last 7 years, high corporate tax rates in the USA, as in the 1950s and 1960s (over 50%), have not been an obstacle to high productivity growth. In order to curb the massive increase in government debt (right graph), taxes will therefore be raised

The government intends to raise corporate taxes moderately from 21% to 28% (the above chart on the right shows the effective, not the nominal corporate tax rates). In addition, many politicians in the USA are now also bothered by the fact that large technology companies have so far largely kept their high profits out of the hands of the state. Interestingly, high tax rates did not have any negative impact at all on productivity in the decades after 1945, including the willingness to invest. In addition, the national debt is extremely high, just as it was after the Second World War. There are therefore many arguments for increasing tax rates for companies in the USA.

In Germany, too, the rampant ignorance of corporate taxation means that it is unfortunately impossible to rule out the possibility of tax increases for companies coming onto the agenda. In contrast to the USA, however, corporate taxes are very high in this country, but large sections of the population and, shockingly, most politicians are completely unaware of this. Many politicians want to abolish the flat-rate withholding tax because it is unacceptable that "rich" entrepreneurs can get away with 25% tax, while some well-paid skilled workers have to pay 45% top tax rate. However, this overlooks the fact that a company (corporation) must first pay 15% corporation tax and a further 15% trade tax on €100 gross profit. When the remaining €70 is distributed to the shareholders or partners, a further €18.50 in withholding tax (25% tax rate + solidarity surcharge) is then due; this leaves €51.50; the effective tax rate is over 48%. If the distribution of € 70 were instead taxed at the top tax rate including the "wealth tax surcharge" of 48% or € 34 after the abolition of the flat-rate withholding tax, the shareholder or entrepreneur would be left with € 36; the tax rate would be 64%. If the wealth tax of e.g. 1% of the company value, which is popular in the left-wing political spectrum, is then added to this, an average company would be taxed at around 75% of its earnings. Germany would then only be able to compete with countries such as North Korea or Cuba. All other countries would then be a real alternative for German entrepreneurs.

2. interest

Low interest rates will probably be with us for years to come. Whenever countries have extremely high levels of debt, they have pushed down interest rates with the help of investment regulations for institutional investors and government bond purchases by their central bank (see chart below right, where this correlation is shown using the example of the USA). This means that companies' financing costs remain low and their customers will continue to be able to take out very cheap loans, e.g. to buy cars or real estate. Interest rates are also very important for the valuation of shares. The chart below left shows that almost two thirds of the price/cash flow ratio (R²=0.65) on the US stock market can be explained by the current interest rate on 10-year US government bonds.

It is therefore very important, particularly for the extremely highly valued US equity market, that US interest rates do not rise any further. The yellow arrow points to the current point, a cash flow of 4.9% of share prices at an interest rate of 1.2%. At the current interest rate level, however, 5.7% would be the fair value. To achieve this, share prices would have to fall by 15%. Due to the pent-up demand for many services in particular, inflation will pick up everywhere in the second half of 2021 at the latest, perhaps towards 3%. If interest rates then rise to 1.9% - the level before the coronavirus crisis began - the stock market would have to fall by 25% to be fairly valued. The corona-related slump in profits must therefore be made up for in order to avoid a slump in share prices. The corresponding risks are much lower in Europe, where share prices could rise by a further 35% before equities become too expensive compared to the extremely low interest rate level, and in Asia. Even if interest rates remain low, this does not mean that share prices in the USA will continue to rise, whereas this is more likely in Europe and Asia.

3. productivity, (de)globalization and populism

Numerous studies show that the general level of intelligence is gradually beginning to decline in a number of countries (example: Edward Dutton, Richard Lynn: A negative Flynn Effect in Finland 1997 -2009, Universitiy of Oulu, Finland, University of Ulster,UK, 2013), which could be one reason for the low productivity growth in many countries. The below-average willingness of governments and companies to invest is another reason; there may also be a connection with the misuse of social networks, initially by politicians such as Donald Trump and Boris Johnson, and more recently by irresponsible financial populists such as Elon Musk, who is certainly a good engineer, but also likes to use Twitter to push investors into at least questionable investments (Bitcoin, Gamestop). In over 40 years, I have only seen the richest person in the world drive small investors into overpriced financial investments out of self-interest once. In December 1979, silver speculator Nelson Bunker Hunt and his brother were the richest people in the world at the time, with $10 billion. At the time, he gave a high-profile interview to "Welt am Sonntag" in which he predicted the decline of all paper money and a further massive increase in the price of silver, which had already risen from $5 to $30 in the previous years. As a budding 19-year-old bank apprentice, I read this and bought silver. On January 14, the price of silver reached $50, only to collapse to $7 within 8 weeks. This taught me in an unforgettable way that you always have to think about why someone is giving you free and unsolicited investment tips. The Hunt brothers had taken out large loans for their silver purchases and wanted to drive up the price of silver further through small investors. Two years after its collapse, they were broke. Incidentally, 41 years later, the price of silver has still not reached the price at which I started at $27. Bonds, on the other hand, which Nelson Bunker Hunt had declared dead, put in the best performance for centuries during this period, while equities achieved a global performance of 5,700%. Investment tips from the super-rich are therefore not necessarily to be followed.

Populism reduces the willingness to take note of facts or even to acquire scientific knowledge. The current uprising by the Education and Science Union against the establishment of an economics and politics school subject in North Rhine-Westphalia is also unlikely to make it any easier for pupils to navigate sensibly in an increasingly complex economic and professional environment and make the right decisions. It therefore reduces productivity.

Globalization has also passed its peak, as the chart below shows. As has been the case since 2007, corporate profits will probably no longer be supported by global trade that is growing faster than the volume of goods produced.

One ray of hope is the future of populism. Trump has disappeared, Erdogan and Putin are in big trouble. Social networks are coming under pressure. Most importantly, however, the wage trends mentioned at the beginning of this article will gradually take away the real basis of populism, namely the supposedly ever-increasing gap between the "elite" and the common people. For demographic reasons, labor is becoming scarcer worldwide, especially in China. In addition, there is a possible wage-increasing delayed effect of the mistakes that Europe and the US made last year compared to the pandemic-experienced Asians. Unlike in Asia, particularly China, the deep and costly economic slump in Europe and the US necessitated ultra-loose monetary policy and extremely high government spending due to the coronavirus. There was a similar difference during the sharp 20-fold increase in oil prices in the 1970s. At that time, the USA, the UK and France pursued a very loose monetary policy to help the economy, which was under pressure from oil prices. Japan, Germany and Switzerland were less generous and fought inflation. As a result, their currencies appreciated sharply. Just as China has kept global wage increases and inflation rates low since the 1990s through masses of cheap exports, an appreciation of Asian currencies against the dollar and the euro could cause inflation and wages to rise more sharply. This should further weaken populism.

Conclusion

The low earnings expectations of the forecast models based on historical data for the global equity markets, particularly for the USA, are confirmed by an overall consideration of future influences. Wages will continue to grow somewhat faster than the economy as a whole, which will dampen corporate earnings growth. An increase in corporate taxes in the USA would have the same effect; the British finance minister has also hinted at a tax increase. In Germany, this step would be a mistake, but that need not be an obstacle for politicians (keyword: Berlin rent cap). Unlike in the last 40 years, interest rates will no longer fall, but will hardly be able to rise either. Their effect on the stock markets is therefore neutral. Should interest rates nevertheless rise, this would be much more dangerous for the US equity market than for the rest of the world. Globalization was an important factor for disproportionately high profit growth and weak wage development; however, it has been stagnating for over 10 years and is likely to decline in the future, thus favouring rising wages at the expense of profits. Future wage trends will therefore weaken populism, which is detrimental to political and economic stability. This means that wage trends will have a slightly dampening effect on profits in the medium term, but should be viewed positively in the long term. Overall, US equities should be significantly underweighted at present, while the rest of the world should be overweighted accordingly.