Numerous crises at the same time - reason for pessimism?

Inflation rates have risen everywhere since the beginning of 2021 and interest rates have also risen since the beginning of 2022. Recession looms in Europe and the USA. The Chinese economy is weakening. The Putin war has now been going on for 10 months - with no end in sight. So it's only natural to be pessimistic, isn't it?

In recent months, it has become clear that the risks to the economy have increased on both sides of the Atlantic. High inflation, higher interest rates and, in Europe, the sharp rise in energy costs as a result of the Putin war have clouded the economic outlook. Therefore, this time we will not be looking at long-term earnings expectations, but at a short-term outlook for 2023.

The current plethora of problems began with the sudden rise in inflation rates worldwide (for the fundamental impact of inflation on the capital markets, see the Capital Market Outlook from May 2022, which you can find here, and for the reasons for structurally higher inflation in the future, see the Capital Market Outlook from June 2020, which you can find here ). Charts 1 a and b show the inflation rates of the last 3 years and the surprisingly late rise in interest rates, which was only triggered by the Putin war - one year after the upward turn in inflation rates. The war had different effects on the two sides of the Atlantic. While the inflation rate in the energy self-sufficient USA has already fallen back below the level of February 2022 (chart 1 a), Germany experienced a further strong surge in inflation after the start of the war due to its high dependence on Russian energy commodities (chart 1 b).

However, global inflation rates will fall again significantly in the new year. The gas price (chart 2 a), which is particularly important for Europe at present, and the container freight cost index (chart 2 b) are two examples of prices that have driven up inflation rates but have been falling again for several months. For example, even if the gas price in Europe were to rise again to its previous high of over € 300/MWh in August 2023, it would then merely stagnate compared to August 2022 and only contribute 0% to the inflation rate. In August 2022, however, it had risen from € 50/MWh in August 2021 to over € 300/MWh, i.e. by 500% (Figure 2 a), thereby pushing up the inflation rate in many European countries.

Chart 2c shows that the US inflation rate has so far followed the container freight cost index, which has been falling sharply for a year, with a 4-month delay. If this economically logical correlation continues, the US inflation rate is likely to fall further in the coming months.

The oil price, which is not yet insignificant, has also fallen significantly since summer 2022 despite the current cold snap (chart 3 a). A further inflation-lowering effect will result next year from the generally expected recession in the US and Europe (chart 3 b, details in the Capital Market Outlook of July 2022, which you can find here ). The 13 deepest recessions of the last 50 years in the USA, Germany and the eurozone have reduced the inflation rate by an average of 3.2 percentage points.

At this point, we can make the positive observation that the high inflation rates on both sides of the Atlantic will fall next year.

Nevertheless, there is likely to be a recession for the time being. There are useful leading indicators for both the US economy and the eurozone. In the US, the interest rate structure, i.e. the difference between the 10-year and 1-year interest rates for government bonds, has fulfilled this function since 1953 (with one exception in the mid-1960s, chart 4). If short-term interest rates are higher than long-term interest rates, banks grant fewer loans because loans usually have fixed interest rates for several years, while banks tend to borrow short-term funds from savers, other banks or the central bank to finance the loans. Loans therefore become less profitable when short-term interest rates rise sharply. A decline in lending deprives the economy of important fuel - a recession then occurs after an average of 13 months.

In the eurozone, real money supply growth is a good early indicator of a recession (chart 5). If the money supply shrinks at a time when a lot of money has to be paid for energy in Europe, demand for other goods falls, which is likely to trigger a recession. The corona recession was a consequence of understandable political restrictions on economic activity and could therefore not be shown by the indicator.

So unlike inflation, we cannot give the all-clear for the problem of an impending recession.

However, this is not relevant. The Federal Reserve Bank of Philadelphia has been asking professional economic researchers for over 50 years about their assessment of the probability of a recession. The last available value from November 2022 was by far the highest ever (chart 6 a). However, the US central bank branch has not calculated how reliable the economic forecasts of economic researchers have been to date. Our analysis has shown that the accuracy of the forecasts is zero. The red dots in chart 6b show the recession phases since 1970. A recession had emerged at the beginning of 1982, although the economic researchers had estimated the probability of this at only 8.7% in March 1981 (red dot on the far left). In the 10 cases in which the probability of recession was estimated to be particularly high (blue dots to the right of the red line), not a single recession followed.

Perhaps the widely expected recession will not happen at all, which would certainly be good news for the stock markets in 2023. However, the fact that more economic researchers are pessimistic than ever before in the last 53 years is probably the main reason why equity strategists are also extremely negative. They are regularly asked by Bloomberg, a respected American financial information company, how the US share index S&P 500 will perform in the coming year. Since the survey began in 1999, November 2022 was the first time that a fall in share prices was expected in the following year (chart 7 a) - just as strikingly pessimistic as the economic researchers.

But here, too, we can reassure you. The correlation between the forecast and actual share price changes is almost exactly zero (chart 7 b).                          

As you know, with two exceptions, FINVIA does not make any short-term forecasts, neither with regard to the economy nor the capital markets, because - as shown above - these do not work.

The first exception is figures that do not come from surveys, but rather reflect how investors or fund managers have actually invested. A good example is the cash ratios in the 300 to 400 largest international equity funds calculated by Bank of America for over 20 years (Figure 8 a).

The logic behind this is that pessimistic fund managers sell some of the shares in their fund and hold cash so that they lose less than the benchmark index in the event of the expected fall in share prices. When the average cash ratio in the funds is particularly high (red circles in chart 8 a), pessimism is therefore also very high; the current figures for September (6.3%), October (6.2%, and November 5.9%) are the highest for over 20 years (red dashed circle in chart 8 a, red oval in chart 8 b). Even the second Iraq war, the financial crisis following the Lehman bankruptcy, the euro crisis, Putin's first war of aggression against Ukraine, Brexit and Trump as well as the coronavirus pandemic have not frightened the professionals as much as the current multiple crisis.

Chart 8 b illustrates the significance of a high cash share. The red dots show the changes in share prices during crises with cash holdings of 5% or more. Cash ratios were also above 5% in 2015, but there was no crisis; share prices showed a moderately positive trend until 2016. Overall, the cash ratio in times of crisis averaged 5.4% and the share price increase 18.1% (red dot with black border); in normal non-crisis times, the cash ratio was 4.6% and the average share price gain was 5.8% (blue bordered dot).

The very high proportion of cash in the large equity funds in the fall of 2022 suggests above-average price gains on the equity market next year; the pessimistic equity strategists need not worry us.

The second exception is surveys that do not involve asking financial and economic experts. In this case, they can be quite helpful for short-term share price forecasts. A good indication of high share price gains in the next 12 months is provided by consumer confidence as determined in surveys. We examined how the respective stock markets would develop in the future if consumer confidence in the USA, China and Europe had been more than 2 standard deviations below the average since 1970 (chart 9 a). The result is shown in chart 9 b. When consumers were particularly pessimistic, share prices rose by an average of 20.3% in the following 12 months (chart 9 b). Overall, the average price gains since 1970 have been just under 6% p.a. In fall 2022, consumers in China and the UK are unprecedentedly pessimistic. Consumer confidence in these countries is even more than 3 standard deviations below the respective average value, which has never happened before since 1970. In September 2022, the average value for all countries also fell below the record lows of February and March 2009, when the global banking system was expected to collapse following the Lehman Brothers bankruptcy, resulting in a particularly severe global economic crisis. In October and November, global consumer confidence recovered only slightly to -1.97.

In view of the negative expectations for economic development in the coming year, it is interesting to note that German equities, which are particularly sensitive to the economy, have fallen to the same valuation level as at the end of the first energy crisis from 1973 to 1974 (chart 10 a). At that time, the Arab oil countries had briefly turned off the oil taps of the Western industrialized countries and triggered great uncertainty about the long-term security of energy supplies. At the end of 1974, the German stock market had lost 26% in real terms since the beginning of the crisis in summer 1973.

In December 2008 - shortly after the Lehman bankruptcy - share performance over the following 10 years reached only 8.3% p.a. (chart 10 b, lowest red dot). Otherwise, future 10-year returns were always in double digits at a valuation of less than 1.0, i.e. below the level of December 1974 (chart 10 b, red dots to the left of the vertical line). The current low valuation is particularly astonishing in view of the fact that German government bonds with a 10-year maturity offered a yield of 10.3% at the end of 1974, making them a highly profitable and safe alternative even for inexpensive shares with good yield prospects. This is very different today with a yield of 2.2% - the pessimists cannot permanently hibernate in "safe" investments with a negative real interest rate of currently -8% until all crises have been resolved.

As with the cash ratios of fund managers, economic forecasts and share price forecasts of equity strategists, we are seeing levels of pessimism in consumer confidence that have not been seen for decades and which have also significantly lowered the valuation of economically sensitive shares. Fortunately, only consumer confidence and cash ratios are of significance here; with these, high pessimism is followed by high share price gains.

German residential real estate is also currently slightly undervalued. The sharp fall in interest rates from 2008 to 2021 (Figure 11 a) caused real house prices to rise in the industrialized countries, although the consequences of the 2008 financial crisis had to be digested by around 2012 (Figure 11 b). The sudden rise in interest rates in 2022 triggered a general decline in prices after just a few months, with the Swedish real estate market (chart 11 b), which had risen particularly sharply by then, already recording significant double-digit real losses (chart 11 c). German residential real estate has also fallen by around 8% since the beginning of the year after deducting the inflation rate.

This means that they are now undervalued, as can be seen from our model in chart 12. Since 1975, the interest rate for 10-year mortgage loans has been in a linear relationship with the average inflation rate of the last 10 years plus the rental yield on condominiums (chart 12). A year ago, the mortgage interest rate was 0.73%, the rental yield was 2.98% and the inflation rate for the 10 years from 2011 to 2021 was 1.4%. Plugged into the equation that has explained 82% of the above relationship for almost 50 years, the result for December 2021 is: rental yield (2.98%) + 10-year inflation (1.4%) = 4.38%. The equation now says that 0.39*0.73% (mortgage rate) + 4.1% should have a similar value. In this case, it happens to be exactly the expected value of 4.38%. In 1981, the equation also worked: rental yield (3.3%) + 10-year inflation (5.3%) yielded 8.6%, 0.39*interest rate (11.03%) + 4.1% yielded 8.4%, i.e. almost exactly the expected value. Investors were therefore satisfied with a rental yield of 3.3% at a very high interest rate of 11% because they had experienced high inflation for years and believed that it would continue to be this high in the future and ensure corresponding future rent increases.

In December 2022, the following values are likely to emerge: Rental yield (probably around 3%) + 10-year inflation from 2012 to 2022 (2.2%) = 5.2% and 0.39*3.12% (mortgage rate) + 4.1% = 5.3%, which is roughly the expected value. However, if investors find that average inflation continues to rise towards 3.5% over the next few years, they will receive higher returns than currently expected, namely around 6.5% annual return. The residential real estate market would then be neutrally valued even with mortgage interest rates of almost 6% (chart 12, orange circle). In the real estate market, only the higher interest rate is currently being taken into account, but not the high probability that inflation rates will be significantly higher than 2% in the coming years. So here too, pessimism currently prevails.

The price of gold is also clearly undervalued. If one ounce of gold (current price: USD 1,792) buys less than half of the S&P US share index (currently at 3841), gold has achieved high gains in value in the years after 1969 and after 2001 (chart 13 a). Gold is also cheap at present. The reason for this is probably also the underestimation of future inflation rates for gold, which in the USA, as in Germany, are expected to be barely above 2% over the next 10 years. This can be seen from the yield differential between normal 10-year US government bonds (3.48% yield) and inflation-linked US government bonds (1.35% yield, source: Bloomberg, 16.12.2022).

Many central banks share this view and are buying large quantities of gold (chart 13 b).

To summarize, we can state that the sometimes unusually pronounced pessimism is not unfounded. However, to conclude from this that the prices of tangible assets such as shares, residential real estate or gold must therefore also fall would not have been correct for decades; some indicators such as the cash ratio of fund managers or consumer confidence have in the past been accompanied by high future returns on the stock market when they indicate a particularly negative mood. When pessimism is high and widespread, the prices of real assets are already low. Often the first signs of an improved situation in the future then emerge, such as the recognizable decline in inflation, the core of the current problems.

‍

You can also download the capital market outlook here.