“There is no such thing as certainty, just varying degrees of uncertainty.”
(Anton Pavlovich Chekhov, 1860-1904, Russian author)
This year started promisingly, but the optimistic mood soon faded. At the beginning of February, volatility spiked sharply and the daily fluctuation range increased significantly. Unusual one-day drops of up to 3% spooked many investors and prompted the more risk-averse to unwind their riskier tangible assets. Volatility strategies also played a part in the heavy losses, forcing leveraged strategies to take action. The markets have entered a new phase. This change will inevitably lead to uncertainty and we must evaluate the situation carefully.
Our proprietary risk indicators suggest that there is currently no major risk of this negative development escalating and that the markets are well positioned to absorb these disruptive factors. Although the Turbulence Index value increased slightly due to the higher volatility, the Systemic Risk Index remains at a low level. This indicates that risk concentration is low; the markets are robust and the likelihood of tail risks remains small.
So what factors caused the market situation to change and what assumptions can we derive from them?
|Asset class||Index||Return |
as of 31.3.2018
in base currency
as of 31.3.2018
in base currency
|Equities World||MSCI World Net USD||-1,28%||13,59%|
|Equities Switzerland||Swiss Performance Index||-5,22%||5,73%|
|Equities EM||MSCI Emerging Markets NR USD||1,42%||24,93%|
|Bonds World||JPM GBI Global Traded TR USD||2,17%||7,60%|
|Bonds Switzerland||Swiss Bond Index AAA-BBB TR||-0,68%||-0,71%|
|Commodities||Thomson Reuters/Jefferies CRB TR USD||1,17%||6,35%|
|Real Estate Switzerland||SXI Real Estate® TR CHF||-1,86%||0,05%|
|Real Estate World||FTSE EPRA/NAREIT Global TR USD||-3,35%||7,51%|
|Exchange rate EUR/CHF||0,50%||9,99%|
|Exchange rate USD/CHF||-2,12%||-4,74%|
The uncertainty began with a sudden rise in market interest rates following exceptionally strong economic data. This coincided with a nightmare for investors: tariffs on steel and aluminum. The political stakeholders reacted by announcing countermeasures along with some unhelpful rhetoric. Since then, the markets have been preoccupied with the frightening scenario of a trade war between the US and China, the world’s two largest economies. A truly unpleasant situation – but one that we must evaluate carefully:
- The protagonists are under no illusions about the considerable interdependence of the two economies. China needs the American market for its basic products, while the US needs China to finance a major portion of its growing deficit. These are good reasons to avoid an escalation and maintain an amicable relationship.
- It’s in both countries’ interests to take a selective approach to increasing the economically damaging tariffs, rather than to raise them across the board.
- China is currently undergoing a unique and important transition from an export-driven economy to a stronger domestic economy. This promising development is in full swing and in the medium term will lead to a considerable easing of the current situation.
- China’s announcement that it will further open the Chinese market to foreign investors, businesses and products is another means of avoiding the impending trade war.
We translated the signals from our indicators into a fundamental scenario with a high probability of occurrence and came to the following conclusion about the tensions between China and the US: both countries have a significant interest in stabilizing their relationship. From an international investor’s perspective, an escalation is out of the question.
Our risk indicators point to the following positive factors that have been overshadowed by the political saber rattling:
- Economic growth is strong and consistent around the world – an extremely rare event that clearly supports the capital markets.
- The impact of the central banks’ planned and expected interest rate rises should be modest and the markets are well prepared for it. There is currently no inflation pressure and none is expected for the foreseeable future. There is thus no pressure on central banks to dramatically raise rates.
- Companies posted their strongest results for some time in the first quarter of 2018. According to predictions from the major economic research institutes, the global economy will continue to develop well over the next two years and corporate profits will keep rising.
- The significant corrections in the past few weeks primarily concerned over-valued securities in technology and innovation and other industries with capital-intensive business models; however, the general market remained largely unaffected.
- The extraordinarily strong market performance in 2017 led to a major increase in the number of short-term investors. In this respect, the correction can be seen as a good thing, as long-term investors have replaced speculative players.
Despite existing residual risks, which can never be ruled out, we remain positive about real assets. As before, our preference is for the emerging markets, which proved to be very resilient during the latest market correction in comparison with the developed world.
“One change always leaves the way open for the establishment of others.”
(Niccolò Machiavelli, 1469-1527, Italian statesman and author)
Findings from Risk Regime Investing (RRI)
Although the risk environment has deteriorated slightly since February, the prevailing mood remains positive. The markets are in fundamentally good shape and able to absorb negative news. Moderate turbulence has led or forced investors to unwind positions. However, the low level of the Systemic Risk Index continues to indicate favorable risk relationships that can be exploited.
We took a slightly more conservative position in February. After the healthy correction, we expect no further setbacks in the weeks ahead. On the contrary, the revision has strengthened the markets’ structure. As there is no current risk concentration, the markets should recover or at the very least remain stable.
We measure the development of our risk indicators daily and would be surprised if systemic risks were to increase significantly in the near term. The situation could then worsen if investors foresee a trade war – which seems unlikely today. An imminent escalation would force us to reduce the proportion of tangible assets in our portfolio and take a conservative position. On the other hand, it is still too early to think about a reallocation to the highest risk level – the Turbulence Index would have to fall significantly to justify such a repositioning.
Findings from Quantitative Stock Selection (QSS)
As mentioned, the markets are currently in a transitional phase with a clear rotation from over-valued to under-valued sectors.
Technology stocks have been the major losers in this environment. For valuation reasons, our QSS approach did not take these securities into account in our PARemerging Market Equities Fund. In January 2018, this meant our fund underperformed slightly relative to the benchmark, since these stocks pushed the reference index significantly higher. In February and March, overvalued technology stocks fell disproportionately, which meant that we once again outperformed the benchmark. We currently allocate 16% to the Value style factor, which is one of six factor groups. Its inclusion in our investment approach has paid off and protected our portfolio from the excessive highs and subsequent corrections.
Reasonably priced financial equities are another example of this trend; they have performed very well in recent months and are now passing on some of their gains. These stocks trade within a natural fluctuation range with prices exhibiting an upward trend. This development is set to continue in the months ahead and we see no reason to sell these securities.
We described this process in our last newsletter in January:
After a long period of economic recovery and growth, it is important that we prepare ourselves for the subsequent downturn. In the knowledge that growth phases can last longer than expected
The two rival factors Growth and Value should also diverge in a transitional phase. After the extremely strong performance from high-growth securities, there will be a changing of the guard in favor of value stocks with high dividends and stable earnings.
These statements are still valid.
Global financial markets – review
The international equity markets suffered losses in the first quarter of 2018. All the leading indices were down, in some cases in the high single-digit range. The SPI was down 5.22%, the S&P 500 slipped 2%, the DAX and Japanese Nikkei lost around 6%, and the FTSE 100 in the UK fell by 8% (all in base currency terms). Swiss-franc based investors made a small currency gain from their European holdings, but this did little to improve the overall picture. The MSCI World equity index was down 1.28% in the first quarter, a loss of 2.99% in franc terms. In contrast, the MSCI Emerging Markets index performed comparably well and topped the table for the quarter with gains of 1.42% (-0.34% in franc terms).
Investment-grade bonds posted a solid first quarter. JP Morgan’s global market index advanced by 2.17%, which represents growth of 0.4% in franc terms. Franc-denominated bonds with ratings between BBB and AAA were down 0.68% between January and March. The yield differential between short and long-term bonds has remained virtually unchanged over the last three months.
After the widespread recovery in the fourth quarter of 2017, volatility returned to the commodity market in the first quarter of 2018. At the end of March, the broad-based CRB commodity index was up 1.17% year-to-date in dollar terms. These slight gains were driven by the oil price, which rose more than 5% in light of geopolitical uncertainty and the crossing of swords between the US and Russia. Gold was up 1.74%, while silver finished the quarter 3.5% lower.
The Fed has led the way with several rate rises, while in Europe the ECB is looking for the ideal exit pace from its extremely loose monetary policy of recent years. But we are still a long way from a normalization of global monetary policy – even in Switzerland. Interest rates in Switzerland and Europe are likely to remain very low for the foreseeable future. Swiss real estate funds posted losses of 1.86% in the first quarter of 2018, while foreign real estate investments were down 3.35% (5.02% in franc terms).
In 2017, the euro was the winner and the dollar the loser among the major currencies. This trend continued into the first quarter of 2018, somewhat slowed in the case of the euro but unabated for the dollar. The euro strengthened only slightly against the franc between January and March, finishing the quarter 0.5% higher than at the start of the year. Against the backdrop of a trade war between the US and China, the dollar fell 2.12% against the franc. The dollar’s weakness was also evident against the euro, with the latter up 2.72% against the US currency in the first quarter.