More risk factors – major market setbacks increasingly likely.
«Interest is the sex appeal of money.» (Erwin Koch, German aphorist, *1932)Over the past two years, more and more European countries have not only been able to refinance at no cost with short-term government bonds, they have also been able to earn serious money by borrowing. The reason? Negative interest rates.
In the eurozone, Sweden and Denmark, central banks have imposed negative interest rates on commercial bank deposits for some time now and the Swiss National Bank (SNB) has recently followed suit. In its announcement on December 18, the SNB underlined its intention to defend the minimum exchange rate for the Swiss franc against the euro, adding that it would move the target range for the three-month Libor into negative territory on January 22, 2015, thus becoming the world’s first central bank to set a base rate below zero.
However, this statement is already obsolete: on January 15, the SNB unexpectedly announced that it was abandoning the minimum exchange rate, a decision that plunged the stock and foreign exchange markets into turmoil. On the FX markets, for example, the Swiss franc temporarily rose by almost 40% against the euro and the dollar. By the evening of January 15, the euro and dollar were down 14% and 13% respectively against the franc. Despite the SNB’s flanking measure of reducing the negative interest rate even further, the franc is likely to retain its sex appeal – at least in the short term.
The Swiss franc lost a huge amount of ground against the US dollar last year. The main reason for this was the decision of the SNB three years ago to peg the Swiss franc to the weak euro; however, this did not lead to a significant appreciation of the US currency until August 2014. The SNB ‘bombshell’ caused a sudden reversal of this development. The dollar now costs as much as a year ago, after all gains were wiped out in a single day.
In the medium term, however, the performance of the franc will depend on its appeal to investors. Speculative gains will already have taken a dive. In the medium term, negative interest rates and the revival of the dollar due to declining commodities markets make the Swiss franc less attractive than its US counterpart. Against the euro, however, it should become stronger, with no further exchange rate changes expected for the foreseeable future, not least owing to fears of deflationary pressure.
The pleasing performance of the stock and bond markets should not detract from the fact that the number of risk factors increased in the final three months of last year. The annual commodities losses, amounting to 18% on average, were caused primarily by the plummeting prices of the European oil type Brent and the US WTI (West Texas Intermediate). We assume that the crude oil losses of more than 40% will have a negative impact on the economies of oil-exporting countries – including the US – and thus on the financial markets.
«Politicians are like photographers: They develop negatives and show them to us in positives.» (Margot Brand, *1958)At a parliamentary session shortly before the end of last year, Alexis Tsipras, Greek politician and leader of the left-wing coalition party Syriza, described the failure to elect a new Greek president as a victory for democracy. New elections are now required under the constitution. Although the radical left are not expected to win an absolute majority on January 25, they are still likely to become the strongest force in parliament. The end of the austerity policy, as announced by Tsipras, and the associated shift away from cutbacks could have unimagined consequences. The International Monetary Fund (IMF) has already announced that it will not discuss any further support measures until after the parliamentary election. What is being sold in Greece as something positive could have a negative impact on the financial markets.
|Equity World||MSCI World Net USD||1.01%||4.94%|
|Equity Switzerland||Swiss Performance Index||1.86%||13.00%|
|Bonds World||JPM GBI Global Traded TR USD||-0.91%||0.67%|
|Bonds Switzerland||Swiss Bond Index AAA-BBB TR||2.10%||6.82%|
|Commodities||Thomson Reuters/Jefferies CRB TR USD||-17.44%||-17.90%|
|Real estate Switzerland||SXI Real Estate® TR||6.41%||14.99%|
|Exchange rate EUR/CHF||-0.30%||-2.16%|
|Exchange rate USD/CHF||3.58%||10.06%|
Our indicators show that the ability of financial markets to digest bad news is diminishing. Over the past three years they have been able to overcome any obstacles within a short space of time, but we doubt that today’s markets could deal with convulsions as quickly. This assumption is backed up by observations in the area of behavioral finance:
- On average, shares make up 44% of the securities held by Swiss banks. Twenty years ago, such values would be equivalent to a buying frenzy among investors and a double-digit percentage fall in share prices over the following 12 months.
- In difficult times, bonds act as a ‘safety net’. Over the past 20 years, this investment category has helped to offset losses from shares. However, the level of ‘safety’ they offer has diminished considerably over time, with bonds now making up just 23% of the average securities portfolio. Not only is this value well below the long-term average of 30%, but the proportion of bonds being held (23%) is as low as in October 2007; i.e. just before the outbreak of the last financial crisis.
- • The focus on fewer sectors on the American stock market index S&P 500 continued in the last quarter. The two biggest sectors – Financial and Information Technology – now make up more than 36% of the total market capitalization of the S&P 500. This has weakened the positive diversification effect of the index.
Although we have observed that the increasing volatility of the markets is making investors nervous – which in itself is positive for future market performance – this has not been reflected in their transactions. We believe they will hold on to their large share positions, a fact that increases the likelihood of significant market setbacks.
Global financial markets – Review
(See previous table)
Our main target markets in Switzerland and the US generated pleasing returns of more than 10% (denominated in francs), despite the low-risk approach. The need to diversify when investing in shares can be seen in the fluctuation range of more than 100% between the performance of the best and worst markets. For instance, it was possible to earn 59% on domestic currency in Argentina but lose 45% on the Russian stock market. Considering that the peso finished even better against the dollar (-30%) than the ruble did (-65%), the actual difference is more than 190%.
Investors working in dollars were unable to take advantage of falling interest rates on government bonds and bonds with high investment grades. Earnings from the local bond indices were wiped out by their currency losses against the dollar, meaning that the worldwide bonds earned only 1% over a 12-month period. The formerly derided PIGS countries (Portugal, Italy, Greece, Spain) were the exception, with Portuguese government bonds, for instance, recording a gain of 35% denominated in euros.
Commodities have been the main reason for the sharp rise in our risk indicators in recent weeks. After already showing signs of weakness throughout the whole year, the decline was further accentuated by the oil types Brent and WTI in the fourth quarter, resulting in a loss of 48% and 46% respectively over the 12-month period. The price of gold ended the year virtually unchanged (-2%).
Real estate is becoming an increasingly popular substitute for bonds. Steady cash flow is perhaps the main reason for a preference for low-return real estate rather than the increasing range of bonds with negative interest rates. This is the only possible explanation for the better performance of Swiss real estate (+15%) and UK and US real estate funds (+21% and +30% respectively, denominated in the local currency) in comparison to last year.
The dollar’s growth continued unabated – at least until January 15, 2015. The predicted transformation from eternal oil importer to potential exporter over the coming decades should eventually improve the US’ balance of trade and result in a stronger dollar. This, along with the more dynamic constitution of the US economy, was one of the reasons for last year’s rise against the euro (+12%) and the franc (+10%). As mentioned, the SNB abandoned the minimum exchange rate for the franc against the euro on January 15, which resulted in the dollar finishing the day 13% down against the franc. This may have changed the exchange rate situation, but it did not alter the fact that the US economy is still more competitive than that of Europe and Switzerland. The rise against the ruble (+65%), however, was caused by additional factors that the Russians played a part in themselves: the tense political situation on the Crimean Peninsula, the civil war in the Ukraine and the resulting sanctions imposed on Russia. In addition, Russia is experiencing significant revenue shortfalls due to the plummeting oil price.