Review

«Risk is very rarely constant, particularly on the financial markets.»
(Simeon Belopitov, Portfolio Manager, PARSUMO Capital AG)

The first half of 2018 was a difficult period for the international equity markets. Volatility rose sharply at the start of February, and despite subsiding in March has remained at a considerably higher (but more normal) level than in 2016-2017. Trade wars, exchange rate fluctuations and interest rate fears have all left their mark, and the greater uncertainty has led to investors reducing their positions in risky real assets. Major divergences can be seen between the different regions and markets, and although regional distortions and turbulence have not yet had a significant impact on the condition of the capital markets as a whole, the corrections on the Asian markets are considerable. The advice once again is to keep a cool head and evaluate the situation with care. A correct assessment of the individual regions and their opportunities calls for foresight and patience.

On the basis of our proprietary risk indicators, we can say with confidence that there is no great danger of a global equity market setback at present. The Turbulence Index, which shows erratic price changes and unusual correlations between the different asset classes, is inconspicuous. The Systemic Risk Index has also remained at a low level, which would indicate a broad-based, less vulnerable market. The risk concentration – the most important parameter and almost unalterable prerequisite for tail risks – also remains low. The chance of significant market setbacks is small and the markets continue to be resilient.

What is our assessment of the current market situation, and which approach is particularly important at present?

In our April newsletter, we referred to the tariff situation as «a nightmare» and pointed out that the US and China should both have a significant interest in stabilizing their relationship and avoiding an all-out trade war. Our opinion has not changed. However, we are surprised by both parties’ stubbornness and unreasonableness in terms of the potentially disastrous consequences of an escalation. Although we still consider it unlikely that tariffs will spiral out of control, this scenario should nevertheless be considered as a residual risk in the market analysis. The Chinese equity markets are already anticipating a major escalation of the trade war and are experiencing significant setbacks.

How should investors behave? Which measures are appropriate and which are not?

Investors are inherently cautious and tend to avoid uncertainty. More prudent investors can create advantages for themselves in such situations, provided they choose the right approach. An important measure is careful diversification. It has been implicitly incorporated into our processes and is part of our DNA, and thus our mindset.

In recent months, it has become clear how important diversification is for all aspects of the investment process and in comparison with other investment approaches. In our pure equity mandates, it takes the form of a diversification of styles based on our QSS approach (Quantitative Stock Selection). Single-style strategies, on the other hand, are much more susceptible to market turbulence.

In our emerging market fund, diversification across different countries and regions is the stabilizing element. It effectively cushions negative developments, such as the temporary but substantial setbacks currently ongoing in China. In contrast, the search for and selection of just one «right» emerging market poses the risk of an unforeseen component that can burden an investment for years.

Diversification also plays a key role in mixed mandates, as investment in different asset classes can help to stabilize portfolio returns. At present, real estate and commodities make a decisive contribution to the reduction of risk and improvement of results. A one-sided, heavily weighted position generally entails higher levels of risk that are not always sufficiently rewarded by the markets.

Diversification has proved its worth in all our products and investment approaches in recent months, and has created greater certainty for us and our valued clients.

However, a measure that would not be appropriate in the current situation would be to take an over-cautious position, where the opportunity costs may be considerable.

Don’t forget the positive aspects

As mentioned, in April we translated the signals of our indicators into a fundamental scenario with a high probability of occurrence and came to the conclusion that the US and China would have a significant interest in avoiding a full escalation of the trade war. On closer consideration, 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 half 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.

US vs. China

In recent weeks and months, we have been surprised by the one-sided correction on the equity markets, even though it has been caused by bilateral problems. We do not believe that the US would be able to survive a trade war unscathed. We would not be surprised if the tide turned, i.e. if the US market became weaker and the Chinese market recovered.

China has a growing domestic economy and almost unlimited potential in adjacent markets. The country continues to demonstrate its talent for acquiring new trading partners. The US, on the other hand, appears intent on isolating its domestic economy. It is alienating its neighboring trading partners, and the opening up of future markets does not appear to be a priority. There is a feeling that the world is making great strides forward, with only the US wanting a return to the good old days. This will not be possible, however, as the emerging nations are now less dependent on the industrialized nations. In fact, their roles appear to have reversed: the emerging markets are increasingly setting the tone and the old economies would be well advised to support and adapt to this development rather than fighting it with power politics.

The «follow the sun» principle should be remembered here. Europe is still reasonably priced, as are the emerging markets, particularly after the latest correction. However, the US market appears over-priced to us and the indices are vulnerable, as their gains come from just a few sectors.

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, with a few exceptions, have proved to be resilient in comparison with the industrialized countries and have excellent growth potential.

Outlook

«Efficient risk management avoids the risk of exposure to unwanted risks.»
(Jacques E. Stauffer, CEO, PARSUMO Capital AG)

Findings from Risk Regime Investing (RRI)

The risk environment barely changed in the second quarter of 2018, and the general mood on the markets continues to be constructive. We have been seeing a healthy market correction since February. According to our indicators, the markets should be able to absorb further negative announcements on the tariff front to a certain degree. Although these disruptive factors have led to a moderate rise in turbulence, they have merely put a halt to the recent upturn. As long as the Systemic Risk Index does not show a significant concentration of risk, we believe the likelihood of significant setbacks is low.

We adopted a slightly more conservative position in February and have not changed our stance since then. Months of positive returns have alternated with slightly negative months, resulting in an unattractive result with a slightly negative outlook. This raises a valid question: is it worth taking these risks? We believe it is, since historically, attractive returns have been achieved in a risk and market regime such as the prevailing one. In our opinion, another market recovery with positive returns is more likely than a painful consolidation with significant losses.

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 worsen if investors expect a global trade war and this materializes in the economic data.

Findings from Quantitative Stock Selection (QSS)

The markets are still in a transition phase, with a clear rotation from over-valued to under-valued sectors. Furthermore, our economic model predicts a shift from economic boom to slowdown. We have thus positioned our portfolios more defensively and significantly changed our style preferences. We have increased the weighting of the style factor «quality» to the maximum, while decreasing «risk» to a very low level.

Our emerging market fund, the PARemerging Market Equities Fund, effectively cushioned the setbacks in China and outperformed the benchmark over four months in the first half of 2018. Despite a costly January with a negative active return of -2.5%, the fund’s performance against the benchmark between January and June was slightly positive at 0.123% after costs.

We would like to refer to our comments from January 2018 again at this point:

After a long period of economic recovery and growth, it is important that we prepare ourselves for the subsequent downturn, but in the knowledge that growth phases can last longer than expected.

And:

The 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 assessments have arrived earlier than expected and bode well for the future. Why?

Due to the extremely healthy performance of the economy and the latest slight cooling, an overheated economy, and the associated negative consequences for the equity markets, is becoming increasingly unlikely. An accentuated interest rate reversal appears to have been avoided for now, and the corrections on the equity markets may prove to be exaggerated. For these reasons – and due to the strong skepticism among many investors – the signs are good that the equity markets will recover.

Global financial markets – review

Equities

In the second quarter of 2018, the performance of the international equity markets was mixed overall. Most leading indices of the industrialized countries recorded gains and were able to offset some of the losses of the first quarter. The SPI was up by 1.35%, but is still showing a loss of 3.95% since the beginning of the year. The S&P 500 advanced by 5.2%, the Dax by 2.5%, the Japanese Nikkei by 3.6% and the UK’s FTSE 100 by about 9% (all in base currency terms). Swiss-franc based investors had to take a small currency loss on their European holdings, although they made a considerable gain on dollar-denominated investments. The MSCI World equity index was up 1.73% in the first quarter, representing a gain of 5.49% in franc terms. In contrast, the MSCI Emerging Markets index performed less well with a loss of 7.96% (-4.56% in franc terms). The reasons for this included setbacks on the Chinese equity market, which lost about 12% in the second quarter in anticipation of an escalation of the trade war.

Bonds

Investment-grade bonds again posted a solid quarter. After a good first quarter, JP Morgan’s global market index fell by 3.04% from April to June, which translated to minor growth of 0.54% in franc terms. Franc-denominated bonds with ratings between BBB and AAA were up slightly by 0.11% in the second quarter of 2018, representing a return of -0.57% since the start of the year.

Commodities

After the widespread recovery in the fourth quarter of 2017, volatility returned to the commodity market in the first quarter of 2018. The performance of equities in the second quarter was mixed. The precious metals segment weakened slightly, while energy remained strong. At the end of June, the broad-based CRB commodity index was 3.06% higher than at the end of March in dollar terms (6.86% in francs), again driven by the high price of crude oil, which temporarily tested the USD 80 barrel mark (Brent).

Real estate

The US Federal Reserve led the way and changed the interest rate for the seventh time this year in mid-June. The European Central Bank (ECB) is still looking for the ideal exit pace from its ultra-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 0.76% in the second quarter of 2018, while foreign real estate investments were up 3.45% (7.27% in franc terms).

Currencies

As in 2017, the euro was the winner and the dollar the loser among the major currencies in the first quarter of 2018. This development saw a sharp turnaround in the second quarter, with the dollar gaining 3.66% against the franc and 5.02% against the euro. The euro also lost ground against the franc and was down by -1.51% at the end of the quarter. The dollar showed remarkable resilience in light of the escalating trade war with China.