Investment Management Update – October 2015

Review

The search for consensus creates a great deal of nonsense.
(Klaus Klages, German philosopher)

The US Federal Reserve Board is in agreement: interest rates can be raised once the US economy reaches full employment again. A decision had already been made to move away from the policy of cheap money when Chair of the Board Janet Yellen first took office. Two years later, Yellen wants to finally implement this without jeopardizing the current economic growth.

However, this is proving to be more complicated than envisaged. On the one hand, there is disagreement over what full employment actually means. The unemployment rate does not appear to be used as a yardstick, otherwise it would have been necessary to increase interest rates at the last meeting. Although the current rate of 5.1% would at least indicate relative full employment, it is 1% lower than the 50-year average and more than 5% below the peaks seen in 2010.
On the other hand another important indicator even suggests the opposite: since the beginning of 2000, the employment rate – the number of people working or looking for work as a percentage of the total population – has fallen from 67.3% to 62.4%, the same level as in 1977. This is accompanied by a reduction in working hours and stagnant wages. These latter figures do little to support the notion that the US economy is close to full employment again.

The double burden caused by the continuously delayed interest rate hike in the US and the economic slowdown in China has led to disenchantment in the financial markets. In the past quarter, shares generated their worst return for more than three years (-8%), and despite rock-bottom interest rates, bonds are only softening the blow slightly (+2%).
It will be interesting to see what figures Janet Yellen will conjure up to justify an interest rate hike before the turn of the year. Her Board has been delaying the decision for too long and it is now time for those within the Federal Reserve to finally agree on an exact definition of full employment. The danger of a «nonsense» explanation has risen considerably in the last few months.

Outlook

The past is sure to catch up with those who turn their backs on the future.
(Ernst Ferstl, Austrian teacher, poet and aphorist)

Perhaps Janet Yellen intentionally missed the opportunity to raise interest rates on September 17, 2015. The Fed Board appears to have come to the realization that, despite the cash floodgates being open, the American economy cannot defy the long-term cycles and is now facing a new recession after five years of economic growth. Not exactly the best moment to raise interest rates.

In addition to the aforementioned signals from the American labor market, there are also other reasons why the whole world may be waiting in vain for an interest rate move. The current gradual devaluation of the Chinese renminbi against the US dollar would gain momentum, resulting in a new wave of competitive devaluations in the emerging markets. The European Central Bank (ECB) is also doing everything it can to keep interest rates low for as long as possible in order to prevent the debt pyramid from collapsing.

Central banks will perhaps reach the conclusion that their open-floodgate policy cannot stimulate the economy, fuel the stock markets, weaken their currencies and ward off inflation forever. Instead, they will have to address some far-reaching undesirable developments: speculative bubbles and over-indebtedness. By pursuing an aggressive low interest rate policy, they have been turning their back on the future for a long time, and sooner or later the past will catch up with them.

We have hedged against the greater likelihood of a strong stock market correction by adopting a defensive position in our portfolios. We implemented target portfolio 1 in two stages in August and September. At 20–25%, this portfolio has the lowest proportion of real assets (equities, real estate, commodities).

We do not currently share the consensus that the previous weak quarter has heralded the start of a year-end rally. Although this scenario would follow the classic pattern of October traditionally marking the start of a turnaround, there are several factors that point against share prices being higher come the end of the year:

• Our prospective risk indicators show a high concentration of risk and are therefore urging caution. Comparatively high values were observed in 2001 and 2007. The financial markets have seen the risk regime change considerably since the start of the year and are now much more fragile than in the past four years.
• According to a survey by the industry organization Swiss Funds Association (SFA), the ratio between capital invested in equity funds and capital invested in bond and money market funds stood at 94% in August. Our analysis has shown that a value above 93% has not resulted in the Swiss Performance Index (SPI) generating a positive annual yield in any of the 23 cases observed since the first data was collected in 1998.
• Only in three out of eleven cases recorded since 1996 has the MSCI World generated a positive annual yield when the aggregated equity weighting proposed by eight Swiss banks has exceeded 45%. For the final quarter of 2015, these institutes recommend a rate of 46%, which corresponds to an expected return of -6% over the subsequent 12 months.
• In the US, the development of the major share indexes – the Dow Jones, NASDAQ and S&P 500 – differed greatly from the combined seasonal cycle, which aggregates data from the past 100 years (broken down into presidential term, decade and annual cycles). The current deviation would suggest that the forthcoming, historically above-average six-month period between October and April may skip a cycle this time round.

Global financial markets – review

(See previous table)

Equities

Equities generated their worst three-month returns since February 2012. The US central bank’s indecision regarding the impending interest rate move, coupled with the Chinese stock market falling by 30%, has resulted in lower equity prices worldwide. It was not just the markets linked to China that were affected (Nikkei -14%, Hang Seng -21%) – the dollar-sensitive stock exchanges of emerging countries, which are combined under the Emerging Market Index, also plummeted (-18%). This time, it was established stock markets, such as those in the US, the UK (both -7%) and Switzerland (-3%), that limited the loss of the globally calculated MSCI World to just 8%.

Bonds

Despite rhetoric to the contrary from the decision-makers, more and more signs are indicating that the US central bank is not likely to raise interest rates this year. As a result, the global bond index has risen by 2% and CHF-denominated AAA to BBB-rated bonds traded on the Swiss market have gained 1%.

Commodities

The technical gains generated in the previous quarter were short-lived. The dramatic decline in the Brent oil price (-22%) dragged both industrial and precious metals deep into negative territory. While the price per ounce of gold (-5%) and silver (-7%) performed somewhat better than the CRB commodity index (-15%), copper suffered double-digit losses, which had a negative impact on shares and bonds of companies in the commodity sector (e.g. Glencore). Only palladium, which is used in gasoline engines, managed to buck the trend (+15%), due to the VW scandal over manipulated diesel emissions data.

Real Estate

Real-estate funds in Switzerland continued their consolidation. The 2% decline over the past three months caused the premium (the amount paid over the net asset value) to fall further from 36% in April to 23% at present. However, this value is still far higher than the long-term average of 15%, which would suggest that the consolidation is not yet over. Real-estate funds traded outside of Switzerland continued to gain ground, up 3% in the US and 5% in the UK.

Currencies

Contrary to expectations, the Swiss National Bank did not use the Swiss franc’s appreciation against the euro and the US dollar as an opportunity to reduce its high foreign exchange reserves. By the end of August, the corresponding benchmark figures had increased for the third time in succession, meaning that the currency gains against the franc of 4% each over the past three months still appear rather suspect.