Investment Management Update – October 2017

Review

«Planning without action is futile – action without planning is fatal.»
(Willy Meurer, born 1934, German-Canadian writer)

The international equity markets continued their excellent performance into the third quarter of 2017, once again proving to be an attractive option for investors. In line with our predictions over the past three quarters, the favorable risk conditions resulted in positive returns. Those who did not take the plunge should ask themselves the following questions: how high is the drawdown potential if they invest now, and how high are the opportunity costs of not investing in the equity markets during this positive phase? Answers to these questions can be difficult and uncomfortable. Due to our overweight position in tangible assets, we focus primarily on the second question.

Our risk indicators have been at a low level for some months now: the Turbulence Index, which indicates the risk of increased market turbulence, still does not reflect any uncertainty among investors. And the values of the Systemic Risk Index lie within a range that suggests that systemic risk is low. Hardly any risk concentration exists and the market drivers are broadly based. The markets continue to be resilient and are expected to keep making positive advances. Market setbacks will remain unlikely in the near future. As long as the risk conditions continue to be favorable, investors should not risk missing the boat.

In terms of performance, the third quarter of 2017 was on a par with the two preceding quarters. The main indices were boosted in particular by a solid September. The emerging countries defended their lead convincingly with a gain of 27.78% since the start of the year, meaning that our overweight position in this equity segment has paid off well. Since this positive performance is growth and valuation-driven, it is expected to continue. We are therefore retaining our overweight position in emerging market equities.

Nevertheless, this prolonged upturn may have entered its final phase, but it is almost impossible to predict when it will come to an end. We believe as many resources as possible should be used to anticipate this more accurately. Experience tells us that upturns of this kind often end in exaggeration. The first signs of this can be seen in the US, although only among a modest number of equities at present. Despite the high index values, there is further potential for the broader market to grow if the observed sector rotation continues in a controlled manner.

With the US market leading the upturn and the Asian markets following, it should now be the European market’s turn to perform at a high level. But the timing of this «follow the sun» masterplan is far from easy. Investors often pull out of a market too early if it does not develop as expected, and are then left frustrated when it picks up again at precisely the wrong moment. A long-term plan should therefore be abandoned only if the general conditions change completely. We are sticking to our strategy of concentrating more on European equities.

Outlook

«All you have to do is touch the right key at the right time.»
(Johann Sebastian Bach, 1885-1750, German composer)

Findings from Risk Regime Investing (RRI)

However, the «follow the sun» principle, exaggeration, valuations and cyclical trends never paint a clear picture. The condition of the equity markets is a jigsaw puzzle with pieces that do not fit together cleanly and which can be interpreted in many different ways. This can be seen in the diverging opinions of the specialists, who draw opposite conclusions from the same analysis. It is therefore essential to be guided by the facts. For PARSUMO, the risk environment remains the most important factor. Due to the low risk concentration and very little turbulence at present, we continue to expect robust markets with a favorable risk-return ratio.

The overweight position in tangible assets, which we entered into at the beginning of the year, has paid off over the last three quarters. We also used the highest risk budget successfully in the third quarter and will continue to do so. The equity market conditions are favorable, and risks taken are rewarded. Since we base our decisions on facts, we are keeping a particularly close eye on any changes to this environment. If our indicators start to show signs of deteriorating risk conditions, we can respond quickly.

Findings from Quantitative Stock Selection (QSS)

In our last Investment Management Update, we wrote: «In terms of regions, we currently favor Europe, Asia-Pacific and the emerging markets. We generally expect a further shift in the factor preferences of investors; i.e. away from defensive-style characteristics, such as high quality and low risk, toward the more cyclical characteristics of value, earnings revision, momentum and growth.»

We have positioned our portfolios accordingly, which has resulted in solid performance with gains above the benchmark. We confirm our assessments of previous quarters and expect the current trend to continue. The main characteristics include:

• An ongoing rotation in lagging sectors
• A partial shift from defensive quality stocks towards cyclical stocks
• An overweight position in Asian and emerging market equities based on the «follow the sun» principle, and a further increase in European equities at the expense of US
• A preference toward the style characteristics of value, earnings revision, momentum and growth, with a moderate shift away from high quality and low risk features

Quantitative stock selection (QSS) is an approach used in factor investing and applies several styles dynamically. We prefer a diversified strategy, as single strategies often have to endure longer dry periods. This is currently the case with low-risk strategies. Although low volatility equities undoubtedly have a positive premium, a strategy focused on this characteristic neglects the interaction between styles.

With an investment approach that incorporates several styles, it is possible to identify at an early stage if the quality of an equity improves, momentum builds, the valuation becomes interesting or earnings revisions start to point upward. In 2016, this pronounced market rotation meant that the best funds from previous years were suddenly among the worst, and vice versa. Thanks to dynamic adjustment of styles to the economic cycle, our portfolios have coped well with these challenges and continued the good results of previous years.

Global financial markets – review

Equities

The equity markets continued their positive performance of the first half of 2017 in the third quarter, again generating considerable returns across the board in dynamic fashion. With the exception of Madrid, Singapore and Sydney, which saw no change, all major equity indices finished September higher than at the end of June. Since the beginning of January, the SPI has climbed 16.53%, the Dax 11.7% and the S&P 500 12.53%. In Swiss francs, this represents growth of 7.7% for the S&P 500. In the UK, the FTSE 100 gained almost no ground and has risen just 3.22% since the start of 2017. The Japanese Nikkei continued its recovery from the second quarter, finishing the third quarter up more than 6% on the year start. The MSCI World Index was up 4.84% in the third quarter, representing an overall gain of 16.01% since the start of the year. Emerging market equities as measured on the MSCI Emerging Markets gained 7.89% and 27.78% respectively, once again clearly outperforming the industrial countries. (All figures in local currency.)

Bonds

Investment grade bonds continued their recovery, albeit at a slightly slower pace. JP Morgan’s global market index advanced by 5.78% between January and September, which in franc terms represents growth of a good 1%. Franc-denominated bonds with a rating of between BBB and AAA saw no change in the third quarter. With a return of -0.34%, they are still slightly in the red for the year to date. The yield differential between short and long-term bonds has remained virtually unchanged over the last three months.

Commodities

In the third quarter of 2017, commodities prices showed signs of a widespread recovery for the first time in quite a while. The broad CRB commodities index gained 5.03% in dollar terms from July to September, although it has still lost 4.28% since the start of the year. The gains were driven by the sharp rise in oil prices. Brent crude oil advanced by more than 16% in the third quarter, and even finished September slightly higher than at the start of the year. Gold and silver prices also climbed after a weak second quarter, and at the end of September had risen by 11.05% and 4.61% respectively since the start of January. The price of palladium, one of the few winners in the second quarter, continued to be driven up by demand from financial investors. With a gain of more than 36% since the start of the year, palladium leads the commodities league table by a significant margin.

Real estate

Due to a more stable euro and uncertain growth, the European Central Bank (ECB) has delayed its exit from bond purchases for now. The US Federal Reserve has already ended its bond-buying program, but a normalization of the global monetary policy is still some way off – including in Switzerland. Interest rates in Europe are likely to remain very low for the foreseeable future. After a positive second quarter, Swiss real estate funds lost 2.81% between June and September, but are still up 4.16% on the start of the year. Foreign real estate investments continued to recover. After recording an encouraging gain of 3.36% for the quarter, they are now up by 10.84% since the start of the year. In franc terms, they made a 6.08% contribution to performance.

Currencies

The euro recovered well in the third quarter, driven by encouraging economic data. It has gained 4.44% against the franc in the past three months, and almost 7% since the start of January. The dollar-franc exchange rate also overcame the weak first semester, with the dollar finishing the third quarter up 1.04%. However, it has lost 4.76% against the franc since the start of the year. Due to the general weakness of the franc in the third quarter, the pound was also up 4.34% against the Swiss currency. The euro again gained ground against the dollar, closing the quarter at €/$ 1.18. This represents a plus of more than 12% between January and September 2017.