«Identifying a problem and accepting that it exists is half the solution.» (Peter Becker, German computer scientist)
In the international equity markets, the decoupling of the US from the rest of the world continues. Divergence of the markets in favor of the US and at the expense of Europe and the emerging markets has been observed for some months now, and was even more pronounced in the third quarter of 2018. It is being driven by economic data, different interest rate developments, and high capital outflows to America. While the US equity markets continue to set records, the emerging markets are confronted with a stronger dollar, which is heaping additional pressure on countries with high levels of dollar-denominated debt. Europe is struggling with ongoing political uncertainty and the approaching Brexit. In this tense environment, the Swiss exchange has managed to recover from its low in February and is up slightly on the beginning of the year.
The equity markets have been largely immune to the many problems that have arisen in recent months – and there is nothing to suggest that this situation will change in the coming months, despite significantly stronger fluctuations. Our proprietary risk indicators show that the risk environment remains favorable. The Turbulence Index and the Systemic Risk Index are still at a moderate and low level respectively, indicating broad-based and more resilient markets. Market setbacks and distortions appear unlikely, and risks taken are rewarded. There are increasing signs that the wheat is separating from the chaff. Investors would be well advised to prudently assess individual markets and regions, and to diversify their portfolios with care.
What is our assessment of the market situation, and which approach is particularly important?
Keep an eye on positive aspects and problem areas
In short: the advantageous risk conditions favor the real-asset markets, and the abundant liquidity should lead to further gains in these asset classes. The economy continues to be generally resilient, even though it has slowed a little. The environment of moderate but steady growth is benefiting the equity markets. Growth of corporate profits is on track worldwide.
Valuations in the US have declined slightly, but are still well above their long-term average. The political headwind from the US is largely reflected in equity prices and US interest rates are gradually returning to normal. However, with regular interest rate hikes still at a very low level, they should act as a catalyst rather than a brake for the time being.
The current development of the international equity markets indicates the potential danger of a trade war. After conclusion of the NAFTA agreement – now known as USMCA – the US will inevitably have to normalize its relations with China. President Trump pursues an extreme starting position strategy; i.e. confront the other party with heavy demands and threaten further escalation, and then quickly move away from the vociferous demands so that in the end an agreement can be reached. The dramaturgy of the trade dispute with China is likely to take the same course, as pressure will mount on Trump to rethink and adjust his economic policies in the coming months. He will, of course, portray his change of stance as a victory in tough negotiations. This could give additional impetus to the equity markets and create potential for further advances.
Rock-bottom interest rates are a thing of the past in the US. In the bond markets, the interest rate differential between US Treasuries and German government bonds has reached a record high, giving the dollar a further boost. The Swiss franc, on the other hand, will be subject to increased downward pressure, which we expect to ease Switzerland’s export industry.
The biggest risks still lie in euro and franc-denominated bonds in the long term. The European Central Bank and the Swiss National Bank are keeping interest rates low for the time being. However, developments in the US will have a lasting impact on the domestic markets and could trigger measures by the central banks.
as of 30.9.2018
in base currency
as of 30.9.2018
in base currency
|MSCI World Net USD
|Swiss Performance Index
|MSCI Emerging Markets NR USD
|JPM GBI Global Traded TR USD
|Swiss Bond Index AAA-BBB TR
|Thomson Reuters/Jefferies CRB TR USD
|Real Estate Switzerland
|SXI Real Estate® TR CHF
|Real Estate World
|FTSE EPRA/NAREIT Global TR USD
|Exchange rate EUR/CHF
|Exchange rate USD/CHF
How should investors behave?
The favorable risk conditions on the capital markets in recent months have suggested a higher weighting of real assets, and we are sticking by this assessment. As mentioned above, risks taken are rewarded by the markets.
In our July newsletter, we wrote:
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.
This recommendation of careful diversification should definitely be heeded in the coming months.
«Only with prospective risk management is it possible to make three difficult decisions responsibly: recognizing an upturn in the markets at an early stage, not exiting too soon, and anticipating a significant market downturn.» (Jacques E. Stauffer, CEO, PARSUMO Capital AG)
Findings from Risk Regime Investing (RRI)
According to our prospective risk indicators, market conditions continue to be very encouraging. The Turbulence Index, which shows erratic price changes and unusual correlations between the different asset classes, is completely inconspicuous. The Systemic Risk Index has also remained at a low level, which would indicate a broad-based, less vulnerable market. The concentration of risk is low, and the likelihood of tail risks is small. Investors do not seem affected by any dominant problem areas, although some most definitely exist. We are, however, observing significant rotation within the markets and indices.
The development of our indicators in recent months has been counterintuitive for many market participants, who were expecting the risks to increase. However, this is precisely why investors should give our risk analyses their full attention. These have been confirmed again by the development of the market in recent months, as prospective risks do not reflect the current situation but instead anticipate future events.
Although valuations in the US have declined slightly, we are standing by our assessment that the American market is overpriced and that there are some good options. We continue to favor emerging markets, some of which have suffered significant corrections, as well as the more favorably valued European and fast-growing Asian markets.
We measure the development of our risk indicators daily and would be surprised if systemic risks were to increase significantly in the near term. If the situation deteriorates, we can react very quickly and adapt our portfolios immediately to the new market regime.
Findings from Quantitative Stock Selection (QSS)
After a prolonged recovery phase and the subsequent boom, the economic cycle now appears to have entered a phase of weakening. It remains to be seen whether this slowdown will lead to a recession, or whether the economy is just cooling down temporarily before gathering pace again.
The continuing rotation from cyclical stocks to interest rate-sensitive securities has also slowed in recent weeks, but we are seeing signs that it is gaining momentum again. Value stocks tend to underperform in recovery and boom phases. In future, investors are likely to pay more attention to the valuation and quality of securities as the economy slows down.
We are countering this development with a slight change to the style weighting in our portfolios. We continue to favor quality and are focusing on defensive stocks. We are currently paying attention to the «value» and «low risk» styles, since these attributes are in demand again after a boom phase. On the other hand, we are reducing our weighting in high-growth securities for as long as our economic cycle model signals a slowdown.
Our PARemerging Market Equities Fund cushioned the setbacks in China well in the second quarter. Since the beginning of the year, the fund has outperformed the benchmark by 1.31% (after costs) and has exceeded it for seven out of nine months.
Global financial markets – review
In the third quarter of 2018, the performance of the international equity markets was mixed; the equity indices diverged. The SPI rose by 4.65% and is now slightly up on the beginning of the year. The US stock markets were again in a record-breaking mood and are still leading the global performance table by some distance, despite the sharp correction in February. The S&P 500 advanced by 7.2% between July and September, and the Japanese Nikkei gained 8.14% thanks to a solid September. The UK’s FTSE 100 posted a loss of 1.66%, while the DAX fell by 0.5% (all in base currency terms). The MSCI World equity index was up 4.98% in the third quarter, representing a gain of 3.27% in franc terms. MSCI Emerging Markets managed to halt its strong downward trend, but still suffered a slight loss of 1.09% (–2.70% in franc terms). With the dark clouds of a trade war on the horizon, China’s equity market lost about 12% in the second quarter, but was up slightly at end of the third quarter. Swiss-franc based investors had to take a small currency loss on their European and US holdings.
Investment-grade bonds again posted a solid quarter. After a good first quarter, JP Morgan’s global market index fell into negative territory in the second quarter and was down by 1.70% from July to September, which translated to a loss of 3.30% in franc terms. Franc-denominated bonds with ratings between BBB and AAA were down slightly by 0.77% in the third quarter of 2018, representing a return of –1.33% since the start of the year.
Commodity prices have been fluctuating since the start of the year. In the third quarter, the performance of raw materials was mixed. The precious metals segment lost considerable ground, but energy (driven by the oil price) again performed well. At the end of September, the broad-based CRB commodity index was 2.11% lower than at the end of June in dollar terms (–3.70% in franc terms). The price of crude oil continued to soar, closing September at USD 85 a barrel (Brent) – its highest level since November 2014.
The US Federal Reserve has been raising key interest rates quarterly, and the hike at the end of September was the eighth in the current cycle. In Europe – and Switzerland – there is still no end in sight to the ultra-loose monetary policy of recent years, not least because of the global trade disputes, which are also affecting export-strong Germany. Interest rates in Switzerland and Europe are likely to remain very low for the foreseeable future. Swiss real estate funds posted losses of 1.82% in the third quarter of 2018, while foreign real estate investments were down 0.78% (–2.40% in franc terms).
In the first quarter of 2018, the euro was the winner and the dollar the loser among the major currencies. This development saw a sharp turnaround in the second quarter, with the dollar gaining considerable ground against the franc and the euro. The difference in interest rate movements between the US and the rest of the world also strengthened the dollar against most currencies in the third quarter. It rose by 0.65% against the euro, but weakened slightly against the Swiss franc between July and September. The euro also fell against the Swiss franc, closing the quarter at –1.47%.