«Uncertainty lies at the heart of contradiction.»
(Katharina Eisenlöffel, Austrian aphorist)
One thing is for certain: 2016 was a year of uncertainty. The Research Institute for the Public Sphere and Society (fög) at the University of Zurich has drawn up a list of dominant media topics for 2016, and topping it are the US presidential elections and its main protagonist Donald Trump. The categories covered in this list are: conflicts, attacks, elections, the European Union, scandals and the economy. Even if the migrant crisis in Europe, the terror attacks in Brussels, Nice and Berlin, the war in Syria and the attempted coup in Turkey are filtered out, there are still plenty of other trouble spots affecting global political and economic developments. What’s more surprising is that neither Brexit nor the US elections, let alone the Italian constitutional referendum, plunged the financial markets into chaos.
There is also growing uncertainty about the effectiveness of the European Central Bank’s (ECB) ultra-expansionary measures. Mario Draghi continues to show his faith in the model and maintain to market players that his monetary policy is working. His critics, by contrast, explain the weak growth in consumption and investment and the failure to reach the inflation target as follows: in this low interest rate environment, households are saving more in order to reach their savings target; companies are plugging the gaps in their pension funds and therefore reducing investment. Economic agents are not acting as the technocrats expect them to.
Nevertheless, there were no major dislocations in the financial markets last year and most investment categories generated positive returns. Somewhat surprisingly, Swiss equities ended the year in negative territory, though the defensive qualities of large caps Nestlé, Novartis and Roche came into their own in the uncertain climate. There is evidently a contradiction between the uncertainties presented in the media and the state of the stock markets.
«Uncertainty generally reflects a lack of knowledge.»
(Willy Meurer, German-Canadian businessman and commentator)
Uncertainty can be measured. More than three years ago, American economists Scott R. Baker, Nicholas Bloom and Steven J. Davis produced the «Index of Economic Policy Uncertainty (EPU)» as a tool for measuring, among other things, the frequency with which the topics of economics, politics and taxes appear in newspaper reports. The more frequently and controversially the topic is reported on, the higher the uncertainty indicated by the index. At the end of 2016, the EPU index closed at the highest level ever recorded since the start of data collection in 1985.
This is unsettling, and scenarios are already emerging that do not bode well for the financial markets. For example, dislocations are expected in the lending markets. If it was not for the old stock market dictum from Carl Meyer von Rothschild – «Buy when the cannons are thundering, sell when the violins are playing.» – we would currently be positioned more defensively. What has this proverb got to do with uncertainty as measured by the EPU Index?
|Asset class||Index||Return |
as of 31.12.2016
as of 31.12.2016
|Equities World||MSCI World Net USD||1,86%||7,51%|
|Equities Switzerland||Swiss Performance Index||0,93%||-1,41%|
|Bonds World||JPM GBI Global Traded TR USD||-8,30%||1,56%|
|Bonds Switzerland||Swiss Bond Index AAA-BBB TR||-2,34%||1,32%|
|Commodities||Thomson Reuters/Jefferies CRB TR USD||3,44%||9,57%|
|Real Estate Switzerland||SXI Real Estate® TR CHF||-0,50%||6,85%|
|Exchange rate EUR/CHF||-1,87%||-1,51%|
|Exchange rate USD/CHF||4,86%||1,68%|
The latent uncertainty of the past 12 months also affected our two prospective risk indicators, and we therefore adjusted the target portfolio to the prevailing stock market conditions more frequently than in previous years. We are currently keeping the real asset allocation (equities, real estate, commodities) close to the strategic weighting (benchmark). The likelihood of price corrections in the particular indices should not be underestimated given the high fundamental stock valuations and the US Federal Reserve’s imminent departure from its easy interest rate policy.
Both the current uncertainty and the following factors are likely to drive equity prices higher in the short to medium term. We anticipate problems in the second half of the year, however:
- After lowering the allocation to equities for five successive quarters, Swiss banks are now developing an appetite for them again. In the fourth quarter of 2016, they increased the recommended equity weighting for mixed mandates by over 3% to 47%. Buoyed by good stock market conditions, it is likely to reach a new record level in the next survey in spring. The potential of most stock market indices would, however, be exhausted: it can be calculated that an equity ratio of 49%, for example, would be followed by a negative index performance of more than –10% over the next 12 months.
- According to data from the Swiss National Bank (SNB), investors’ actual allocation to equities is below that recommended by Swiss banks. At 42%, the current allocation is well below the record set in the summer of 2000, when investors invested half of their portfolio in equities. If the allocation continues to rise it should reach almost 45% by summer – the level it was at just before the start of the 2007/08 financial crisis. An equity weighting of 45% is most likely to result in a negative equity index return of –4% over the 12 months that follow.
Risk concentration as a measure of the susceptibility of market indices is not only essential for calculating our own risk indicators. We are also observing the current concentration in the United States because the two sectors with the largest weightings in the closely followed S&P 500 (currently these are information technology and financials) are strong predictors of the future development of the index. Their combined weighting of 38% is the highest in 13 years. Our calculations show that if it were to go over 40%, the expected annual return would be well into negative territory.
Global financial markets – review
(See previous table)
Frontier markets are enticing investors with above-average returns and risks – and these roughly 20 stock exchanges on the geographical and economic periphery headed up the earnings table in 2016. Top performer Kazakhstan was up 62% on the year – nota bene when calculated in US dollars – thanks to the recovery of the oil price. Brazil (+57%) and Russia (+52%) as traditional emerging markets also performed brilliantly. In Moscow, the consequences of the sanctions imposed on it by the West were ignored, and it was speculated that the recession that has gone on for two years would come to an end. By contrast, three out of the bottom 10 performers in the table were from Europe. In Italy (–14%), Portugal (–17%) and Denmark (–17%), special factors hit individual sectors (banks) and highly weighted individual stocks (Novo Nordisk).
Top-quality bonds suffered higher quarterly losses than they had seen in a long time. JP Morgan’s global market index plummeted 8% in the final quarter of 2016. What’s more surprising is that it still produced a return of just under 2% for the year as a whole. Swiss franc-denominated investment grade bonds (those with a rating of between BBB and AAA) performed less well. They lost 2% in the fourth quarter, taking the annual return down to 1%. There were no exceptions in the world’s bond markets when it came to the yield curve: it became steeper everywhere, which means that the yield differential between long-term bonds and corresponding bonds with a shorter maturity widened significantly. This development can be seen as a reflection of improved economic prospects.
The rise in commodity prices exceeded many experts’ expectations. Copper was trading at USD 5,500 a tonne at the end of the year, 15% above the estimates. Among the precious metals, platinum produced a return of just 4% for the year, while gold was up 9%, strongly outperforming the Swiss banks’ forecasts of 1%. Silver was the winner among the precious metals – thanks to its many industrial uses, silver prices gained 18%. Analysts were spot on with their forecasts for Brent oil: the price of USD 54 a barrel at the end of December was a hair’s breadth from their forecast of USD 53 a barrel.
Rising interest rates in the fourth quarter had little impact on real estate investments. Despite a consolidation between October and December of last year, fund investments in Switzerland yielded an annual return of 7%, relegating the «competition» from the Swiss bond and equity markets to the bottom of the league table. US real estate funds yielded an even higher return. Only the special situation in the UK (Brexit) caused real estate investors disappointment. The decrease in value in sterling terms of 9% would not have been too bad; investors operating in Swiss francs, however, faced a loss for the year of 22% on UK real estate.
The development of the two most important currencies had a neutral effect on the Swiss export industry. The US dollar appreciated by 2% against the Swiss franc thanks to a strong final quarter, while the euro depreciated by 2% for the year and this occurred entirely in the fourth quarter. The strong depreciation of the British pound of 14% last year has been readily ascribed to Brexit, but in truth it had already lost half its value during the first quarter – in other words, before the referendum in June. The dislocation was greatest in the emerging market currencies. The Venezuelan bolivar and the Egyptian pound lost around 30% and 50% of their value, respectively; the Russian ruble and the Brazilian real, by contrast, ended the year with a gain of over 20%. The Icelandic krona was the top performing currency among the industrial nations. The gradual lifting of restrictions that had been put in place after the financial crisis helped Iceland’s currency to appreciate by 13% against the Swiss franc.