Investment Management Update (RRI) – July 2016

Review

«It is a maxim of the wise to leave things before things leave them.»
(Baltasar Gracián y Morales, 1601–1658, Spanish Jesuit, Philosopher and Author)

The world seems to be coming apart at the seams. Refugees are being forced to leave their homes in droves. American presidential candidates are straying from the path of reason, while central banks are leaving the world of positive interest rates behind. Even the Brits can’t be relied on. At least the early exit from the European Championship only caused anger and disappointment in the home of football.
Brexit, on the other hand, has the potential to spark a wildfire on both sides of the channel. As if this weren’t bad enough, the initiator Nigel Farage has abandoned ship and left others to clear up the mess. The question of whether, in this case, it really is wise to leave the known behind in search of the new is a valid one.
The financial markets provided an early answer in the final days of the previous quarter. The wave of volatility that immediately followed Britain’s surprising decision at the end of June to leave the EU caused havoc on the global markets.

The two biggest losers so far have been the UK currency and the British real-estate market. In the final week of the quarter alone, the pound was down 8% against the Swiss franc and the euro, and as much as 10% against the dollar. Real-estate funds were hit even harder, with more than 10% being wiped off their value in June and more losses expected in the coming months. Some fund companies were promptly forced to suspend dealing, as they were no longer able to handle the huge volume of investor redemptions. Government bonds with the highest credit rating have benefited the most from the renewed uncertainty, generating positive returns across the board.

Interest rates sank to record lows, and investors in Germany, Japan and Switzerland are even living with negative rates. In other words, they are paying interest for the right to hold safe government bonds for more than 10 years. In the month of the referendum, UK equities were up 6% despite the surprising Brexit result. In contrast, the markets of the European periphery countries suffered a big blow in June, with those in Athens (–16%), Milan (–7%) and Madrid (–6%) hit the hardest. But Brexit had no impact on the US stock markets, as the Dow Jones Index rose by 1%.

Outlook

«Facts mixed with opinions are a highly explosive cocktail.»
(Stefan Fleischer, *1938, former analyst at a major bank)

According to Citi Research, around a third – more than seven trillion dollars’ worth – of all government bonds issued by developed countries are being traded at negative yields. The international financial services provider Tradeweb estimates that more than half of all outstanding bonds in the eurozone are priced in this upside-down way. The Financial Times already reported back in May that 16% of global sovereign debt is negative-yielding, suggesting a volume of 10 trillion dollars.
Precise facts can be hard to come by, especially when it comes to the effects on the financial markets. Mixed with opinions, this is likely to create a truly explosive cocktail. We fear that this modern form of debt repayment – whereby the creditor is expected to finance the reduction of the debt itself with negative interest rates – will not be accepted in the long term. Investors are being forced into risky investments in order to achieve their investment targets.

In the past quarter, our risk indicators have been at a level that would justify a slight overweight position in real assets (equities, real estate, commodities). However, the prospects for future returns diminished just before the quarter end. It is now more likely that the market indices will become increasingly vulnerable to fluctuations in the coming months.
The two prospective risk indicators that determine our target portfolio are currently moving in the same direction: The more medium- to long-term-oriented SRI (Systemic Risk Index) has been rising continuously since May and has reached a level that suggests above-average market vulnerability and predicts systemic risks for real assets. The short- to medium-term-oriented TI (Turbulence Index) is moving in harmony with the SRI. It is signaling a high level of volatility as well as unusual behavior between asset classes, which does not bode well for the next one to three months. It is advisable to adopt a more conservative position for real assets at present, and presumably into the fall months.
Based on our predictions, there are few arguments in favor of holding an overweight position in equities at the moment. The much-cited reason, that there is no way to avoid equities in a negative interest environment, reminds us of paradigms that have resulted in disappointment in recent history. In 2000, there was a common misconception that the internet era could only produce winning equities. And in 2007, bundling together the mortgages of many lenders with poor credit ratings was thought to be a good investment option. However, another good reason for maintaining a defensive position in risky investments is the carelessness with which investors are throwing themselves into equities while forgetting that high share prices are very often associated with an impending index decline.

• At the end of June 2016, Switzerland’s banks recommended that more than 19% of equities in mixed portfolios should be Swiss. In the past 20 years, an equity weighting of 19% or more has only generated positive returns over the subsequent 12 months in one in five cases. In the other four cases, the portfolios suffered an average loss of 14%.
• More than 38% of all resources invested by Swiss fund providers are held in equity funds – a level that has only been reached seven times in the last 18 years. In all subsequent years, an average loss of 8% was suffered.
• According to statistics published by the Swiss National Bank, the equity weighting in the custodian accounts of Swiss banks stood at 43% on average over the past 12 months. In more than 70 cases, these high equity weightings resulted in an average equity index return of –11% over the 12 months that followed.

Global financial markets – review

(See previous table)

Equities

In the second quarter of 2016, the international stock markets saw very mixed results. Up until the halfway point of the year, US indices were able to build on the modest gains from the first quarter. The Dow Jones and the more broadly invested S&P 500 gained 1% and 2% respectively between April and the end of June. Swiss equities were up 4% in the second quarter, but were unable to offset the first quarter losses. The Nikkei in Japan plummeted 7%, as it had no solution to the strong yen, which despite negative interest rates experienced a resurgence. The Euro Stoxx 50, which is dominated by financial stocks, was hit hard after the Brexit vote in particular and finished the quarter down 5%. This means that both indices have now fallen for two consecutive quarters. Securities from the emerging markets continued to generate positive returns: With a dollar-denominated increase of 6%, the MSCI Emerging Markets Index has been firmly in positive territory since the start of the year.

Bonds

The turbulence in the final days of June had an unprecedented effect on the bond markets. Straight after the end of the second quarter, the current upturn resulted in all outstanding Swiss government bonds delivering negative returns. In other words: To ensure guaranteed repayment against Swiss government debt, investors are prepared to forgo any returns until 2064 and even pay an insurance premium. Accordingly, franc-denominated bonds increased by 2% in the second quarter, and the global bond index even saw a dollar-denominated return of 4%.

Commodities

The shock of the British referendum result caused the price of gold (+7%) and silver (+19%) to soar. It is thought that the Bank of England (BoE) and the European Central Bank (ECB) may relax their monetary policies even further in the wake of Brexit, which would reduce the opportunity cost for holding precious metals again. The oil price has remained stable for the past two months, but has seen a huge 36% rise over the quarter as a whole. The price of coffee increased by 16% in the first half of 2016. This helped the diverse CRB commodities index to perform better in the second quarter than the other investment categories mentioned here.

Real Estate

Real estate, which tends to be less vulnerable to fluctuations than equities, suffered the greatest post-Brexit upheaval. The opposing trends in the US and UK are plain to see: On the other side of the Atlantic, real-estate shares increased by 6% in the second quarter; in the UK, the 10% loss in June meant a 7% hit for the quarter as a whole. The real-estate funds on the SIX Swiss Exchange performed steadily, generating a return of 3%.

Currencies

Brexit also had a negative impact on the pound. In the second quarter, the UK currency was down 5% against the Swiss franc and the euro, and as much as 7% against the dollar. At the end of the quarter, the pound had reached its lowest level against the dollar since 1985. The euro was up against the franc until just before the quarter end, but the uncertainty surrounding Brexit dragged the European single currency into negative territory (–1%). The dollar and, above all, yen were able to benefit from the currency market turbulence, gaining 2% and 11% respectively against the franc.