Fin de Siècle

Fin de siècle is French for “end of century” but is also a term used to refer to the years from the end of the 19th century until the outbreak of World War I. It’s also seen as a time of decadence and the end of the belle époque. There was a sense that the end of an era was nigh.

Just like today. The heatwave summer of 2018 came to an abrupt end with the sudden onset of winter, especially in France and Spain, where hundreds of cars got stuck in the snow. At political level, the Merkel era is drawing to a close: she will not seek re-election as leader of her party in December and she announced that she will not run in the next parliamentary elections. The scramble to succeed her has begun and it will be telling in terms of the future internal direction of the party.

But enough with the introduction already; what we really want to talk about is the capital markets. After an extremely bumpy October, leading to marked declines¹ on the global equity markets (see Figure 1), the seemingly never-ending upturn is showing some signs of faltering. Not that a recession is on the horizon, but there is a sense that it will come at some point. Between now and then we could face one or two challenges on the markets. Figure 2 shows the effect the falls in stock prices had on credit spreads. Often in the past, the credit markets have set the agenda for equities but this October the opposite was the case. Weak equities led to a sharp widening in high yield spreads. There has been much speculation about the cause of the equity downturn but, to my mind, no truly convincing arguments. Of course, one argument is political uncertainty in all its facets but there was nothing really new about any of it. The reporting season for the third quarter was satisfactory, too, with corporate profits, in most cases, surpassing what were high expectations as it was. A big question mark still remains, therefore, which perhaps will not be answered for some time yet.

Figure 1: Market capitalisation on the equity markets

Figure 2: S&P500 equity index and high-yield OAS

Figure 3: Investment grade spreads in EUR and USD

Figure 4: High-yield spreads in EUR and USD

Looking at the above, it is interesting to note the wide variation between the movement in spreads on corporate bonds denominated in euro and the spreads in U.S. dollars, especially in the high-yield segment (see Figure 4). No doubt this is due largely to the higher corporate profits – caused partly by Trump’s tax reforms – and thus the distinctly better performance of the U.S. equity markets than their European counterparts. However, this does not explain why investment grade spreads look very similar (see Figure 3). Presumably, the index components are very similar in euros and dollars because many IG issuers issue bonds in both currencies. In the high-yield segment, the U.S. market has a much greater energy sector weighting. Either way, there is still room for improvement in all of the four segments we have looked at here and this, as well as the ongoing liquidity shortage on the bond markets, is likely to spoil the fun in the coming months.

Figure 5: U.S. GDP

Figure 6: Eurozone GDP

While we may understand the global context, we should also look at the regional variations that are reflected in economic growth. To illustrate these variations more vividly, we have used identical scales in Figure 5 and Figure 6. Even though the first estimate of economic growth in the U.S. of 3.5% (QoQ ann.) was lower than in the previous quarter, not only is the eurozone lagging behind, it is actually weakening, with growth of only 0.8% (QoQ ann.). The aforementioned tax reforms under Trump have brought about a distinct surge in growth. Not only that, but the excessive bureaucracy in Europe and increasingly strict environmental legislation is, of course, dampening economic momentum in the eurozone countries. Moral judgement aside, this is an undeniable fact.

The trend in economic data overall is completely different for the U.S., as we can see from the surprise indicator for both economic areas (Figures 7 and 8). While expectations in relation to the U.S. were well beaten at the beginning of the year, the opposite tended to be the case in the eurozone. On this side of the Atlantic, the figures were much weaker than expected, and now the data is again falling short of estimates. In addition, political uncertainty was a negative factor, most recently in Italy. It’s no wonder that European equities were so much weaker than their U.S. counterparts. There are also big differences in the changes in market expectations for money market interest rates. Figure 9 charts not only the trend in 3-month rates in the U.S., but also the changes in expectations for this trend. Since the beginning of the year, market expectations for future rates have risen between 0.5% and 1%. In the eurozone, on the other hand, expectations tend to be unchanged (see Figure 10). In other words, central bank policy comes as no surprise and is on a very steady course while political events are failing to inject impetus.

On the contrary, the diesel emissions scandal, as well as the strict introduction of the new WLTC/WLTP standard for measuring fuel consumption on 1 September, are putting the brakes on the automotive industry. The sector is immensely important for the German economy, which has the largest share of eurozone GDP. Figure 11 charts new passenger car registrations in Germany. The year-on-year drop of more than 30% speaks volumes and does not bode well for economic development in Germany and, with that, in the eurozone as a whole between now and the end of the year.

Figure 7: U.S. economic surprise indicator

Figure 8: Eurozone economic surprise indicator

Figure 9: 3-month EuroDollar interest rate and the implied rates at the beginning of the year and at the end of October

Figure 10: 3-month Euribor interest rate and the implied rates at the beginning of the year and at the end of October

Figure 11: New car registrations in Germany

Figure 12: Currency hedging costs on a 12-month basis in EUR/USD

In summary, it can be said at this point that in Europe in particular economic growth has lost a significant amount of momentum. It is too early to tell whether this is a temporary phenomenon or, in central bank parlance, a transitory event. As things currently stand, the downturn is significant enough to cause concern that the ECB is much too far behind the curve and that the next European recession could be practically around the corner, while the key rate still stands at -0.4%. Where’s the room in that for positive stimulus?

In the U.S., however, things look comparatively rosy. Momentum is still intact and Donald Trump will – if he holds the majority in Congress in the midterm elections, which are imminent at the time of writing – continue his very pro-business policies. If he, as currently expected, loses his majority in the House, the Democrats are sure to block as many of his initiatives as possible. So, for now, all we can do is wait. The following questions remain, however: How much more stimulus can Trump’s government inject? Will it be enough to push out the next recession further and perhaps even beyond the horizon?

If things turn out as indicated, it will mean that the challenging times on the capital markets will continue indefinitely. For euro investors the cost of currency hedging, which is of course set largely by the interest rate differential, may continue to rise sharply and thus make hedged investments in USD assets prohibitively expensive (see Figure 12). Investors who are unwilling or unable to take the currency risks are all but confined to the eurozone, where investors are rewarded with negative real yields and poorer prospects on the equity markets.

Success in this environment still calls for expertise and a steady hand. Whether fin de siècle or end of an era, times have rarely been easy on the capital markets. That said, in this environment it is getting tougher and tougher.

¹ In total, valuations on all equity markets lost more than USD 8,000,000,000,000 in October. This is almost double Germany’s GDP in 2017.

Positioning of the Ethna Funds

Ethna-DEFENSIV

October will go down in the annals of the capital markets as one of the worst months of the past 100 years. A study conducted by one major German bank found that 89% of all the asset classes it looked at were detractors from performance. It was hard to avoid this correction. Sure enough, despite the Ethna-DEFENSIV’s high credit quality, the correction affected fund performance last month. The Ethna-DEFENSIV’s performance for the month was -0.52 %, which is solid in comparison with other investments.

• The use of rigorous hedging strategies with tight stop losses did limit our losses. Bond portfolio duration was adjusted to the market conditions and stood at 3.4 at the end of the month.
• Despite the low liquidity on bond markets, we managed to further improve portfolio quality. If an economic downturn really is in the offing, as described in the introductory commentary, the higher the credit quality, the better, so the portfolio is more robust. In any case, we believe we are still correct in maintaining a low-risk profile for now with a defensive mandate.

Ethna-AKTIV

Now that a few regional equity markets have been in a correction or even a bear market for quite some time, Wall Street, too, declined for a time in October. Led by technology stocks, the U.S. equity market recorded its biggest monthly loss in seven years. The trigger for this price movement is less geopolitical events and economic data, but rather the long-term U.S. interest rates. While the yield on 10-year U.S. Treasuries in August was 2.81%, during September it steadily headed towards the previous high for the year. Then, at the beginning of October, it finally well and truly broke this mark and recorded a new multi-year high of 3.26%, stoking fears that the decades-old bull market in interest rates had come to an end. This prospect hurt credit markets as well as equity markets. What’s more, the relatively clear message from the current reporting season in the U.S. is that it is no longer enough just to satisfy expectations. Even a slightly cautious outlook is enough to get punished by the market: just look at Caterpillar and Apple. Topics that dominated the headlines in previous months – Italy’s budget, peak earnings, the global trade war and the midterm elections in America – have faded into the background for the time being but, looking ahead, they will be back in the news again very soon.

• The turbulence on the equity markets in particular had a negative impact on the AKTIV portfolio. As prices fell, the equity allocation was reduced by as much as 20% relatively quickly and carefully through sales and options, but even so, this asset class accounts for most of the month’s negative result. Oil stocks, purchased in anticipation that the price of oil would rise, were one of the biggest relative losers. The equity portfolio’s basic regional split into exposure to the U.S. and exposure to China, predominantly in the form of liquid futures, remains in place.
• As can be expected in this environment, the USD position in particular, which had been increased to 9%, had a loss-limiting effect. Another portfolio management tactic was to increase duration incrementally from 3.6 to 4.9. However, the ensuing positive contribution to performance in the flight to safety environment, with interest rates falling again, was unable to make up for the losses due to significant increases in spreads. On the whole, however, the bond portfolio was only down slightly. The improvement in the quality of bonds made in the last few months bore fruit in this environment and proves that we took the right measures for this stage of the economic cycle.
• We take as a note of caution the fact that globally the growth dynamics are flagging and the key central banks are about to dial back their supportive monetary policy. However, the statistics for the fourth quarter of a midterm election year are unambiguous: 18 times out of 18, the S&P500’s lows in October were overturned by the end of the year. Although we are sceptical about such historical comparisons, we do see potential for a year-end rally.

Ethna-DYNAMISCH

In October, there was a veritable storm on the global equity markets. Almost all the key equity indices saw double-digit declines over the last month. Even in hindsight, it is hard for experts to say why the storm came right now. Based on our constant market analysis, we have noticed a challenging situation since the beginning of the second half of the year, in which positive and negative factors for the future course of the equity markets were more or less balanced. Therefore, it was conceivable that the market could go in either direction. In light of this, the Ethna-DYNAMISCH always held a significant exposure to equities but the risk capacity was far from fully utilised. Ultimately, while this positioning was a conscious choice, it was unrewarding because, if markets fell, losses could not be avoided entirely but, if markets rose, gains would have been relatively modest. In other words, ex-post, we wouldn’t have been able to generate an optimum result. Ex-ante, our actions were responsible and appropriate at the time and from today’s perspective, too. Our portfolio actions and outlook are outlined below:

• Given the situation described earlier on, our net equity exposure was around 50% at the beginning of the month – similar to our positioning in the summer months. This exposure includes the hedging components, such as futures and options. Once prices began to fall on the equity markets, the options in particular automatically carried more weight and influence. As panic mounted on the markets, we started to buy shares towards the middle of the month, and scaled back hedging. This turned out to be a little premature because another wave of selling gripped the equity markets in the second half of the month. We also took advantage of this to make careful successive purchases at the more attractive valuations. Since nothing about our overall perspective on the equity markets and about the generally constructive outlook has changed over the course of the month, we will continue this approach going forward.
• At single stock level, there was a marked increase in volatility in the entire equity market in October, which can be attributed to the ongoing quarterly reporting season. At the risk of sounding hackneyed, a stock-picker would consider the recent market correction a healthy development. There were marked declines in growth and quality equities with slightly higher valuations. As such, we managed to acquire a few high-quality new additions to the equity portfolio at attractive entry levels. These include the U.S. company Alphabet (parent company of Google), the Alibaba Group (largest IT group in China), which is also listed in the U.S., and General Mills (one of the largest food manufacturers in the world, known in Europe mainly for its ice cream brand Häagen-Dazs). With valuations generally lower, and now that the outlook for the end of the year and for 2019 is clearer following the recent reporting season, the equity markets should offer good support.
• We remain cautious in relation to bonds. During the equity market correction, credit spreads on corporate bonds also widened, so, once more, the high cash position we have held since early this year has paid off. At the same time, interest rates and yields have risen further, especially in the U.S. This enabled us to expand our position in long-dated U.S. Treasuries. These bonds offer very good protection in the event that the economy weakens faster and sooner than currently expected. If yields rise further, we intend to expand this portion of the portfolio and increase the weighting to above 10% once again.

In summary, one could say that the general market environment remains challenging. On the stock markets, there is still enough fodder for bulls and bears, which is likely to keep volatility high, too. That said, the risk/return ratio has greatly improved since the recent correction and the resulting fall in valuations. The Ethna-DYNAMISCH, offering risk-controlled access to the equity market, remains a suitable investment in this environment.

Figure 13: Portfolio ratings for Ethna-DEFENSIV

Figure 14: Portfolio composition of Ethna-DEFENSIV by currency

Figure 15: Portfolio structure* of Ethna-AKTIV

Figure 16: Portfolio composition of Ethna-AKTIV by currency

Figure 17: Portfolio structure* of Ethna-DYNAMISCH

Figure 18: Portfolio composition of Ethna-DYNAMISCH by currency

Figure 19: Portfolio composition of Ethna-DEFENSIV by country

Figure 20: Portfolio composition of Ethna-AKTIV by country

Figure 21: Portfolio composition of Ethna-DYNAMISCH by country

Figure 22: Portfolio composition of Ethna-DEFENSIV by issuer sector

 

Figure 23: Portfolio composition of Ethna-AKTIV by issuer sector

Figure 24: Portfolio composition of Ethna-DYNAMISCH by issuer sector

* “Cash” comprises term deposits, call money and current accounts/other accounts. “Equities net” comprises direct investments and exposure resulting from equity derivatives.