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Your questions, our answers

Currently, the tragic situation in Ukraine is a focal point for the entire world. Therefore, in our first issue of Clear and Simple for this year, our Portfolio Managers discuss the impact this geopolitical conflict has had on our base scenario. Has this, in conjunction with high inflation rates, resulted in implications for monetary policy – and how will the Ethna-DEFENSIV react to this? In addition, they look at whether there are opportunities for investing in distressed assets, particularly for the Ethna-AKTIV. Finally, they look at what a stagflation cycle could mean for the investment universe of the Ethna-DYNAMISCH.

Has your base scenario changed in light of the Russian invasion of Ukraine? If so, could you explain how?

We have seen a dramatic deterioration in the economic scenario for 2022 as a result of the Russian invasion of Ukraine. At the start of the year, our base scenario for 2022 assumed above-trend global growth of 4.4%, supported by the reopening of economies around the world. It was expected that inflationary pressures would be resilient, but would progressively fade as supply issues were resolved and central banks started to tighten their policies. However, this rather benign scenario was tempered by the risk that inflation would remain high for longer and that economic growth would soften due to the combination of inflation and tighter policies.

The war in Ukraine has dampened this scenario considerably. Coupled with the sanctions subsequently imposed by the US and Europe, it has caused energy and commodity prices to spike dramatically. The war represents a major negative supply and demand shock for the global economy – one that will damage supply chains, exacerbate price pressures, and curb growth by undermining confidence and hampering international trade. This type of stagflationary shock brings with it a significant increase in downside risks, as well as increased uncertainty. Global growth has also been revised downward and inflation is now expected to remain high for longer.

In January, some experts were talking about seven potential interest rate hikes from the Fed this year. Given the current situation regarding the war in Ukraine, what do you expect from the Fed and the ECB for 2022? How have you adjusted the portfolio of the Ethna-DEFENSIV after the latest events in Ukraine?

In our opinion, the situation in Ukraine will only have a limited impact on the US Federal Reserve’s monetary policy. Following the Fed meeting on 16 March 2022, Jerome Powell made it clear that fighting inflation has top priority. This means that several interest rate hikes are certain this year and that interest rate increases of more than 50 basis points are also possible in the future. The so-called dot plots, which are published once a quarter by the central bank and reflect the interest rate expectations of the individual Fed members, actually point to seven interest rate hikes on average. This would bring the Fed Funds Rate into the range 1.75% - 2% by the end of this year.

For much of 2021, we already prepared the bond portfolio of the Ethna-DEFENSIV for the normalisation of central bank interest rates and reduced the duration in the portfolio accordingly. This was done by swapping longer-dated bonds for shorter-dated ones and by taking short positions in bond futures. In retrospect, this proved to be the right thing to do and we were able to make gains on the interest rate derivatives position. In the wake of the Ukraine war, demand for secure sovereign bonds was temporarily high once more, which consequently led to a decline in yields. Here we reacted quickly and flexibly to the changed situation and extended the duration to 4 by closing all short Treasury futures in February 2022. However, when the issues of refinancing higher defence spending and a European energy supply independent of Russia took centre stage, we again gradually reduced the duration by once again taking short positions on interest rate derivatives.

Overall, we reacted very flexibly and were able to benefit from the high volatility in the bond market and the, at times, strong yield movements through flexible duration management. Since the beginning of the year, the Ethna-DEFENSIV has gained 1.25% through interest rate derivatives, of which around 0.15% is attributable to Bund futures and 1.10% to Treasury futures.

Do you believe that the current period of high volatility is a great opportunity to invest in distressed assets that could be significantly oversubscribed? If so which ones?

The Ethna-AKTIV is known for its high degree of flexibility, as well as for taking advantage of opportunistic investment opportunities. A distressed asset refers to an asset that is sold at a significant discount to its fair value for a variety of reasons. As a rule, the corresponding seller needs cash or liquidity and therefore becomes a price-insensitive “forced seller”. In theory, the decision to step in as a buyer now seems quite simple. In practice, the situation is somewhat more complex. One must be both able and willing to do so. For the former, in addition to having sufficient liquidity oneself, there must also be the capacity to take on additional risk. Position limits from risk or drawdown management restrict the options for action here. There are also several aspects to consider with regard to the willingness to buy these assets. In particular, the liquidity risk, or more accurately the illiquidity risk, must be taken into account even more strongly in the risk/return analysis for such investments, as it is already distorted by the obvious stress situation. Through active risk and position management, we avoid having to sell positions that we do not want to part with. Only this enables us to take a closer look at such alternatives. Once these conditions are met, we have the necessary flexibility to turn to these investment opportunities, even at short notice. However, where we are not willing to compromise - and cannot do so because of the fund’s profile - is the question of liquidity. Consequently, this approach shifts our focus away from “distressed” bonds towards highly mispriced equities. As a rule, the aforementioned forced sales of both asset classes take place in the same market phases.

Various macro-economists expect that we will soon enter a stagflation cycle. What does this mean for both companies and the stock markets, and how will the Ethna-DYNAMISCH deal with it?

Stagflation refers to the constellation of weakening economic growth combined with high inflation. While leading indicators recently signalled the peak of pandemic-related inflation, this hope has been dispelled for the time being by the Ukraine war and the associated commodity price increases. This has made a stagflation scenario more likely.

High inflation rates have an ambivalent effect on companies and their stock market valuations. On the one hand, inflation is reflected in the fundamentals, i.e. at the revenue and earnings level. The effect at the revenue level is positive if companies are able to pass on part of the price increase to their customers. The inflationary impact at the earnings level, on the other hand, depends on the extent of this transfer and on efficient cost control. Companies with the appropriate pricing and negotiating power can therefore offer real growth even in an inflationary environment. This characteristic makes equities relatively attractive compared to nominal asset classes, such as bonds.

On the other hand, the mandate of price stability is forcing central banks to counter inflation with increasingly tight monetary policies. This shift away from what was, until recently, a very expansionary monetary stance represents a headwind for the capital markets that should not be underestimated: firstly, through the withdrawal of liquidity, and secondly, through the negative impact of higher interest rates on the valuations of various asset classes. This applies in particular to the pricing of equities, as rising interest rates increase the discount factor for future earnings and consequently put pressure on valuations (for a more detailed discussion of the influence of central banks in the current environment, see our most recent Market Commentary) 

In the Ethna-DYNAMISCH, we are countering this market environment on the one hand - at the selection level - by focusing on companies with pricing power, business models that are less dependent on the economic cycle, and attractive valuations. On the other hand, at the allocation level, we have reduced the equity exposure over the last few months through various hedging instruments in order to mitigate the unavoidable volatility caused by the adjustment processes that have already begun and are still to be expected on the capital markets. Last but not least, the central banks’ compulsion to react to rampant inflation, in addition to declining economic growth, has recently increased the number of negative factors for the stock markets.

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