Your questions, our answers
In our latest issue of Clear and Simple, our Portfolio Managers discuss the post-lockdown impact of the Covid-19 pandemic, how any escalation in tensions between the US and China would affect the already weakened economy, and the Fed and ECB quantitative easing measures. They then look at the Ethna-AKTIV’s positioning and where we see opportunities to generate performance, before explaining the fund’s foreign exchange strategy for the next few months. Finally, they discuss in which types of stocks/sectors the Ethna-DYNAMISCH sees the most opportunities.
With most of the world now emerging from the first phase of the Covid-19 pandemic (the initial spread of the virus and the resulting preventative measures, such as lockdowns), we are now moving to the second phase. In your opinion, what will be the two to three month post-lockdown economic impact on the major developed economies?
It is important to remember that – even without a global lockdown - these types of estimates are subject to uncertainty, due to the interdependencies between the numerous factors involved. Therefore, they can only be made with a caveat. That is why we consciously refrain from setting our expectations within too narrow a range. We assume that there is no alternative to the resumption of all global economic activities, and that this will happen more rapidly than was conceivable just a few weeks ago. However, we also caution against too much euphoria, as growth figures will not quickly return to pre-crisis levels. In our opinion, it is misguided to assume that after this type of shock we will see redundancies reversed, companies returning to their customary level of investment or consumers resuming shopping with confidence within a few months or even quarters. Instead, we believe this will be a more long-term process. The monetary and fiscal policy measures will not be able to overcome the solvency problems of a large number of the impacted companies. Consequently, we expect to see a sharp rise in corporate insolvencies over the next few months, as well as a consumer whose saving rather than consumption rate is increasing. As a result, our Ethna Funds are positioned to allow us to take advantage of the opportunities that arise, while always keeping an eye on the risks.
Do you believe that we are likely to see an escalation in the current tensions between the US and China? How would this affect the, already weakened, global economy?
We still stand by our assertion that this conflict will remain with us over the next few years. There will always be phases of escalation between the two economic superpowers – such as the one we are currently experiencing. Given the upcoming US election campaign, we are likely to see more tension than less. For both US political camps, the People's Republic of China is a convenient bogeyman, a good way of distracting attention from domestic political problems or challenging agendas. While the gradual deglobalisation that this entails is already taking on concrete forms, any further escalation of the conflict will lead to more volatility in the markets in the short term and be detrimental to global growth in the long term. In our view, the European Economic Area will continue to be the clear loser, as it is virtually caught between the two fronts. In terms of the regional asset allocation of the Ethna Funds, this means that we will continue to give US assets a higher weighting in the future.
The Fed and the ECB have both strengthened their quantitative easing (QE) measures significantly. What impact is this having on bond markets? How would you assess the current risk/return ratio for bonds?
To cushion the effect of the coronavirus (and the governmental measures to contain it) on the global economy, central banks - in particular the ECB and the Federal Reserve – have been progressively implementing a range of countermeasures. Through its established asset purchase programmes, such as the Corporate Sector Purchase Programme (CSPP), the ECB is currently buying bonds at a rate of EUR 40 billion per month. At the end of March, it set up a new facility, the Pandemic Emergency Purchase Programme (PEPP), with which it is buying additional bonds to the tune of EUR 100 billion per month. These combined monthly purchases include around EUR 20 billion in corporate bonds and EUR 100 billion in public sector bonds (sovereigns and agencies). The Fed, on the other hand, has focused its efforts on US Treasury debt and has bought more than USD 1.5 trillion of these bonds since mid-March. This is a significant amount, given that the outstanding federal debt is currently sitting at around USD 18 trillion¹. The Fed has also set up two new facilities - the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). With a combined volume of USD 750 billion, these programmes are designed to buy corporate debt on the primary and secondary markets, with the latter buying corporate bonds indirectly through ETFs since May 12th.
The goal of both the ECB and Fed purchase programmes is to keep funding costs for governments and corporates at a significantly low level and, as such, both have been successful. The cuts in the Fed Funds Rate by the US central bank, coupled with its bond purchases, have already led to record low yields for US Treasuries, with yields on 10-year Treasuries at around 0.5%. As a result, refinancing the huge US fiscal deficit has become less expensive. Better rated corporates (those in the A area or higher) that are denominated in EUR or USD have quickly been able to refinance at (near) record low yields. However, for the majority of the weaker corporates (those with a BBB rating or lower), in particular those strongly exposed to the Covid-19 related lockdowns, refinancing is still more expensive than at the beginning of the year. Yet we are optimistic that further central bank buying and additional signs of the lockdowns being eased will also reduce refinancing costs for them. Those corporates that were able to issue have used the last two months to fund significant amounts on the capital markets in order to further increase their liquidity, repay bank lines of credit, and redeem short-dated commercial paper.
We are still of the opinion that the corporate bond universe offers investment opportunities for a large range of investors. The risk premia of these bonds compared to sovereign bonds (US Treasuries and German Bundesanleihen) have also increased since the Covid-19 virus became a pandemic. Therefore, corporate bonds now offer a higher excess return. For the remainder of the year, we expect corporate bonds to show a positive performance, through collecting coupons, rolling down the yield curve effects and spread tightening. At the same time, they offer limited risk, as the continued central bank buying offers strong support. Therefore, in our view, corporate bonds offer a compelling risk/reward ratio, which is why they will continue to be at the core of the Ethna-DEFENSIV portfolio in the coming months and will allow us to generate performance from both interest payments and capital gains. In general, we prefer to invest in corporate bonds with high liquidity. For us, a slight pick-up in yield does not justify moving a less liquid investment as, if we need to divest ourselves of the bond, we would have to accept a discount if it has less liquidity. However, the current central bank purchases have significantly increased the volume of corporate bonds that we regard as liquid.
Thanks to its defensive positioning, the Ethna-AKTIV has achieved a very stable performance with low volatility. What would trigger a change in this strategy? In the coming months, where do you see the most opportunities to generate performance?
It is not quite correct to talk about a change in strategy. The fundamental philosophy of the Ethna-AKTIV, our balanced multi-asset fund with a special focus on capital preservation and attractive risk-adjusted returns, has not changed even during this crisis.
The Ethna-AKTIV currently has a more defensive positioning and we are not currently considering the question of switching to a more offensive portfolio construction. After all, a more defensive portfolio - such as the current one - does not necessarily mean that we are not taking advantage of opportunities. In the current situation, it simply means that we are not necessarily looking for opportunities in the most offensive asset class, equities. Our active and flexible management approach enables us to allocate the fund's resources to the asset classes that we consider the most attractive in terms of risk/return ratio. In view of the fact that the current crisis has not yet passed and we are currently experiencing a recession, we believe that the risk/return ratio is currently most attractive for corporate bonds, foreign currencies and gold. We believe that the rapid recovery in equity prices over the last few weeks is fragile and unsustainable and we expect more attractive entry levels to be available in the coming months. Consequently, the Ethna-AKTIV currently only has a below-average equity ratio of approximately 20%.
In terms of foreign exchange (FX), what is the Ethna-AKTIV’s strategy for the next few months? What is your view on the USD?
So far, our foreign currency positions in US dollars and Swiss francs have made a positive contribution to annual performance. The continued strength of both currencies, despite massive interventions by the Swiss National Bank and the ultra-accommodative monetary policy of the US Federal Reserve, reinforces our view that exchange rates will continue to rise. Of course, both currencies are also benefitting from a degree of weakness in the euro, which is a reaction to relatively lower growth forecasts and, to an even greater extent, the absence of a functioning fiscal union. In our view, the EU economic stimulus package proposed in the last week of May is a step in the right direction. However, not only is it unclear whether this will win the necessary approval, it also does not correct the constructional flaws inherent in the monetary union over the long term. In the short term, this may mean some headwind for our FX positions in the Ethna-AKTIV, which is why we scaled them back in the run-up to the EU proposal. In the long term, we continue to expect both a strong Swiss franc and a strengthening US dollar, the scarcity of which has not yet been significantly reduced by the measures of the central bank.
In light of the global pandemic, are there currently specific types of stocks in which you are most interested or are there any sectors in which you prefer not to invest right now? Looking at the next six months, in which sectors do you see the most opportunities? Which, if any, market segments do you believe are likely to benefit from the pandemic?
As at any other time, in the current environment you have to look at both sides of the coin when investing in equities. On one side, there is the business and balance sheet quality, as well as future growth opportunities. On the other is the valuation - what do I have to pay for a particular company or sector?
Given the considerable economic uncertainties stemming from the fight against the pandemic, the exclusion principle is most helpful as a first step. Companies that were already suffering from balance sheet problems or structural headwinds before the crisis are now facing a much harder time. In the Ethna-DYNAMISCH, we avoid these types of stocks. In terms of individual industrial sectors, almost all of the current problems are concentrated in the banking sector. Here, too, we remain extremely cautious. In the current special circumstances, valuation is not only difficult but will remain of secondary importance to us.
Conversely, the operational profit side of the crisis is larger than it appears at first glance. Digitisation has received a huge boost in all areas of business and social life. E-commerce and digital payment service providers are also booming, which also benefits related industries. Other sectors that are already attractive from a business point of view, such as the health sector, could experience much more than just an image boost as a side effect of Covid-19. However, among all the obvious winners of the crisis, we now have to pay very close attention to higher valuations, which should significantly limit the upside potential, especially over the next few months. Moreover, investors are positioned very one-sidedly in this regard, which poses additional risks for them in the short term. Therefore, over the past few weeks, we have tactically reduced the corresponding positions in the Ethna-DYNAMISCH, even though it is precisely here that we will continue to find the most attractive business models over the longer term.
At this point, it is worth mentioning companies that can neither be described as direct winners nor losers of the pandemic. These include telecommunications companies, utilities and non-cyclical consumer goods producers. In stress situations on the capital market, the shares of such companies have recently proved their defensive characteristics. Looking forward, however, we do not expect to see much upside potential, especially for utilities and telecommunication companies. However, in the Ethna-DYNAMISCH we are still invested in selected market leaders in the consumer sector.
Last but not least, the golden mean is still where we are likely to see the best opportunities over the next few months. "Finding the best among the losers", as a colleague recently aptly put it. Examples include strong market leaders in struggling sectors, such as tourism or retail. These will have to contend with difficult circumstances for the time being. But in the end, they should emerge from the crisis stronger, which sooner or later will be reflected in share prices. With these stocks, we can currently set attractive accents in the equity portfolio.
Please contact us at any time if you have questions or suggestions.
ETHENEA Independent Investors S.A.
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