Your questions, our answers
In our latest issue of Clear and Simple, our Portfolio Managers discuss whether the Fed is likely to maintain its dovish stance – even if inflation continues to rise – and how this might affect markets. They also look at what impact the proposed global tax reform would have on equity markets and explain what any future tapering of the Fed’s asset purchase programme would mean for the fixed income market. Finally, they discuss whether Asian equities would be interesting for the Ethna-AKTIV and what level of equity exposure they envisage for the fund in the third quarter of 2021.
Do you expect the Fed to maintain its dovish stance and support the economy in 2021 and 2022, even if inflation continues to rise? Or do you consider it more likely that it will increase interest rates? Should the latter be the case, in your view, how pronounced would the market impact be? Would a similar case apply to Europe and the ECB?
Last year, the Fed changed its monetary policy framework and moved to Average Inflation Targeting (AIT). This means that the Fed is prepared to let inflation temporarily exceed its 2% target in order to compensate for previous periods where there was inflation undershooting. After having missed its inflation target for a prolonged period, the Fed is not dissatisfied with the current increase in inflation expectations, as this helps anchor medium-term inflation expectations at a higher level. Under this policy, the Fed will not act pre-emptively to constrain inflation and its decision making will be data-dependent – focusing on economic data and without a predetermined path for policy tightening.
As the majority of the members of the Federal Open Market Committee (FOMC) have repeatedly pointed out, the Fed considers the current inflationary spike a transitory phenomenon, fostered by the unprecedented policy response to the Covid-19 pandemic, the jump in commodity prices, pandemic induced supply-chain disruptions and a particularly important year-on-year base effect. Once the global economy regains its pre-pandemic level of activity, economic growth is likely to return to its natural trajectory and inflation should revert to its pre-pandemic path. The Fed does not expect any change in long-term inflation dynamics. Structural forces that have been prominent during the past decade, such as demographics, globalisation, and technological progress, will maintain a disinflationary pressure over the medium term.
Chairman Powell has frequently underscored that any policy change will be communicated well in advance, and we currently do not expect any interest rate hike until 2023. However, the normalisation process is likely to start earlier than this, with a reduction of the Fed’s monthly asset purchases (so-called tapering). However, even in this case the Fed will provide early guidance to the markets. At this stage, were we to see a premature tightening of US monetary policy, this would surprise the markets and would likely create a severe market correction.
In terms of the eurozone, recovery is lagging behind that of the US economy. The vaccination process is gathering speed and the EU recovery funds are likely to be disbursed later this year. The eurozone economies are progressively reopening and the ECB has clearly pledged to continue supporting the recovery via its expansionary policy. Inflationary pressures in the eurozone are muted and we don’t expect any premature tightening of the ECB’s monetary policy.
During the recent G7 meetings there were discussions about a possible global tax deal that would force digital giants to pay a higher share of taxes, with a potential agreement anticipated around October. Do you view this, on top of President Biden’s plan to increase corporate taxes in the US, as a threat to either US or global equity markets?
In early June, the G7 Finance Ministers agreed on the need for a global tax reform with two main pillars. The first pillar provides for the "largest and most profitable multinational companies" to be taxed where they generate their revenues. This reallocation applies to 20% of profits exceeding a 10% margin. The second pillar involves the introduction of a global minimum tax of 15%.
This reform goes against the trend of declining effective tax rates, which had been strengthening for years in a downward spiral – numerous countries have lowered their taxes as a competitive reaction to tax havens. This means that, on the one hand, the reform addresses the question of tax justice. On the other hand, the timing of the G7 agreement is also a reaction to rising government deficits in the wake of the Covid-19 pandemic.
It is not yet possible to quantify the precise impact of the reform on corporate profits - and, by extension, on the stock markets - because of the lack of precision and the absence of a global consensus. However, it is conceivable that the reform will have different impacts depending on the sector. There are two opposing camps. On the one side are the sectors that are already highly taxed, such as energy or automotive, whose capital-intensive businesses prevent the shift of profits. These will tend not to experience any additional tax burden. On the other side are those sectors whose characteristics, such as a focus on digital business models and intellectual property, have favoured the implementation of systematic tax avoidance in the past. This applies in particular to the pharmaceutical and technology sectors. But here, too, the tax reform - due to the low proportional reallocation (pillar 1) and the relatively low minimum tax (pillar 2) - will only have a moderate impact on corporate profits and equity valuations. On a broad scale, the global reform will therefore not be structurally market-moving.
This view also applies to the plans to increase the US corporate tax rate from 21% to 28%. This could have a low single-digit percentage impact on the US equity market, based on model valuation methods. However, we can assume that this planned US tax increase has already been priced into the market to a certain extent, as it was announced at the end of March.
Even if the tax reforms only marginally influence the overall market in each case, it is nevertheless important, firstly, to recognise them in the comprehensive evaluation of the equity market as potential uncertainty and stress factors, and secondly, to examine their concrete influence at the single stock level, and therefore also implicitly at the sector and country allocation level. Both of these factors are taken into account in the top-down and bottom-up analyses of our funds.
Federal Reserve officials have signalled that they are ready to start thinking about a time when they might need to scale back their asset purchase programme, which is currently at about USD 120 billion per month. Do you consider this a threat and/or could it lead to a liquidity crash on the fixed-income market? How would you position the Ethna-DEFENSIV’s bond portfolio to manage this type of scenario?
The majority of the Federal Open Market Committee (FOMC) members, including the Chairman Jerome Powell, are still of the opinion that it is too early to start discussing the timing of any potential tapering of bond purchases. Their argument is that the progress made towards the dual targets of full employment and inflation at 2% has not been sufficient. As the latest employment reports, in particular, were disappointing, the US is not likely to achieve the associated target as soon as hoped. Conversely, inflation figures delivered a surprise to the upside, however, within the FOMC, the majority view is that this relates primarily to base effects, temporary bottlenecks, and pent-up demand following the reopening of the economy and, as a result, will be transitory in nature. However, other Federal Reserve members argue that the recent spike in inflation figures at least warrants a discussion on how and when to reduce the pace of bond purchases. Given both the steady recovery of the US economy and higher inflation rates, it is only a question of time before the Federal Reserve starts to reduce its asset purchases, even if this takes place later than anticipated.
The markets will be prepared for this type of move, as discussions among investors have been taking place for at least three months. We also are certain than the central bank has learned from the past and will not allow a second "taper tantrum" to take place. Therefore, any announcement regarding scaling back bond purchases will certainly not lead to a liquidity crash. The Fed will remain the dominant participant in the US Treasury market. As they already own USD 6 trillion of the total USD 28 trillion of marketable US sovereign debt, this allows them to steer the market in their favour. We expect the Fed to reinvest those sums from maturing securities for a longer period of time. The strong US economic recovery, the prospect of further fiscal stimulus, and the current overshooting of inflation would justify a further rise in long-term yields in the US. These arguments are more than offset by the intervention of the central banks, the fact that the increased yields are already attractive for foreign investors and US pension funds in particular, and the flood of liquidity within US money markets. The latter is resulting in short-term financing rates in the US to move into negative territory.
Currently, the Ethna-DEFENSIV’s bond portfolio has a moderate duration of slightly above 5. This not only reflects the expectation of stable to slightly decreasing yields in the near future, but also our commitment towards capital preservation. However, we believe that it is inevitable that long-term yields will rise towards the end-of-the year. Such a move will not occur in a straight line but in waves, which calls for active (duration) management. The current wave points towards lower yields, at least in the coming weeks, but the next upward move should start from lower yield levels than the current ones. When the time comes, we are ready to reduce duration once more to benefit from rising yields.
Given that solid growth is expected in China and some other Asian countries, and the related equity market have been lagging YTD, have you considered increasing the exposure to Asian equities in the Ethna-AKTIV?
It is important to note that we evaluate all markets in terms of their risk/return profiles when making investment decisions. For example, we consider the Japanese stock market to be a good value proxy and were also invested there for a time as part of the implementation of the reflation trade. However, because Japan has been a laggard for a long time in terms of vaccination progress and there is still a degree of uncertainty due to the Olympic Games taking place in the summer, we preferred the alternatives in Europe in recent weeks. This is one of the reasons why we have a position in the Swiss equity index in the portfolio. However, given the steadily improving situation in Japan, we are more optimistic now, which is why we are currently gradually increasing our exposure to Japan once more and reducing our index investments in the US. In this way, the fund is more broadly positioned for the summer.
China was a pioneer in the fight against the pandemic and was the only major economy not to experience negative growth in 2020. Accordingly, Chinese stocks also performed well last year. At the moment, however, there are a number of reasons why we are slightly sceptical about future stock prices in China. The credit momentum in China is declining, the influence of the state (particularly with regard to the regulation of technology companies) is not entirely predictable, and we also believe that an easing of tensions with the US is currently priced in too strongly.
For these reasons, we are currently only planning equity investments in Japan for the Ethna-AKTIV, not in China.
In light of recent market developments, what level of equity exposure do you envisage for the Ethna-AKTIV in Q3? Do you intend to maintain your current high exposure or reduce it?
In determining the range for exposure management, many factors with differing impacts come into play. However, the points highlighted in the previous answer regarding regional and, where relevant, sectoral allocation usually only represent the second level in the decision-making process. Before that, it is necessary to determine in how many stocks one can and should invest in the first place.
While the question of "can" (in the sense of "can afford") is mainly determined by the expected volatility in relation to the current drawdown, the question of "should" takes into account factors from the areas of macroeconomic environment, valuation, sentiment, seasonality, as well as trend, with varying importance. Currently, neither equity volatility nor the annual performance of the Ethna-AKTIV are arguments against an equity exposure, which is why we can focus entirely on an analysis of attractiveness.
As the positive factors (relative valuation, supportive monetary and fiscal policy, and an intact trend) currently prevail in our analysis, despite the high absolute valuation and the already very positive sentiment, we are maintaining an above-average equity allocation for the Ethna-AKTIV for the third quarter.
Please contact us at any time if you have questions or suggestions.
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