Your questions, our answers
There were rich pickings to be had in capital markets last year, especially in equity markets. However, the investment world looks quite different in 2022, with high inflation, a weakening outlook in the US, and fears of recession in Europe. What is the view of the experts at ETHENEA on the direction the economy is going? How is the Ethna-DYNAMISCH, an equity-focussed multi-asset fund, being managed against this backdrop? In the bond-focussed Ethna-DEFENSIV, much greater emphasis is being placed on hedging the duration of German Bunds than US Treasuries at a time of rising interest rates – why and what next? What is the Ethna-AKTIV’s strategy in the face of the current headwind? And what is the argument in favour of holding US securities in the portfolio at the moment? These are the questions our portfolio managers will be addressing in this year’s second issue of Clear and Simple.
High inflation, a weakening economic outlook in the US, and fears of recession in Europe. Other economic regions are also facing major challenges. In your opinion, is a soft landing still possible for the US economy? Can a recession in Europe still be avoided?
As we exited the global pandemic and central banks started to normalise their policies, the global economy was hit by two significant exogenous shocks. The war in Ukraine and the Covid outbreak in China are two major negative supply and demand shocks that have increased stagflationary risks and are seriously challenging policymakers. The situation is very uncertain and growth prospects are divergent across regions. Central banks around the world are on a tightening path and they are serious about containing inflation and keeping a lid on inflationary expectations.
The economic situation in the US is healthy despite some weakening of momentum in the first quarter of this year. The labour market is very strong, salaries are rising, and consumer and business demand is expanding at a solid pace. The economy seems well placed to support the Fed’s aggressive tightening path, but downside risks have increased, including risks of policy missteps that could push the economy into recession.
The situation in Europe is more complicated. Europe is greatly affected by the crisis in Ukraine because of its proximity to the conflict, its strong business links and its dependence on Russian energy. Recession risks in Europe are real and the probability of a recession will depend on the duration of the conflict, its effects on energy prices and on business and consumer confidence. The labour market will also be key to determining whether consumers will be able to continue supporting aggregate demand.
A soft landing for the global economy is still possible but is becoming less likely. An end to the conflict in Ukraine and a global resolution of the Covid-19 crisis remain key to resolving supply chain issues, taming inflationary pressures and supporting the global recovery. Achieving a soft landing will also require the appropriate economic policy mix, involving the gradual normalisation of monetary policies as well as supportive and well-targeted fiscal policies providing central banks with the necessary scope to withdraw accommodation without causing a recession. The risk of policy mistakes in this environment has increased considerably. While a double-dip recession is not our baseline scenario, a soft landing may be starting to look like wishful thinking.
2022 has so far been a difficult year for equity markets. Even though valuations have already come way down, the commentary from financial and economic analysts seems to be getting bleaker. How is the Ethna-DYNAMISCH being managed in this market environment?
Stressors for equity markets have indeed come to a head in recent months. Many come down to one common factor: high inflation.
This is compelling central banks to tighten their monetary policy. On the one hand, rising interest rates reduce the current value of future returns - which has a negative impact on equity valuations. On the other, equities become less attractive in relative terms when nominal yields on fixed incomes rise.
Also, in real economy terms, companies’ profitability prospects decline as inflation increases. Higher production costs reduce profit margins and consumers rein in their spending because inflation is eating into their real wealth.
These factors have been impacting the equity market of late. The situation may even worsen, depending on what happens with inflation - especially since the current valuation level cannot be described as attractive despite an already steep fall in prices. The price-to-earnings ratio (P/E), a classic heuristic valuation metric, suggests that the current price level – of the S&P 500, for example – is around its average figure for the past five years. However, this does not take into account the fact that companies’ profit margins were at record highs of late - which will not be sustainable given the high inflation. Cyclically adjusted metrics such as the popular Shiller P/E ratio, on the other hand, indicate that valuations are still relatively high.
Given the constellation of numerous medium-term stressors as well as lower - though not cheap - valuations, the positioning of the Ethna-DYNAMISCH remains cautious. This caution can be seen in the low net equity allocation, for one thing. While it was below 30% throughout April, we recently raised it to almost 50% to 60% in an opportunistic and counter-cyclical move during a period of overselling in mid and late May. For another, our temporarily high cash position, which in recent months has ranged from almost 40% to 70% – including cash substitutes (short-dated AAA bonds) and synthetic cash (via equity hedging) – acts as a stabiliser in the current, difficult market environment for risk assets.
At the same time, we recognise that the recent equity market correction is also creating many opportunities at individual security level. We have already begun gradually to build up positions in quality companies and intend to step this up as soon as the overriding stress factors abate or are sufficiently priced into markets.
Much greater emphasis is being placed on hedging the duration of German Bunds than US Treasuries in the Ethna-DEFENSIV at the moment. What is the reason for this? Do you intend to continue doing this in future?
The Fed is on a path of monetary tightening and we believe that capital markets have already priced in most of the interest rate rise. For example, the yields on 2-year US Treasuries, which are generally a good indicator of where interest rates will go, are currently 2.65%. Interest rates have been in the region of 2.50% to 2.75% since April, which would imply between eight and ten rate hikes. The ECB is further behind the curve and is tightening monetary policy much less aggressively than its US counterpart. That said, we believe the ECB will have to follow suit in due course. Firstly, because the US dollar would strengthen further against the euro if the gap between US Treasuries and German Bunds were to widen. It would cost more to import goods and services, as well as cause added inflationary pressure. The Fed is the most important central bank in the world and other central banks will likewise have to raise rates sooner or later. Secondly, because inflation in the euro zone has recently reached the highest it has been in decades. It's true that most of the price rise is probably down to energy prices and shortages in supply chains, but there’s not much the ECB can do about that. However, the ECB can manage inflationary expectations indirectly through its forward guidance. Forward guidance - a communication from the ECB about the likely future course of interest rates - must be credible and substantively consistent with the central bank’s monetary policy measures, so that market participants and citizens trust that the ECB is taking its price stability mandate seriously. This has to be bolstered by the ECB taking decisive steps towards normalising monetary policy. These measures may only have limited impact in the short term but, even so, they will still have important psychological effects and will be able to moderate inflation once again in the medium term.
We are of the opinion that the rise in interest rates in the euro zone is not yet fully priced into German Bund yields. For that reason, we are sticking with our bias towards short-dated Bunds for the time being. As soon as we believe that the rise in yields has peaked and the risk/return ratio is deteriorating, we will reduce the position.
With rising energy prices, persistent inflation, restrictive central bank policy and the war in Ukraine, the current headwind is multifaceted and strong. What strategy are you pursuing with the Ethna-AKTIV against this backdrop? Can any performance at all be generated in this environment? In your opinion, when is the right time to increase the equity allocation again?
As a general rule, it has to be said that there will be never be one single moment which changes the positioning, at least ex ante. Rather, there will be a period in which a process of adjustment takes place, both in terms of thinking and realisation. What is required in any case is a shift in the risk-return ratio in our favour. Even though volatility greater than 30 is generally regarded as an unsuitable entry level, it will be hard to avoid taking on risk again at some stage at a relatively high level of volatility - that is, if we don’t want to miss out on a lot of the upside. We have identified three fundamental factors as potential factors in this shift. Firstly, an about-turn by the central banks; secondly, credible fiscal measures that render a recession scenario obsolete and, thirdly, an immoderate decline in value that prices in an economic downturn. In addition, it must be said that highly volatile periods such as these cause distortions that make stockpicking worthwhile in the long term. This means that although we currently hold a fully hedged portfolio, we expect to generate additional added value (selection alpha) through security selection.
As an active manager of a multi-asset fund, there are, of course, performance opportunities in other asset classes as well. The timing for products with credit risk is more or less based on the management of the equity allocation. We believe that better entry opportunities in this area will arise in the course of the year. Management of the duration and currency exposure has already made a lasting contribution to performance this year. We are working all the time on continuing this positive trend.
Recession is becoming increasingly likely - including in the US.Is the Ethna-AKTIV nevertheless holding onto its US stocks?
We believe there is no reason not to. In all likelihood, the economic cycle in the western world will unfold relatively uniformly – that is, with a lag of several months at most. The stability and, in many cases, leadership of the US equity market continue to justify our focus on this market, which incidentally is also much less influenced by anxiety over political survival or even the chaos of war. Individual security selection is one possible source of alpha, as I have said; for the Ethna-AKTIV, however, beta management (equity market risk) is a much greater generator of added value. So, it can make more sense to have a solid equity portfolio that is exposed to less basis risks and which can be managed flexibly using liquid futures. In our opinion, the S&P 500 constitutes an attractive investment pool for this.
Please contact us at any time if you have questions or suggestions.
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