Your questions, our answers
In our latest issue of Clear and Simple, our Portfolio Managers explore whether a recession in the U.S. is imminent and explain how this affects our view of different asset classes. They then discuss the positive returns from fixed income in the Ethna-AKTIV and the Ethna-DEFENSIV, before answering your questions on the downward trend in yields, our expectations for growth equities, and Brexit.
We have seen an inverted U.S. curve. In your opinion, does this mean that a recession is imminent? What impact does this have on your view of the different asset classes?
We do not believe that there will be a recession in the U.S. in the coming months. We have been hearing warnings about a recession being imminent and the fact that the U.S. yield curve is currently inverted is often used as evidence of this. However, it is important to note that, although the yield curve is undoubtedly a key indicator for a recession, not all inversions lead to recessions. Therefore, it is important to use the curve in conjunction with other indicators.
Current economic data and leading indicators do paint a mixed picture, however, we believe that, in this instance, the inverted yield curve does not indicate a recession. Firstly, although there is clearly a slowdown in economic growth, the considerably larger service sector remains relatively robust, compared to the much weaker manufacturing sector. Secondly, consumption needs to be taken into account. Approximately 70% of U.S. GDP depends on private consumption, i.e. on consumers’ willing to buy. Before previous recessions, the number of initial applications for unemployment benefits rose – this has not yet happened. As long as consumers retain their livelihood and are not restricted in their consumption, in our view a recession is unlikely.
Should profits decline sustainably and companies be forced to lay off employees, this picture could change. However, we currently expect corporate earnings to remain relatively constant in 2019 and to rise again in 2020. The current supportive central bank policy, the presidential election next year and the fact that we do not anticipate a further escalation in the trade dispute only reinforces our view that an imminent recession is unlikely.
In terms of the management of our portfolios, this means that we will continue to be overweight in U.S. companies on both the bond (Ethna-AKTIV and Ethna-DEFENSIV) and equity (Ethna-AKTIV) sides. Given the relative strength of the U.S. economy, we also expect the U.S. dollar to appreciate, which is why we currently have a significant dollar position in the Ethna-AKTIV.
The Ethna-AKTIV and Ethna-DEFENSIV have a strong year-to-date performance. Did you expect to see such positive returns from fixed income?
In December 2018, the global equity markets experienced significant losses. At the same time, the risk premiums on corporate bonds increased, resulting in corresponding price falls. The Ethna Funds were not completely immune to this development, and we also experienced marked price setbacks due to investments in individual equities and subordinated bonds. To safeguard ourselves against further price losses, we started rotating our portfolio towards very high-rated bonds with medium term maturities.
In 2019, we took further action. From early on, we added more corporate bonds to the portfolio, with an average rating in the strong investment grade range. In addition, we took advantage of some of the opportunities that arose from the market turbulence at the end of 2018.
The increasing willingness of central banks to support the weakening economy through interest rate cuts and renewed bond purchases boosted the performance of our bond investments. We also took advantage of the U.S. Federal Reserve's turnaround to increase the duration of the bond portfolio significantly by purchasing Treasury futures. Thanks to this successful overlay management, we were again able to continue our already strong performance in the corporate bond segment. By allocating our investments to a stable portfolio of corporate bonds, complemented by an active overlay strategy, we were able to achieve a performance that would otherwise only be expected from the equity or high-yield bond markets.
Even though the absolute performance of our bond investments might have surpassed our own cautious expectations from the beginning of the year, we have remained committed to our macro view. Over the last few months, this approach has demonstrated how an excellent performance can be achieved by consistently following our strong convictions via our active and flexible portfolio management approach.
Yields have come down significantly since the beginning of the year. Do you expect this trend to continue for a longer period of time?
Over the coming months, we expect worldwide long-term yields to converge. With investors continuing to search for positively yielding assets, we anticipate increased investment in USD-denominated bonds, which will further drive down U.S. yields. In fact, the yields on 10-year Treasuries could fall to 0.7% in the coming six to nine months. In addition, given the current uncertain economic environment due to the U.S.-China trade conflict, the geopolitical issues resulting from the recent attacks on the Saudi Arabian oil industry, and concerns about the impact of a cooling global economy, Treasuries will further benefit from their status as a safe-haven asset.
In the Eurozone, we expect yields to remain low, as the ECB has announced that in November it will restart its asset purchase programme at a rate of 20 billion euro per month. Therefore, we will continue to invest in new issuance of corporate bonds, primarily in the A-rating category and with a maturity of around 10 years. This will also allow us to benefit from the extra premiums usually offered at new issuance.
In the sovereign bond space, we prefer U.S. Treasuries and Spanish government bonds. For the former, this is due in part to our expectation of an appreciation in the U.S. dollar against the euro and to the arguments in favour of falling yields already noted, while the latter is supported by the aforementioned ECB asset purchase programme.
Overall, we expect the bond portfolio to continue to generate not only steady returns from coupons but also further capital gains, primarily from USD-denominated bonds.
Growth equities have shown a strong performance over the last few years. What are your expectations for the future of equities in this market segment?
The valuation premium for growth stocks has emerged over the last three years and is now at its highest level since the internet bubble burst at the beginning of 2000. However, we do not anticipate that prices will continue to rise in this manner and reach the excessive valuation levels of the 1990s. Instead, we consider a sideways trend over the coming 1 - 3 years more likely. Due to the strong profit growth, equities will be able to return to a normal market valuation during this period. Although interim corrections - even stronger ones - are possible, we would currently rule out the type of sharp drop in prices we saw in 2000, as these are merely higher valuations. In most cases, the price increases of growth stocks are underpinned by strong fundamental data, although they have risen a little too sharply in the short term. However, it is clearly not a bubble.
Nevertheless, for valuation reasons we are cautious about investments in in growth stocks in the Ethna-DYNAMISCH. Due to the cyclical vulnerability of value equities, there are currently only a few investment opportunities. Many companies are struggling with the weakening economy and there is currently no improvement in sight. For this reason, we are focusing on companies with a reasonable valuation and a stable business model. This has allowed us to develop a robust portfolio with a good mix of value and growth stocks. With our equity portfolio constructed in this way, we are confident that we are optimally positioned.
The Brexit deadline is fast approaching. What is your base case scenario?
Brexit has been haunting us for more than three years now. Leaving aside the benefits of an open dialogue in a democracy, which can and must take place, not much has been gained from this withdrawal discussion. Even with the deadline of the now second extension about to expire, it is still very difficult to predict what will happen after October 31ˢᵗ We are faced with a number of fundamentally different, potential outcomes that make reasonable, probability-based investing almost impossible. The only common denominator in all of the scenarios is the fact that uncertainty and the compulsion to resort to dual planning have already caused considerable economic damage.
During the second quarter, the UK economy shrank and the sentiment indicators for the manufacturing and construction sectors adopted a recessionary mood. Now, even the resilient service sector is cooling down. Nevertheless, we have seen an increase in the UK equity indices since the end of 2018. While Boris Johnson claims that the UK is prepared for leaving the EU without a deal, experts are hinting at significant problems for the medical system in the event of a no-deal Brexit and 79% of smaller businesses say that they have made no preparations for a no-deal event. On top of that, the majority of small businesses have stated that they do not know how to prepare. All this proves the uncertainty and lack of transparency around the Brexit event.
For us, this shows that there are currently no positive arguments for UK assets. In addition, we anticipate that price volatility will increase until end of October, another factor that does not support longer-term investments. Although the Bank of England is likely to reduce short-term rates in the UK and the government has capacity to increase its spending, these measures will only be able to partially offset the negative economic effects from a no-deal Brexit outcome.
Therefore, we are currently refraining from investing in UK assets, as we have identified much more convincing alternatives in investments in U.S. dollars and Swiss francs, as well as both corporate bonds and equities outside the UK.
Please contact us at any time if you have questions or suggestions.
ETHENEA Independent Investors S.A.
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