Your questions, our answers
In our latest issue of Clear and Simple, our Portfolio Managers discuss how sustainability standards are taken into account in the positioning of the Ethna Funds. They also answer questions about the sources of performance of the Ethna-AKTIV as well as the assessment of the further development of two top weightings in its portfolio - Amazon and Alphabet. They also look at how the Ethna-DEFENSIV is reacting to the recent rise in inflation and what the expectations are for the development of inflation as well as long-term yields should central banks hike their interest rates soon. With regard to the portfolio of the Ethna-DYNAMISCH, they explain the role that investments in chip manufacturers and in "pandemic profiteers" play, as well as whether Asia will be given more weight in the short to medium term. Finally, they discuss the characteristics of a business cycle and which key figures should be observed for investments.
How are the Ethna funds currently positioned in terms of sustainability standards? How will ESG factors affect future positioning?
Sustainability has now become a mainstream topic within our society. As a result, many investors are currently considering how they can make their investments ‘greener’ - or more sustainable in general - without positioning their portfolios too one-sidedly in favour of individual themes and thereby risking losing a healthy diversification.
At ETHENEA, this question has also been on our minds. We want to offer our clients responsible investment solutions with competitive and sustainable returns. Therefore, sustainability has become an integral element of the three Ethna Funds over the past 10 years. Environmental criteria, social characteristics, and good corporate governance aspects - summarised under the keyword ESG - are incorporated into each of our investment decisions, as are the evaluation of return opportunities, risks, and the liquidity situation of individual securities.
With the EU Sustainable Finance Disclosure Regulation (SFDR) in force since spring, all of the Ethna Funds are classified as so-called Article 8 funds. Detailed information on this can be found on our website as well as in a concise summary in our March 2021 Market Commentary. Even though an objective ESG assessment of actively managed multi-asset funds tends to be somewhat more difficult to make due to their flexible structure and the use of derivatives, the ratings of the most important rating agencies, such as MSCI or Morningstar, consistently reflect our successes in this area to date.
And yet we are only at the beginning of this journey. Just as the investment process of the Ethna Funds has always adapted to the evolving challenges on the capital markets over the years, our understanding of sustainability and the conclusions that can be drawn from it for our portfolios will also continue to develop in the future. One factor that should not be underestimated is the specific design of the EU taxonomy, which is about to be launched. Over the next few years, it could play a major role in guiding global capital flows - with corresponding effects on yields and valuations on the capital markets. Reflecting these developments in our multi-asset funds at the appropriate time is part of a prudent and sustainable investment strategy.
Given that the Ethna-AKTIV currently has a low bond weighting, a very high cash quota and its equity allocation is capped at 49%, from where do you believe you can generate further performance?
From a conceptual point of view, the performance drivers of an actively-managed multi-asset fund are, in decreasing order of importance:
- the allocation decision between the asset classes,
- the selection of the corresponding individual securities, and
- tactical overlay management of the risks taken.
Given that the equity exposure in Ethna-AKTIV is limited to 49%, it is a rather conservative multi-asset fund and this is one of the reasons why investors choose this product. The future performance will continue to be generated with precisely these components. Compared to previous periods, we can currently expect lower returns from the fixed-income area, as the local risk premiums are already at record lows. However, this does not mean that there will be no return from the bond allocation, it will just be lower than in the past. Nevertheless, the fund has sufficient flexibility and the Portfolio Management Team has the expertise to continue to generate a risk-adjusted, attractive return from the equity, commodity and currency asset classes, not only at the allocation level but also at the selection and overlay levels.
In recent years, US technology companies have faced increased scrutiny over their size and monopolistic power. Amazon and Alphabet are two of the top weightings in the Ethna-AKTIV in terms of single stocks. Given that Amazon demonstrated a rather sideways performance development over the last year, do you still believe in this company?
Absolutely. Anyone who found the shares interesting a year ago must find them even more interesting today. Even if it seems suspicious at first that all analysts who follow this share give it a buy recommendation, we agree with this opinion. After all, there are a number of good reasons for this. After years of above-average growth, the company has adjusted its own forecasts slightly downwards for the next few quarters, but we think that these adjustments were made very conservatively and that therefore surprises to the upside are entirely possible. Moreover, it is the high margin service segments, in particular, that continue to beat estimates, i.e. grow faster than anticipated by the market. With a price-to-earnings (P/E) ratio for the next year of just over 40, a company with this type of market position and growth is attractively valued. Viewed over the last 10 years, Amazon's current valuation is even in the lower range. It is precisely because the share's sideways movement over the past year has opened up a valuation gap in favour of Amazon compared to the broad index that we added it to the portfolio a few weeks ago and are convinced of its further potential.
Given the recent rise in inflation and the expectation of the central banks that this increase is transitory, how are you positioning the Ethna-DEFENSIV’s portfolio? Do you expect central banks to hike rates soon and what does this mean for long-term yields?
In August, inflation hit 5.3% in the US, down from 5.4% in the previous month. Although the pace of acceleration seems to have peaked, inflation numbers remain at relatively stable levels. We are seeing a similar picture in Europe, where consumer prices grew by 3% last month, and inflation in Germany is sitting at 3.9% - its highest level since the end of 1993.
Significant fiscal and monetary support, acute labour shortages, and a strong recovery in consumer spending in the US (August retail sales +1.8% month-on-month) are among the reasons for the high inflation figures. However, they are short-term in nature and should moderate once stimulus ends and the economy has managed to adapt. This is the base scenario of all the major central banks and is also what we consider most likely.
However, there are also good reasons for inflation to stay higher than anticipated, and the underlying developments must be watched very carefully. First, producer prices continue to be significantly higher than consumer prices. Prices for raw materials have an impact on the B2B businesses first and then affect consumer prices with a time lag, due to inventories, fixed price lists etc. If consumer spending remains strong, companies will channel higher prices through to consumers over time, leading to higher consumer price inflation. Second, although the job market has not yet fully recovered, there is evidence that there are ample job opportunities, but that employees are reluctant to get back to work. Whether this is due to ongoing Covid-19 and Delta variant concerns or other reasons, employees seem to be in a stronger position than one year ago and can potentially negotiate better salaries. Finally, after years of globalisation, the Covid-19 pandemic was the decisive event for some countries to roll this back somewhat and repatriate the production of goods and delivery of services deemed necessary for a functioning society (e.g. Covid-19 face masks). Growing protectionism, as seen in the US, China and to some extent also in Germany, could drive up consumer prices.
Given the current inflation outlook, we consider yields of around 1.30% (US) and -0.30% (Germany) too low. The voices within the central banks calling for an end to the support programmes are getting louder. The ECB already announced in September that it would decrease its bond purchases from EUR 80 billion to around EUR 60 billion - although they are not calling it tapering, but are referring to a recalibration of monetary support. On the other side of the Atlantic, the Fed is likely to start tapering at the end of this year. Nevertheless, we are still seeing a great deal of liquidity in the system, and demand for sovereign bonds is likely to remain high on the institutional investor side. There, higher yields levels will be used to ‘buy the dip’, which will limit the upside for yields. Therefore, we expect yields to rise slowly and steadily over time, but to remain at very low levels. In terms of short-term interest rates, we do not expect central banks to raise these any time soon. As a first step, they will reduce their bond purchases. As a second step, they could raise interest rates, but we do not expect this to happen before the beginning of 2023 in the US. In Europe, interest rate increases will follow even later.
There are good arguments both for and against higher than anticipated inflation, where the former would have a negative impact on capital markets. It is necessary to be prepared for this, particularly for a conservative fund such as the Ethna-DEFENSIV. As a result, we reduced the duration of the portfolio from about 5.5 years to 3.4 years. This provides a hedge against higher inflation numbers and seems reasonable at current low yield levels.
Does the recent global shortage of electronic components impact any companies in the Ethna-DYNAMISCH’s portfolio? Do you view the current situation as an investment opportunity and do you have plans to invest in a chip manufacturer?
The shortage of chips impacts the automotive industry in particular, and, to a lesser extent, producers of a range of electronic devices, such as mobile phones or game consoles. In the Ethna-DYNAMISCH, we are currently only minimally invested in these sectors with Samsung Electronics. However, thanks to Samsung's strong vertical integration, it produces many of the chips it needs itself, so the company is more likely to emerge from the current situation as a net beneficiary.
We clearly see the chip industry in general experiencing an overarching structural growth trend, driven by advancing digitalisation in a myriad of areas. However, we have also seen that much of this future growth is already reflected in current valuations. Even if the current chip shortage continues well into 2022, we believe that the potential risks of a ‘hog cycle’, which has been typical of developments in the semiconductor industry in the past, are also increasing. In light of this, we are not currently planning any investments in chip manufacturers or their suppliers.
Given that we may see a rise in Covid-19 cases in the Autumn, are you considering increasing the Ethna-DYNAMISCH’s investment in companies or sectors that have benefited from the pandemic?
For us, the expectation of an increase in Covid-19 cases is no reason to significantly change the positioning of the Ethna-DYNAMISCH. It is true that equity markets initially showed a marked reaction to the pandemic and, at times, favoured defensive or cyclical stocks. However, with the anticipated normalisation of economic activities, the equity markets have already largely dealt with the pandemic. Therefore, going forward, we do not anticipate any sudden rotations - across sectors or investment styles - as we saw at the beginning of the pandemic. Nor do we currently see an attractive risk/reward profile in the obvious Covid-19 winners. Instead, we are continuing to focus on companies with sustainable quality that benefit from structural growth trends.
Asia, in particular China, is currently the region with the highest expected economic growth. Are you considering increasing this region’s weighting in the Ethna-DYNAMISCH’s portfolio in the short to mid-term?
Above-average economic growth does not necessarily go hand-in-hand with above-average stock market performance. China's GDP, for example, has outperformed that of all industrialised countries over the past decade. At the same time, however, the Chinese equity market underperformed its Western counterparts. Moreover, the recent stricter regulatory interventions, which not only hit the previously well-performing technology sector (although they were particularly impacted), show that investing in China comes with its own country-specific risks, which are difficult to assess.
In principle, we are open to investments in Asia. However, sector and single stock characteristics play a more important role for us than the economic growth of individual countries. Therefore, the Asian stocks on our watch list are primarily the result of sector attractiveness and individual investment cases and not the result of a targeted country allocation.
Can you explain the typical progression the business cycle takes when moving from the early to mid-cycle? What changes will we generally see in terms of key figures, and what does this mean for investments?
When we talk about a ‘business cycle’ or an ‘economic cycle’, we are generally referring to economy-wide fluctuations in the aggregate economic activity. Each business cycle consists of a series of stages where the economy fluctuates between periods of expansion (growth) and contraction (recession). Economic variables also fluctuate depending on the phase of the cycle. Factors such as gross domestic product (GDP), interest rates, inflation, employment, investments, and consumer spending can help to determine the current stage of the business cycle.
Business cycles have no defined time frames. They can be short, only lasting a few months, or long, lasting several years. It is generally accepted that economic expansions don’t die of old age but instead can be disrupted by a set of macroeconomic, political, or external events. Although the actual lengths of each can vary, periods of expansion tend to be more prolonged than periods of contraction. Although these periods generally differ from country to country, increased globalisation and interconnectedness between countries tend to suggest an increase in business cycle synchronisation (particularly during downturns).
A typical business cycle usually consists of four distinct phases:
Early cycle: usually a phase of recovery from a recession. Activity accelerates, economic indicators rebound from negative to positive, and output and inflation progressively regain their previous levels (reflation). Economic policies are expansionist and provide ample liquidity for economic activity and the markets. Overall, the early cycle is beneficial for financial markets as “the rising tide lifts all boats”.
Mid-cycle: the longest phase of the business cycle, where sequential growth slows from the rate experienced during the early-cycle phase. Overall, economic activity remains solid and credit growth is strong. Monetary policy is still accommodative but becomes progressively neutral. Unemployment falls, price pressures are on the rise, and the output gap gradually narrows. Riskier bonds and equities usually still benefit from healthy growth, but as monetary policy normalises, sovereign and investment grade bonds become less attractive investments. Volatility usually bottoms out leading to good risk-adjusted returns.
Late cycle: economic growth has already passed its cyclical peak. While still positive, growth loses momentum and softens. With low unemployment, wages tend to rise and price pressure increases. Rising inflation may lead to a tightening of monetary policy. Higher interest rates and uncertainty about future growth affect both the economy and the performance of risk assets. We also see an increase in volatility. Slower growth and higher rates lead to widening credit spreads, making riskier bonds less attractive. Equities can still perform well if earnings growth remains solid, but risk-adjusted returns are more modest. As interest rates approach their cyclical peak, investment grade bonds with a good rating and sovereign bonds become an attractive portfolio hedge.
Recession: a combination of forces (high interest rates, macroeconomic or social imbalances, and external shocks) can drive the economy into a recession. Economic activity contracts, unemployment rates rise, inflation rates decline, and the output gap becomes negative. Profits fall and company defaults become more widespread. Central banks move to an accommodative monetary policy to support economic activity and set the stage for the recovery. The aforementioned slowing economic activity and declining profits, together with a deteriorating risk sentiment, negatively impact risk assets. Equities can decline and we could move into a bear market. On average, market downturns start before we see a slowdown in the real economy. In such an environment, safe assets, such as Treasuries and investment grade bonds, usually perform well.
Please contact us at any time if you have questions or suggestions.
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