Your questions, our answers
Central banks are intensively tightening the restrictive course of their monetary policy to fight high inflation. Global economic growth is slowing down drastically and the development of the major economic blocs is uneven. Against this backdrop, ETHENEA's experts have answered your questions. Looking at the equity markets, do you expect a value decade and is this reflected in the Ethna-DYNAMISCH? Which asset class or strategy made the biggest contribution to the performance of the Ethna-AKTIV last year and which weighed most heavily on the performance? How did the portfolio managers deal with the rally in equity prices in the summer and how do they ensure that the fund participates in a possible long-term trend reversal with rising equity prices? Are there indicators that can show a difference between a bear market rally and a trend reversal? Looking at the bond markets, what is the medium-term duration management strategy of the Ethna-DEFENSIV & Ethna-AKTIV?
Looking at the big picture, Dr Andrea Siviero gives his assessment of a global recession and how Germany in particular could develop against the background of skyrocketing energy prices. He also addresses the question of where he positions himself on the exchange rate of the two currencies given the recent EUR/USD parity and whether he expects the EUR to depreciate further. Our portfolio managers will be addressing these questions in the third issue of Ganz Konkret for this year.
Given the rising interest rates, and the latest hawkish comments from the Fed do you expect the next decade to be a “value” decade vs the “growth” decade we experienced on equity markets till last year? Is that reflected in your Ethna-DYNAMISCH portfolio?
The binary division of the equity universe into “value” and “growth” stocks is popular. Broadly speaking, it delineates slow(er) growing from fast(er) growing companies. The differences in these growth dynamics are reflected in valuation levels.
“Growth” stocks in particular have benefited from the low interest rate environment of recent years – i.e. also from a lower discount factor for future earnings. Covid-19 has given an additional boost to the dominance of these stocks, which are backed by more pandemic resilient business models, in 2020 and 2021. Recently, however, this outperformance of “growth” over “value” has come back into perspective, considering the rising interest rate environment and slowing post-pandemic growth rates. As these developments are already largely reflected, we don’t expect a “value” decade. However, the focus of the Ethna-DYNAMISCH is not generally on “growth” stocks either.
In our investment decisions, we avoid the extreme edges. This means that we neither invest in cheap companies that lack structural growth nor do we go for disruptive companies whose valuations are fed by exaggerated expectations for the future. Instead, we focus on balance, i.e. on companies that are growing structurally but whose valuations are adequate to allow a favourable entry. We do not think in terms of binary categories “growth” or “value”, as this does not do justice to the complexity of the capital market.
Which asset class or strategy made the biggest contribution to the YTD performance of the Ethna-AKTIV, which asset class was the biggest detractor to performance. How did you handle the summer equity recovery?
In addition to the inherent diversification and construction-dependent portfolio stability of an active multi-asset approach, the ability to react to the macro environment via allocation decisions is another advantage. Accordingly, it should come as no surprise that the ranking of the most important performance drivers varies over the years. The Ethna-AKTIV is no different. While in 2020 it was bonds and in 2021 equities, this year it is the currency allocation that makes the biggest contribution to performance. In a fundamentally very challenging year, where there is literally no asset class to hide in, our open currency allocations have contributed almost 3% to performance so far. The majority of this is attributable to the US dollar, which has performed even better than we anticipated. On the downside, the equity allocation has contributed slightly more than -4% this year. However, this must also be put into perspective. Without the positive contribution of our future overlay, the contribution would have been almost another 3 % lower. On the bond side, the picture is very balanced and very positive for this environment. The losses due to spread widening were almost offset by the duration overlay. In a year in which the various bond indices almost consistently show double-digit losses, this can definitely also be described as a good result.
How do you ensure that the Ethna-AKTIV is part of a possible long-term trend reversal with rising equity prices in late summer? What indicators can show a difference between a bear market rally, and a trend reversal?
Basically, the question of trend reversals naturally only arises if, like us, one wants to deliver added value via the allocation decision. The timely adjustment of the asset allocation to longer-term trends represents the basis for the success of the concept. It should be clear that a trend change is usually characterised by a process rather than a specific point in time. The crux is that a trend change, to the positive is very difficult if not impossible to distinguish at the beginning from a short-term bear market rally. The fact is that both the highs and the lows can only ever be identified in retrospect. Therefore, it is important to have a framework of decision-making tools that can identify a process of trend change. Fundamental data and also leading indicators are of limited help here, especially if they are not extremes in the historical distribution. This means that only when, for example, purchasing manager indices, price-earnings ratios or equity risk premiums are quoted in historical extreme ranges do they gain significance in the assessment of possible market turning points. As a rule, however, the market has already bottomed out by then. In respect thereof, various sentiment indicators are more closely linked to possible turning points and provide a good contra-indicator at extreme points. However, it must be considered that sentiment extremes occur more frequently than decisive trend reversals. Last but not least, purely technical indicators, such as market breadth, the number of new highs or the failure to fall below past price lows, also help in assessing the situation. Since the last points in particular are of a purely quantitative nature, they are excellently suited to disciplining one's own macro investment and corresponding positioning.
What is the mid-term duration management strategy of the Ethna-DEFENSIV & Ethna-AKTIV, do you intend to change anything to the current approach
We have been cautious about the risk of rising yields all year. The bonds in the portfolios had and have a short remaining maturity and additional hedges have made the duration close to zero or even negative in some cases. Currently, the central banks (ECB and Federal Reserve) are just in the middle of their rate hike cycle and the Federal Reserve's balance sheet reduction has just reached the maximum pace of USD 95 bn per month. Therefore, in the short term, there is no reason to move away from this cautious positioning. However, as interest rate hikes progress, yields - especially on shorter-dated bonds - could become attractive and risks could clearly take a back seat to opportunities. This point could be reached in the fourth quarter of 2022 or early 2023. In that case, we could adjust our duration strategy and initially dispense with hedging transactions. Investments in short-dated US government bonds could then become interesting. Since we expect a significant decline in US inflation (below 4%) in the second half of 2023, yields on two- to three-year Treasuries above 4% would be attractive in our view.
What is your opinion on a global recession? How do you think the Europe, especially Germany, will develop against the backdrop of high energy prices?
The global economy has been hit this year by two major supply and demand shocks (the war in Ukraine and Covid outbreaks in China) that caused a stagflation-like scenario of high inflation and considerably slower economic growth. During the second quarter of the year central banks around the globe decided that considerably tighter monetary policy was required to bring down inflation and inflationary expectations and accelerated the pace of tightening. In an environment of high inflation, slowing growth and considerably tighter monetary policy, the risks of recession have increased significantly.
We currently observe a substantial synchronized economic slowdown with surveys and leading indicators already pointing to a contraction in economic activity. The three largest economic blocs may well enter in recession in the next six to nine months, but growth potential, inflation dynamics and the origin of their recessions are significantly different. The US economy is resilient with a strong labour market and healthy consumer spending, but a recession could be caused by the Fed’s excessive monetary tightening. China’s economy has been slowing down for some time and despite policy support, its zero Covid policy and the deep crisis of the property sector may precipitate a recession.
The European economy never really recovered from the pandemic induced recession, it is plagued by historic high inflation, a deep energy crisis, and a severe squeeze in real personal income. Heavily dependent on Russian energy, Europe and particularly Germany have been hit hard by the consequences of the war in Ukraine and ensuing sanctions and trade disruptions. The German industrial sector is suffering from supply shortages and weak domestic and global demand. Despite a healthy labour market, wage growth has been muted and consumer confidence is at historic low levels due to the erosion of the households purchasing power. The ECB started in July to tighten their policies, and it is determined to continue this path to bring inflation back to target. Fiscal policy is becoming expansionary with several European countries providing supplementary fiscal support to alleviate the harmful effects of stagflation but after the summer bounce, a European recession seems almost inevitable.
With regards to the recent EUR/USD parity, what’s your stance on the USD/EUR exchange rate? Do you expect the EUR to get even lower?
The USD has been the strongest G10 currency in 2022 and appreciated by about 13% YTD against the Euro. The appreciation of the USD comes on top of an 8% gain against the European currency during 2020.
There are several reasons for the overall strength of the greenback. Despite some sluggishness in the first half of the year, the US economy seems to be resilient to high inflation and tighter policies with a strong labour market, healthy wage increases and solid consumer and business spending. In the coming quarters the US economic expansion is likely set to outperform growth in both the Eurozone and China. During the past 18 months, the USD also benefited from its safe-haven status attracting international capital flows in times of international crises and benefited from a “stagflation bonus” deriving from high inflation and weaker global growth.
The strengths of the USD against the Euro have been compounded by the intrinsic weaknesses of the Eurozone economy and the marketed divergency between the Fed and the ECB policies. The Eurozone economy has been hit hard by the consequences of the conflict in Ukraine and the ensuing sanctions that caused a sharp increase in energy prices and a surge in inflation severely constraining consumer and business confidence. While the Federal Reserve increased its policy rate by 250 bp since March, the ECB normalization process has been delayed by a weakening economy, market fragmentation (widening of the sovereign spreads within the Eurozone), and political tensions. During the summer, with inflation at record high the ECB changed its tone and became decisively more hawkish to bring inflation down and control inflationary expectations.
Despite a more hawkish ECB and the strong USD appreciation during 2022, we expect the USD to remain firm against the Euro with the potential for further appreciation. The scenario of weakening global growth and high uncertainty remains supportive for the USD which continues to benefit from an aggressive Fed and a resilient US economy. Plagued by the energy crisis and declining confidence, the Eurozone economy will likely end up in a recession in the coming quarters and with high sovereign debts and marked regional divergencies, the ECB tightening path remains a very challenging process. A tighter ECB policy could provide some short-term relief to a battered Euro, but it is unlikely per se to change the current pattern of Euro weakness.
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