Your questions, our answers
Right now, inflation is a hot topic. Therefore, in our latest issue of Clear and Simple, our Portfolio Managers discuss what impact higher inflation could have on the capital markets. They also explain whether specific ESG indicators are given more weight in the decision-making process of the Ethna Funds. In addition, they provide their assessment of the further development of the US dollar and explain its weighting in the Ethna-AKTIV. Finally, they look at the announcements of various central banks regarding tightening of monetary policy and discuss what this means for the Ethna-DEFENSIV’s portfolio.
What would be the implications of higher inflation for capital markets?
Higher inflation rates would be of fundamental importance for the capital markets. Basically, inflation is good for debtors and bad for creditors. In times of high inflation, real assets benefit in relation to financial assets. Equities offer some protection against inflation and are clearly preferable to bonds in periods of rising inflation. Both sector and single stock selection in the equity market are of paramount importance in the event of rising inflation. Cyclicals in particular would benefit from inflation, an example here would be commodity shares. Growth stocks, on the other hand, tend to have a rather difficult time. This is particularly true if interest rates rise in line with inflation, which is likely to happen. On the other hand, financial shares, in particular those of banks, would benefit greatly from rising interest rates. We have been living in a deflationary world for 40 years. If we were actually to enter an inflationary era now, it would have a huge impact on equity markets. There would almost certainly be a shift in favourites. Very few investors have that on their radar. There would be significant reallocations. Such a paradigm shift would not only be associated with significant risks, but also opportunities.
Some Portfolio Managers have decided to favour a few specific ESG indicators when choosing a company, for example:
• the percentage of independent board members;
• whether a company has a policy against child labour;
• whether the company has a golden parachute agreement.
When implementing your ESG strategy, do you focus on specific factors that you deem more important than others?
In terms of implementing our ESG strategy, we have designed a three-tiered approach that also reflects the differences in the importance of various aspects.
On the first level are rigorous exclusions. In addition to sector and product exclusions, these are predominantly factors that we consider to be so important that they must be adhered to by every company. Looking at the concrete examples in the question, child labour, for example, would fall under these exclusion criteria. Such fundamental minimum requirements can be included very easily under the 10 principles of the UN Global Compact, which, in addition to human rights and labour standards, also include environmental aspects and the prevention of corruption.
In addition to these fundamental factors, there are many other individual aspects to which, however, we do not assign any individual exclusionary power in the decision-making process. Rather, it is the overall increase in the number of weak indicators that can lead to exclusion (the second stage of our approach) or the individual importance of specific ESG aspects in the concrete context of a company analysis that can increase or reduce the attractiveness of an investment (the third stage).
In the latter case in particular, the exact context of the complete investment scenario plays a decisive role. For example, in the case of family businesses listed on the stock exchange, we are more likely to tolerate a below-average valuation in terms of governance factors, as this is not necessarily accompanied by a detrimental development of the company's performance, nor is there any detriment to other stakeholders of the company. In the end, however, what is true for conventional valuation and fundamental factors is also true for ESG factors: everything will rarely be perfect. However, if all the indicators considered point strongly in the right direction, the better an investment will be in comparison to the investment alternatives.
The euro has been depreciating against the US dollar, from USD 1.22 at the beginning of the year to USD 1.15 in November. Has this movement worked in the Ethna-AKTIV’s favour so far this year? Do you expect the trend to continue? What impact will this have on the Ethna-AKTIV’s positioning?
This position has paid off for the Ethna-AKTIV and we expect this trend to continue in the coming quarters. There are several reasons for this. In addition to diverging central bank policies, it is primarily the global growth slowdown that argues in favour of a stronger US dollar. The greenback tends to strengthen when global trade slows down. After several quarters of very high growth rates due to pandemic catch-up and normalisation effects, we expect a gradual slowdown, which in turn should result in a stronger US dollar. Furthermore, we are again seeing a divergence between the current policies of the US Federal Reserve and the European Central Bank. While the Americans have already started tapering, the Europeans are still far from the beginning of normalisation. In our view, the ECB’s policy even offers potential for disappointment, as we doubt that the interest rate moves already priced in by the market can really be implemented. If the short end of US interest rates were then to rise as well, the trend would be reinforced and the US dollar would have even more tailwind with the interest rate differential then in effect. For the positioning of the fund, this scenario means retaining the already high US dollar allocation.
The Fed has decided to taper the pace of its asset purchases by USD 15 billion a month starting in November, the Bank of England and a number of smaller central banks in Europe have signalled tighter monetary policy. How do you plan to position the Ethna-DEFENSIV portfolio to adapt this change?
First of all, it is important to note that although the Fed started to reduce its monthly bond purchases by USD 15 billion in November and December, the central bank will continue to expand its balance sheet – probably until mid-2022. Therefore, even though the pace of bond purchases will be reduced, the Fed will continue to provide markets with fresh liquidity, which should stabilise yields. The same holds true for the ECB, which has scaled back its bond purchases in the last quarter of 2021 from EUR 80 billion to EUR 65 -70 billion, but will continue buying bonds until at least March 2022.
On the other hand, central banks are clearly signalling that the era of ultra-accommodative monetary policy is coming to an end. Inflation continues to rise and has proven to be less transitory than central banks anticipated, leaving them little room for missteps. With a more hawkish Fed and hotter inflation figures, we expect US Treasury yields to continue to rise more sharply compared to Bund yields. Therefore, in recent months, we have gradually reduced the duration of the bond portfolio in the Ethna-DEFENSIV, progressing from 5.1 in July, to 3.3 in August, and to 1.8 in October. In November we finally decided to reduce the duration in USD-denominated bonds to zero. In the case of eurozone sovereign bonds, in particular Bunds, there are two reasons that we see more limited upside potential for yields. First, the ECB is less hawkish than the Fed, and we do not expect them to raise rates anytime soon and certainly not before the US central bank. Second, demand for Bunds remains high and free float¹ is extremely low at around 10%. Institutional investors, such as banks, pension funds and hedge funds are often required by law to hold a certain number of Bunds as collateral, which, in combination with limited supply, will keep yields under pressure. Therefore, we have not hedged our euro-denominated bond portfolio, which primarily consists of bonds of short- and medium-term duration and accounts for 20% of the portfolio.
¹ The free-float measure for the four largest euro area economies (Germany, France, Italy and Spain) is defined as holdings of general government bonds by price-sensitive private-sector investors as a share of total outstanding bond supply, both expressed in ten-year maturity equivalents. Price sensitive investors are defined as all sectors other than the foreign official sector, insurance companies and pension funds, and the Eurosystem. Source: The monetary policy non-puzzle in bond markets (europa.eu).
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