Portfolio Manager Update
Key points at a glance
- Sticking with a 0% equity allocation
- Bond portfolio positioning much more cautious with an average duration close to 3 and high rating quality.
- Even though short-dated U.S. Treasuries and Bunds are less attractive, there is little alternative to them when it comes to risk mitigation.
- Tried-and-tested concentration on high-quality short-dated bonds and other interest rate hedges remains in place
31/10/2022 - In November 2021 the Ethna-DEFENSIV divested itself of its equity positions and has since exclusively concentrated on bonds. Even though the Ethna-DEFENSIV’s equity investments are capped at 10% and thus tend to be of lesser importance, it is still worth commenting on this decision and our sticking with a 0% equity allocation.
The Ethna-DEFENSIV would not have been able to produce a positive performance in 2021 without equity investments. Getting out just before the top of the market and at record-high valuations no doubt was a wise move as well. When will equity investments again be an interesting prospect for the Ethna-DEFENSIV? That’s a hard question to answer. Sure, equity valuations are much more attractive than they were a year ago, but is that enough?
Not only did we get out of equities but we also put the bond portfolio on a much more cautious stance. With an average duration close to 4 and a high rating quality, we are positioned for tougher times. But not even this extremely conservative positioning, which became even more risk-averse over the course of 2022 (duration of 3 and a further increase in rating quality) was enough to avoid steep losses on bonds. Quality bonds denominated in euro have lost approx. 15% on average to date in 2022, meaning they have done no better than equities. Thanks to our conservative stance, however, we managed to limit the bond losses to approx. 10%. What has helped this year is both our futures transactions to provide additional hedging against interest rate rises and currency positions denominated in USD and CHF. These have enabled the Ethna-DEFENSIV (T) to limit the year-to-date losses to 3.17% in 2022.
To come back to the original question, inflation remains very high, even extremely high in the eurozone. Central banks are immensely restrictive and are almost outdoing each other in hiking interest rates. The fact that labour markets are robust – with the number of job vacancies remaining high – allows for these interest rate increases, despite the growing risk of recession, especially in Europe. Almost everyone now expects the eurozone to enter a period of negative growth at the beginning of the fourth quarter. But negative growth is not stopping the central banks from continuing along their path as long as labour markets are robust. In this current phase, where key rates continue to rise rapidly and global growth is slowing markedly, equities still do not strike us as our best choice. Moreover, it is now once again possible to earn steady interest income with bonds. Bonds issued by quality companies with yields of 4% in EUR and 5% in USD and a residual maturity of up to 5 years are safe alternatives when it comes to limiting fund price volatility. Short-dated U.S. Treasuries are yielding 4.5%, while Bunds are only giving approx. 2%. Even though these yields are less attractive, there is little alternative to these high-quality portfolio constituents when it comes to risk mitigation.
To our mind, it is too soon to add equities to the mix. We anticipate further sharp fluctuations in bond and equity markets. For that reason, we will stick with our tried-and-tested concentration on high-quality short-dated bonds and other interest rate hedges for the time being. We will continue adding currency risks to the mix.
Equities’ time will come again, but probably not until 2023.
Key points at a glance
- Equity exposure back to 0%, short position was systematically liquidated in the October rally
- The foreign currency weighting currently stands at 20% (USD: 21.5%, CHF: 0.6%); modified duration +1.4%
31/10/2022 - After a not especially auspicious September, it was not exactly all systems go for October on the stock market, 35 years after the Black Monday Crash. That said, the global financial markets did relatively well over the course of October and pulled well clear of the lows for the year. While the micro and macro situation tended to favour the bears, the abysmal sentiment supported the bulls. However, it must be said that this poor sentiment – as found in surveys – does not necessarily jibe with market participants’ risk exposure, which is still relatively high in the historical context. As described in the introductory market commentary, from a strategic perspective, a better indicator of a true bottoming out that generally comes with a capitulation would be a reduction in investment rates in line with sentiment.
However, in light of seasonality in particular, which is now positive. we can no longer rule out the possibility that we have seen a characteristic low for this bear market. Because the fundamental situation continues to deteriorate, however, we highly doubt that this is the case and assume that this is another typical bear market rally. Third quarter reporting season, which is still underway at the time of writing, did bring better-than-expected figures, but overall earnings and revenue were much lower in addition to a persistently cautious forecast. Moreover, any earnings growth there was is only positive thanks to the good results of energy companies. There isn’t any really positive news to report on the political front either. In London the new Prime Minister had to step down shortly after the Chancellor of the Exchequer, and in Beijing President Xi was confirmed as leader for life. It is safe to assume that the consolidation of his power by reorganising the government apparatus in his favour will further inflame the clash between the People’s Republic and the West. The war on Europe’s doorstep is also far from over. It remains to be seen whether any negotiations with President Putin are held at the G20 Summit in Bali. Japan is still undertaking unilateral currency interventions. After the yen broke well through the first intervention level, Japan again shored up its currency by making purchases. They have now used up several dozen billion U.S. dollars on interventions out of their prized currency reserves (~USD 1.17 trillion at the end of August).
In this environment, the Ethna-AKTIV’s defensive positioning only paid out to a limited extent. Another attempt to earn money in this bear market by way of short positions in equities was stopped out at a loss. However, the equity base portfolio did better than the market due to its underweight in technology. Both duration and currency overlay were slightly negative to the same extent. Nevertheless, we are sticking to our guns for both and have slightly expanded the two positions. The U.S. dollar exposure was again increased to just over 20% and, on the duration management front, only a short position on the European yield curve was implemented in expectation that interest rates there will rise again. Basically, after years of massive support from central banks, the market is effectively hanging on central banks’ every word. Considering that the second-round effects of inflation are still being felt, however, we do not expect a departure from the current restrictive policy any time soon. In addition, to justify a higher strategic equity allocation, we would like to see a bottoming out of companies’ profit forecasts, which are currently falling. In the past, this was one of the better indicators of the end of a bear market.
Key points at a glance
- Equity markets were volatile in October: typical of a bear market.
- The economic risks are slow to crystallise, as the results and forecasts from the current reporting quarter show.
- Since stress factors are still dominating, we are keeping our net equity allocation low. At the same time, we are building up or expanding positions in quality names.
31/10/2022 - There is no shortage of market-moving impulses these days. In the first half of October, the impulses were macro data points, at the epicentre of which was inflation and its impact on monetary policy. The manic reactions (in both directions) of prices surrounding every publication are a reflection of market participants’ current uncertainty over when there will be a let-up in the pressure from these macro factors.
Quarterly reporting season in the second half of October also brought numerous micro data points to bear. 280 S&P 500 companies, which account for around 72% of the market capitalisation, had published their quarterly report by the end of October. On average, company earnings rose 1.8% compared with the prior-year quarter. However, like last quarter, this statistic is skewed by the volatile earnings trend in the energy sector. Excluding this sector, S&P 500 earnings growth would be well inside negative territory, at -4.8%.
Despite that, the current quarter is turning out better than analysts had previously expected, especially since, informally, they are likely to have been even more pessimistic. However, going by the average price reaction in the wake of the release of quarterly figures, there is little to celebrate; with the outlook for the coming quarters remaining restrained, as the combination of stresses stemming from weakening consumer demand, cost pressure and a strong U.S. dollar remain in play.
While things have recently been extremely volatile in the equity market with these macro and micro impulses, our market assessment has not changed significantly. The aforementioned stress factors remain to the fore. Even though we can foresee the speed of the (U.S.) cycle of interest rate hikes abating in view of disinflationary tendencies, the economic risks on the company and budgetary front will only gradually crystallise and lessen. For that reason, we would be well advised to remain patient. Our strategic top-down positioning, focusing on cash and cash-like positions of around 64% and a low net equity allocation of around 33%, reflects this restraint.
Despite the difficult market environment, from a bottom-up perspective, attractive opportunities to get into quality companies are cropping up now and again. We recently built up a position in Coloplast A/S. The Danish medical technology company is a leader in medical products related to ostomy, continence and urology care, which is a non-cyclical market segment. Coloplast’s organic growth rate is above average with an operating margin of more than 20% and is using its cash both to pay out dividends and for share buybacks. At the turn of last month we took advantage of the recent relatively moderate valuation to take up a position in this defensive growth stock.
With a combination of strategically cautious top-down allocation and, at the same time, careful build-up and expansion of individual securities, we are navigating a market environment that remains difficult: on the one hand, stress factors are still to the fore but, on the other hand, opportunities are arising when it comes to security selection.
* “Cash” comprises term deposits, call money and current accounts/other accounts. “Equities net” comprises direct investments and exposure resulting from equity derivatives.
HESPER FUND – Global Solutions (*)
Key points at a glance
Markets recovered on hopes of an end of monetary tightening in the near future
- Monetary authorities remain firmly committed to monetary tightening, but markets are focused on the easing pace of tightening.
- Despite signs of economic slowdown and peak headline inflation, core inflation remains steady and broader-based.
- With the exception of Chinese equity markets, major stock markets rebounded from their lows on declining yields and hopes of the Fed’s step down.
- The dollar pulled back mildly with an improved risk sentiment. Currency volatility among major currencies remained high.
- In the UK, the new government under Rishi Sunak cancelled Liz Truss’ fiscal program and relied on austerity measures to restore stability to public finances. The pound and government bonds rallied strongly as the UK restored political stability and fiscal moderation.
- Market sentiment forced us into a tactical retreat in the second half of the month. The overall short net equity exposure of the HESPER FUND – Global Solutions was reduced to -2% and the overall duration, including derivatives, turned positive. The short exposure to the British pound was halved.
- The fund’s average USD exposure remained at around 28% despite the dollar’s decline, as it should benefit from the weak global economic outlook and a still- restrictive Fed.
As of 31.10.22
Waiting for the Fed’s fifth disproportionate rate hike in a row
During the summer months, markets speculated on an early dovish pivot by the Fed. The markets’ expectations were later disappointed by J. Powell’s hawkish speech in Jackson Hole. Now the markets are focused on a Fed’s step-down i.e. reduction in the size and the pace of interest rate hikes.
Inflation figures in most countries continue to indicate that the battle against inflation is far from over. In the US, PCE core inflation, an inflation indicator closely watched by the Fed, rose above 5% in September. Inflation in the Eurozone broadened and reached a new record high, while economic activity slowed. Headline inflation increased by 10.7% and core inflation by 5% in October as the ECB hiked interest rates again. It is obvious that rate hikes will not last forever. Faced with increasing signs of economic slowdown and the threat of recession, central banks around the world have reduced their rate hikes and market participants are now expecting signs of a pullback by the Fed. The Bank of Canada surprised last week by raising rates less than expected, and San Francisco Fed President Mary Daly recently stated that it was time for the Fed to start talking about slowing the pace of monetary tightening. Thus, all eyes are on the upcoming Fed meeting to get a better understanding of how fast and how far the Fed will tighten policy for the world’s largest economy.
The US economy is still resilient thanks to a tight labour market and healthy consumer spending. However, the Fed’s aggressive tightening in recent months is gaining traction as leading indicators and surveys of future activity point to a significant market slowdown in the future. Jerome Powell has reiterated in recent months that the Fed is determined to fight inflation and will tighten policy until there are clear signs that US core inflation is coming down to the Fed’s policy target on a sustainable basis. The Fed does not want to repeat the mistakes of the past and should focus on long-term price stability. We therefore expect the Fed to continue its tightening cycle for some time to firmly anchor inflation expectations. The end of the Fed’s forceful policy “frontloading” is nearing, but there is still a lot of uncertainty about the Fed Funds Terminal Rate and how long the Fed will maintain its restrictive stance.
The UK’s schizophrenia, from unfunded fiscal expansion to austerity
You can’t always get what you want. The Rolling Stones’ lyrics are always a good reminder. It happened with Liz Truss government’s fiscal expansion attempt, and also with the Hesper not closing its positions on time amid unprecedented political turmoil and unexpected events, and a very sharp reversal on the pound and gilts hurt the fund’s performance in October.
Stock markets recovered
Central banks scaling back their aggressive policy tightening triggered an impressive relief rally in October, with equities rebounding from September's disappointing performance and bonds recovering from their 21 October lows as yields stabilised. As measured by the Bloomberg Aggregate Index, investment grade bonds remained flat in dollar terms in October, but they are still -20% year-to-date. In fixed income, UK gilts were the star of the month, initially falling (10-year yields briefly touched 5% just before the meltdown) and then not only recovering but gaining 4% during the month (yields closed the month below 3.5%).
Equity markets around the globe recovered thanks to more cautious statements by central banks, hopes for a peak in inflation and a stabilisation of yields, which led to significant risk appetite. The main exception was the Chinese stock markets, which suffered heavy losses after the authoritarian conclusion of the National Party Congress. The end of the bear market is always a tough and delicate call, but the macroeconomic environment does not point to an easy way out of the current malaise.
During the month, the S&P 500 rose by 8%, the Dow Jones by 14%, and the Nasdaq Composite by only 3.9% due to large profit losses in the technology sector. The small-cap Russell 2000 Index increased by 10.9%, whilst in Canada, the S&P Toronto Stock exchange gained 5.3% (+6.5% in USD).
European equity markets rebounded as well. The large-cap Euro Stoxx 50 Index jumped 9% (an increase of 10% when calculated in USD), while in the UK, the FTSE 100 rose by 2.9% (+6.5% in USD). The defensive Swiss Market Index increased by 5.5% (+3.8% in USD terms).
Asian equity markets were mixed as Chinese equities slumped after the Communist Party Congress. China’s lurch turns to one-man rule triggered a historic market rout as foreigners fled. The Shanghai Shenzhen CSI 300 Index fell by 7.8% (-10.3% in USD) and the Hang Seng Index plunged 14.7% to its lowest level in history. In Japan, the blue-chip Nikkei 225 increased by 6.4% (+3.8% in USD, due to the depreciation of the yen). In South Korea, the KOSPI Index plunged 6.4% (-6.7% in USD). India’s BSE Sensex stock market decreased by 5.8% (-4.1% in USD). The Australian stock market rose by 6% (+ 4.5% in USD).
Positioning and monthly performance
The HESPER FUND – Global Solutions performed poorly during the month as the pound and government bonds continued their decline and risk-off sentiment affected our positioning with net short positions in equities and long positions in dollars.
The T-6 EUR share class fell 3.7% in October. Year-to-date the fund is -1.18%. Total assets continued to rise and reached EUR 76 million at the end of the month.
In October, the HESPER FUND - Global Solutions T-6 EUR share class recorded the largest monthly loss since inception with -3.71%. Foreign exposure and transaction cost 1.3%. The share class is 4.19% below its all-time high of 29 September.
YTD the fund is at -1.18% and +2.28% year-on-year. Total assets reached a new high of EUR 76 million by the end of the month. Volatility for the last 250 days was higher at 7.23%, though retaining an attractive risk/return profile. The annualised return since inception fell to 6.08%.
As we head into November, the fund remains cautious. On the currency front, the HESPER FUND – Global Solutions has the following exposure: 28% in USD, 8.3% in CHF and -7.6% in GBP.
Overall, net short equity exposure was reduced to -2% and negative duration reverted to a slightly positive duration (less than two years).
As always, we continuously monitor and calibrate the fund’s exposure to the various asset classes to adjust to market sentiment and changes in the macroeconomic baseline scenario. Over the past nine months, geopolitical events have also played a decisive role in our asset allocation. A de-globalisation trend is clearly emerging, which may also keep inflation higher for longer. The end of loose monetary policy is the most important event currently taking place.
Macro scenario of HESPER FUND - Global Solutions
Global markets have been shaken this year by an increasingly hawkish Fed, arguing that it needs to quash sky-high inflation even at the risk of a hard landing for the economy. As the Fed prepares for another hike, the trade-off between price stability and economic growth appears to be intensifying as robust inflation and labour market data contrast with signs of weakness in other parts of the US economy.
In the face of persistently high inflation and the risk of losing control of inflation expectations, central banks must stay the course to restore price stability by tightening policy and keeping interest rates at restrictive levels for some time. Fiscal policy support should mitigate the cost of living and must be temporary and targeted so as not to counteract tighter monetary policy.
Our macroeconomic scenario a further significant slowdown of the global economy in the medium term, with persistently high inflation and continued restrictive policies. In this environment, a global recession appears increasingly likely. This challenging macroeconomic scenario is compounded by several potential threats, including significant risks for financial stability, as the end of loose monetary policy may break a weak link in the financial system. It is too early to say whether the global slowdown will resolve in a few quarters of negative growth or whether we will face a much harsher recession. The scenario remains very uncertain and there are still considerable clouds on the horizon.
*HESPER FUND - Global Solutions is currently only authorised for distribution in Germany, Luxembourg, Italy, France, Austria and Switzerland.
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