What bridge construction and financial markets (sometimes) have in common
In June 2000, almost exactly 20 years ago, London’s Millennium Bridge was inaugurated. The 325 m long footbridge connects the City of London with the world-renowned Tate Gallery of Modern Art, which lies on the south bank of the Thames. The suspension bridge was designed by star British architect Norman Foster. However, within just two days of opening, opinions on the aesthetic and technical masterpiece soured. Having been open to pedestrians for only two days, the bridge had to be closed for modifications for the next two years. What happened?
People crossing the bridge caused it to sway excessively from side to side, something that the engineers hadn’t factored into their calculations beforehand. As a result, the bridge was dubbed “the wobbly bridge”. The sway was so extreme that structural modification had to be undertaken at an additional cost of £5 million (on top of the total cost of construction of £18.2 million). The “error” in the original design was quickly identified: while the bridge was designed to take the weight of 5,000 pedestrians, their behaviour in reality differed from the theory of how they would behave. The majority of people crossing the bridge unexpectedly walked in step whereas the designers had assumed that their gait pattern would be non-uniform and asynchronous. External factors, such as gusts of wind and random initial sway, caused people to synchronise their steps, further magnifying the sway due to the positive feedback phenomenon as people tried to balance. The lessons about human behaviour in such situations that were learned in the context of the Millennium Bridge in 2000 have been applied to all new bridge constructions since then.
In financial market theory, too, it has become clear over recent decades that the reality of human behaviour is far removed from the textbook homo oeconomicus. In the meantime, diverse anomalies that traditional economic theory hadn’t considered in its basic assumptions were empirically tested and scientifically proven. The branch of research that this gave rise to – behavioural finance – was initially held in contempt but eventually became an established economic science when psychologist Daniel Kahneman was awarded the Nobel Prize in Economic Sciences in 2002.
Still, portfolio managers are often envious of their engineering colleagues. As always, when building a bridge, its ultimate success depends almost exclusively on the exact and proper application of the fundamentals of engineering. With a few spectacular exceptions, such as the Millennium Bridge, unexpected aspects of behaviour do not constitute a significant risk. If we look at stock market history, starting with the Dutch tulip bulb market bubble in the 17th century right through to the current coronavirus crisis, even the best economics degree is no guarantee of success in the capital markets. The external influences are too complex, forecasts are too uncertain and the influence of the human psyche is too great. The famous stock market expert André Kostolany took the view that the role of psychology in what goes on in the stock market could not be overestimated. In his opinion, psychology accounts for 90% in the short- and medium-term.
At any rate, regardless of exact percentages, the influence of human behaviour on capital market developments can be regarded as significant. So, naturally, when carrying out our macroanalyses, we afford this factor the weight it deserves. In addition to general economic data; geopolitical, fiscal and monetary policy; fundamental corporate figures; absolute and relative valuation parameters; conclusions drawn from the interest rate, commodities and currency markets, sentiment data help flesh out the big picture and go towards making the decision on the appropriate equity allocation with regard to risk and return. Sometimes it is precisely these (ostensibly rather unconventional) factors that can have the final say in a successful allocation decision in situations of great uncertainty, or in situations of supposed security.
Looking at the tactical asset allocation for the Ethna-DYNAMISCH over time, recent years alone are replete with instances where analysis of investor sentiment ultimately emitted the most meaningful signals for active management of the net equity allocation and for general risk management. It makes a crucial difference whether investors in general are expecting the worst and are positioned accordingly or whether they see the future through rose-coloured glasses, and the euphoria that goes with this is reflected in the portfolio. For example, the latter was the case at the beginning of the year, which led us to reduce equity risks successively and to expand the hedging components – quite apart from the reports out of China about the first cases of coronavirus infection. Just a few months beforehand, in late summer 2019, the situation was completely different from the point of view of behavioural economics, which, in addition to other aspects, led us to expand the equity allocation considerably at that time.
The latest “aha” moment in the context of stock exchange psychology came on 10/11 March of this year: share prices had broadly already fallen by around 20% from their peaks and we initially had a constructive buying intention, underestimating the later consequences of the COVID-19 pandemic, which was slowly escalating. After all, as the saying goes, “buy on the sound of cannons”. The closer we looked at what was happening around us in the market, the more we realised that everyone was buying. What we were still seeing was controlled greed rather than capitulation. Consequently, the signs were there, in ever greater number, that the equity market was still a good way off a lasting bottoming out, which led us in the Ethna-DYNAMISCH to put in place extra equity hedges of more than 30% again, resulting in one of the lowest net equity allocations in recent years. The equity markets lost another almost 20% in subsequent days before the central banks injected an unprecedented amount of liquidity.
Not only the above examples but also scientific findings show how important a cautious management approach is for actively managed multi-asset funds. A high degree of flexibility – both mentally and in the portfolio – has always been a hallmark of the Ethna funds and the portfolio management behind them. Therefore, our investors are not completely exposed to the caprices of the financial markets; rather, they get risk-controlled access to the capital markets through active and forward-looking fund concepts. After all, excessive movement can cause not only bridges to wobble, but can also prove too much for investors in periods of stress in the financial markets. That, too, it will come as no surprise to hear, is one of the findings of behavioural finance.
Positioning of the Ethna Funds
After days of negotiations, the EU member states agreed the Next Generation EU recovery plan of EUR 750 billion. The support package is intended to help the economy to recover as quickly as possible from the damage caused by the coronavirus pandemic. At the same time, the budget for the European Union for the next seven years was set at more than EUR 1 trillion. In the meantime, the actual damage to the global economy has been disclosed. German economic output in the second quarter is 10.1% below the previous quarter, and thus is one of the better figures for the large economies within the European Union. Italy’s GDP is -12.4%, France’s even further at -13.8%, and the decline in Spain’s GDP is even more severe at -18.5%. Even in the U.S., where lockdown was lifted relatively soon, the economy has shrunk considerably. However, the reported figure of 33% less than the previous quarter is an annualised figure, so it is not comparable. The comparable figure of -9.5% is slightly better than Germany’s.
However, this record-breaking economic decline is already history because market participants are always looking to the future. The latest news on this front is rather rosier. The purchasing managers’ indices (PMI) in the eurozone were already back above the reference value of 50 in July, both for the services sector and for manufacturing sector. National fiscal programmes and the approved EU package should help to consolidate this trend. The PMI in the U.S. is above 50 for the manufacturing sector and still slightly below 50 for services, which would suggest growth. At the moment, a resurgence in COVID-19 cases is cause for concern. In the U.S., the early lifting of lockdown has led to a dramatic rise in cases of infection since mid-June. In this environment, steady economic recovery in the U.S. is less likely. Consumer confidence – an important indicator – also fell again in July versus June. In Europe, new COVID-19 cases are also on the rise again, albeit only slightly. Some travel restrictions have already been tightened up again. Consumer confidence is no worse but then nor has there been any further improvement.
At its last meeting, the Federal Reserve stated that containing the coronavirus was crucial to positive economic development. Accordingly, it reaffirmed that it would take all measures necessary to help stabilise the economy. While the Fed has not yet decided anything new, it will extend existing support measures. Nor did the ECB decide on any new measures at its meeting in July. It remains a significant buyer of bonds under its various purchase programmes. The central bank measures have pushed up both the prices of corporate bonds denominated in EUR and in USD. The price of gold is also climbing steadily, thanks to negative real interest rates in addition to the now greatly flagging strength of the USD. Within the Ethna-DEFENSIV, we closed the remaining USD position at approximately 1.145. At month-end, the USD had weakened further to 1.19 versus the EUR. A contributing factor was the U.S. central bank’s declaration that if external demand kept up it would make the USD available in almost unlimited amounts.
In July, the Ethna-DEFENSIV (T class) gained further ground thanks to the advances made by its bond portfolio and its gold allocation, with a performance of +1.52%. Performance is thus back in the black in the year to date, at +1.27%. We don’t expect the current environment to change much in August either. Central banks will continue their bond purchases, and real interest rates will remain negative. Economic recovery will be hampered by the spread of the COVID-19 pandemic. Therefore, we are also starting the new month with a corporate bond exposure exceeding 80% and a gold allocation of almost 10%. Rounding off this positioning is a CHF allocation of not quite 15%. Even though the Swiss franc weakened slightly versus the euro in July, we expect fresh upward pressure on CHF in the coming weeks.
The previous months’ developments continued in July as well: COVID-19 case numbers are not improving, the gap between the winners and loses in the crisis is getting ever wider, and central banks are adhering to their supportive stance and are calling on governments again and again to provide more support. While Americans are still finding it hard to pass their next fiscal package in what is a politically divided country, the European Union surprisingly reached a compromise on a joint recovery package.
It was this very deal that accelerated the recovery of the European single currency, which in two months has recouped the last two years’ worth of losses. As mentioned in the last Market Commentaries, we are not taking a contrary stance, and hedged our last dollar holdings over the course of the month. Given that no reforms have been agreed, we still harbour doubts about the sustainability of the economic package. That being said, we must deal with the reality of a strong euro in the short term. Movement in the euro versus the Swiss franc is more moderate and we are maintaining our position.
Given the extremely low expectations beforehand, the ongoing reporting season has thrown up a number of positive surprises. However, many companies still cannot give a full-year guidance due to uncertainty about how the pandemic will unfold. Standing in contrast to this, and representing the aforementioned winners in the crisis, are the large-cap technology giants’ results published in the last week of the month. These companies even managed to exceed what were already high expectations. Against this backdrop, it should come as no surprise that the more tech-heavy equity indices did better again last month. We adjusted our weighting slightly in respect of this. Equity allocation was lately increased to 23%; the technology and communications weighting increased to one third of this.
In both interest rates and gold, the prevailing trend in recent months intensified. With the tailwind provided by further falls in real interest rates, the precious metal even hit a new all-time high this month. Since we see no reason for a trend reversal soon, we are holding on to our gold position.
Looking ahead, in the next few months we expect a period of sideways consolidation due to it being summer, which is usually quieter, and to the upcoming U.S. election. Given the resulting lack of catalysts, we are maintaining our current, rather conservative portfolio mix.
The gulf between Wall Street and Main Street is a regular topic of debate these days. Here, Wall Street stands for the supposedly too-high equity indices, while Main Street has to deal with the economic and social consequences of the global COVID-19 pandemic on a daily basis. As so often is the way, the simplest thing to do is to pick a side and argue one’s case. There are arguments in abundance. The objective problem here is the arguments in favour of Wall Street and Main Street are both very valid and are totally justified. Since this discussion is so central to everything else and there is little other news to report, let’s use this Market Commentary to reassess the current position.
Wall Street’s standpoint: the global money supply is inexorably ballooning due to central banks’ purchase programmes. For every security that one of the major central banks buys from its previous owner, the latter receives cash and has a problem reinvesting it. As a result, the prices of all financial assets become inflated as more and more money is flung at fewer and fewer available assets. In the low/zero/negative interest rate environment, at the end of the day valuation plays a much lesser role – and rightly so!
Main Street on the other hand represents all the problems in the real economy: already weak economic growth for years is being greatly compounded by the most recent economic shock due to the stresses associated with the coronavirus. We cannot expect a lasting improvement for the foreseeable future. Case numbers are continuing to rise globally; there is a corresponding strain on the consumer climate and many initially temporary job losses are threatening to become permanent – especially in countries with social security systems that are less well-developed as those we have in large parts of Europe.
Interestingly, both trends outlined did not originate with the arrival of the coronavirus. They have actually intensified exponentially in recent months. There is a snap tendency to dismiss such extremes as exaggeration but, broadly speaking, we are actually not even near the scale of historic excesses in the financial markets. How far developments will take us this time simply cannot be estimated with any reliability.
Meanwhile, in the Ethna-DYNAMISCH, we remain true to our motto: to offer investors risk-controlled access to the global equity markets. Therefore, for us, growth at a reasonable price (GARP) is part of responsible investing. Growth at any price (GAAP), as some companies with a vulnerable business model strive for in economically challenging times, drives some segments of the equity markets to new highs and, in our view, constitutes a foreseeable and unattractive risk. For this reason, there has recently been little need to make adjustments in the Ethna-DYNAMISCH. In July, we increased hedging, again countercyclically, into individual price spikes, resulting in a net equity allocation of 37.9% at month-end (following on from 43.1% at the end of June). Besides minor adjustments to individual security positions, the foreign currency hedges in USD were again expanded – before the currency lost considerable value in the second half of the month versus a euro that was gradually gaining strength.
Figure 1: Portfolio structure* of the Ethna-DEFENSIV
Figure 2: Portfolio structure* of the Ethna-AKTIV
Figure 3: Portfolio structure* of the Ethna-DYNAMISCH
Figure 4: Portfolio composition of the Ethna-DEFENSIV by currency
Figure 5: Portfolio composition of the Ethna-AKTIV by currency
Figure 6: Portfolio composition of the Ethna-DYNAMISCH by currency
Figure 7: Portfolio composition of the Ethna-DEFENSIV by country
Figure 8: Portfolio composition of the Ethna-AKTIV by country
Figure 9: Portfolio composition of the Ethna-DYNAMISCH by country
Figure 10: Portfolio composition of the Ethna-DEFENSIV by issuer sector
Figure 11: Portfolio composition of the Ethna-AKTIV by issuer sector
Figure 12: Portfolio composition of the Ethna-DYNAMISCH by issuer sector
* “Cash” comprises term deposits, call money and current accounts/other accounts. “Equities net” comprises direct investments and exposure resulting from equity derivatives.
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The investment funds described in this publication are Luxembourg investment funds (fonds commun de placement) that have been established for an unlimited period in accordance with Part I of the Luxembourg Law of 17 December 2010 relating to undertakings for collective investment (the “Law of 17 December 2010”). An investment in investment funds, as with all securities and comparable financial assets, carries the risk of capital or currency losses. The price of fund units and income levels will therefore fluctuate and cannot be guaranteed. The costs associated with fund investment affects the actual performance. Units should solely be purchased on the basis of the statutory sales documentation (Key Investor Information, sales prospectuses and annual reports), which can be obtained free of charge on the website www.ethenea.com or from the fund management company ETHENEA Independent Investors S.A., 16 rue Gabriel Lippmann, L-5365 Munsbach. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information or a solicitation of an offer to buy or sell securities. Contents have been carefully researched, compiled and checked. No guarantee for correctness, completeness or accuracy can be provided. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information, or an offer to buy or sell securities. The contents have been carefully researched, compiled and checked. No guarantee can be given for correctness, completeness or accuracy. The information includes past data which are no indicator of future performance. The management fee, custodian bank fee and all other additional costs are taken into account in the calculation of the unit price as stated in the provisions of the contract. Performance is calculated using the BVI method (German federal association for investment and asset management), which means that the calculations do not include an issuing charge, transaction costs (such as order fees and brokerage fees), custodian bank fees, or other management fees. Including the issuing surcharge would reduce performance. The performance shown is not a reliable indicator of future performance. Munsbach, 04/08/2020