Ask the experts – questions stirring our clients (and the financial markets)
We are always available to answer our clients’ questions and concerns regarding their portfolios. Once every quarter, we summarize clients’ most frequently asked questions and our experts’ answers and give you firsthand insights into our asset management and investment advisory operations.
Supply-chain problems, more expensive raw materials – how long will prices continue to rise, and what role does the shortage of skilled labor play?
Kaiser Partner Privatbank: Inflation in the USA soared to 7.5% in January, roaring to its highest level in 40 years. Inflation in Switzerland and the Eurozone has also recently climbed to readings last seen years or even decades ago. Everywhere one looks, data points have continued to surprise (significantly) on the upside lately – the apex of inflation anticipated at the start of this year is nowhere to be seen thus far. In fact, the general increase in prices has gradually broadened in recent months. In the USA, for example, inflation has since surpassed the Federal Reserve’s 2% target for around 90% of the items in the basket of goods and services. Inflation is also increasingly broader-based in Europe. What’s set to happen next with prices?
We still expect to see a continual pullback in inflation rates during the course of this year (starting from February or March onward) for two reasons. One is simple base effects, i.e. year-on-year (price) comparisons with an ever higher starting point. Moreover, we have observed lately in a variety of indicators (freight rate indices, subcomponents of purchasing managers’ indices) and anecdotes from the recent corporate reporting season that supply-chain obstructions are gradually easing. Furthermore, another driver of (US) inflation over the past year – the market for used cars – has already seen a mild pullback in prices lately. But the upward price pressure isn’t relenting everywhere. Slow-reacting US housing rent prices will probably continue to rise for a while. The danger of a wage-price spiral also appears particularly pronounced in the USA and has already started to spin. Inflation in the USA and Europe is thus unlikely to return to pre-pandemic levels so quickly. Arguments for inflation staying persistently stuck above central banks’ 2% target have mounted. Alongside the point raised by the European Central Bank itself about the costs of the green transformation, those arguments particularly also include tight labor market conditions and the shortage of skilled workers, which should put jobholders in Europe as well in a better wage negotiation position in the medium term. Companies will then face a choice between paying a higher “price” in the form of either wage hikes or lost business due to staffing shortages. As long as somewhat higher inflation in the future stays within a range between 2% and 3% and inflation expectations nevertheless remain anchored close to central-bank targets, this arguably would not pose a problem either for the economy or the financial markets. This scenario, however, would require heightened vigilance by central banks because if financial markets’, businesses’ and consumers’ inflation expectations overshoot on the upside, they would have to vigorously tighten the interest-rate screw, which would significantly increase the risk of a recession and send equity markets tumbling.
Where is the apex?
Inflation looks set to turn downward soon
Sources: Bloomberg, Kaiser Partner Privatbank
Are central banks “behind the curve”? What interest-rate policy are the markets pricing in, and how realistic are those market expectations?
Kaiser Partner Privatbank: In the face of overshooting inflation rates, central banks on both sides of the Atlantic are proverbially “behind the (interest rate) curve.” This accordingly sparked hectic verbal maneuvering toward a distinctly more hawkish stance among Fed and ECB officials in recent weeks. This U-turn has since been (over)abundantly priced in on the interest-rate markets. They are pricing in around six quarter-point rate hikes by the Fed by the end of this year. But the markets don’t believe that the Fed is capable of going much higher. Afterwards they see only limited rate-hiking potential left for 2023 and even a return to rate cutting from 2024 onward. Meanwhile, in early February the markets anticipated an initial 10-basis-point rate increase by the ECB by as early as July followed by another three hikes by the end of this year. How realistic are those expectations?
We consider the Fed rate-hiking path priced in to be entirely realistic. Nowhere is the economic recovery farther advanced than in the USA, and that country is facing the tightest labor market and the greatest inflationary pressure. Raising the federal funds rate to 2%, up to the lower bound of the “neutral” interest rate (at which a national economy can grow sustainably without inflationary pressure, according to the textbook definition), which the Fed itself hypothesizes to lie at a little less than 2.5%, is advisable in any case. The rate-hiking pause priced in afterwards could also actually materialize because the Fed will first want to observe the effects of the rate increases, and the significant pullback in inflation rates projected for the first half of 2023 could give the Fed precisely the time it needs to do that. The trickiest question is what happens afterwards. At the moment, the markets are expecting that either the neutral interest rate in the USA is unusually low or that the Fed will once again capitulate to weak equity markets and/or will stifle the downturn and the risk of a recession will massively increase from next year onward. What’s not priced in at the moment, in contrast, is the alternative scenario in which inflation resumes rising from late 2023 onward after having taken a breather, forcing Fed officials to undertake further rate hikes. Such a development is still a tail risk for now, but it could turn into more than just a negligible variable in the quarters ahead.
Unlike the situation in the USA, we consider the market expectations regarding the ECB overblown. Three rate hikes or even more for 2022 are clearly overkill. For one thing, inflationary pressure in the Eurozone is not as high as in the USA. Moreover, an output gap (still) exists, and the national economies of the Eurozone have not yet returned to their pre-pandemic growth path. Furthermore, after years of undershooting its 2% inflation target, the ECB has comparatively greater leeway to tolerate a temporary overshooting of inflation. ECB President Christine Lagarde also cannot disregard developments on the Eurozone’s periphery and concerning the bonds of its southern member states, which currently are reacting sensitively to even the faintest signs of monetary policy tightening. And finally, the right sequence of withdrawing liquidity is also important: bond purchases should be brought to an end before any rate hikes, and doing that takes some time. So, in our view, an initial rate hike by the ECB at its December policy meeting followed by additional (and more than currently expected) rate hikes in 2023 and 2024 is more realistic because the output gaps will probably close next year and this will likely generate more “homemade” inflation. Upward pressure on wages is then also bound to increase. And last but not least, the Eurozone periphery should grow into a stronger position in the quarters ahead, in part because disbursements from the NextGenerationEU recovery fund will have trickled through to the economy by then, likely making it more resilient to a somewhat more restrictive monetary climate.
On the verge of an interest-rate reversal
Rates are still low
Benchmark interest rates
Sources: Bloomberg, Kaiser Partner Privatbank
How enduring is the sector rotation from technology to cyclical stocks?
Kaiser Partner Privatbank: Value stocks have significantly outperformed growth stocks in recent weeks. The energy and financial sectors in particular have posted above-average gains. The technology sector, meanwhile, has been the worst laggard year-to-date. The rotation from growth to value has particularly been caused by the recent movements in interest rates and bond yields. Expectations about the speed and magnitude of the upcoming policy rate hikes by the US Federal Reserve and other central banks have increased considerably since the start of this year and are accordingly reflected in short- and long-term market interest rates. Growth companies’ projected revenue and earnings in the distant future are now being discounted with higher interest rates than before, which is putting pressure on valuations. This is fostering a rotation into much cheaper value stocks, some of which also directly benefit from higher interest rates (and higher inflation). On top of that, the price of oil is a special factor that has especially been giving the energy sector a big lift lately. Will value stocks continue to outperform in the near future?
The answer to that question is dichotomous. In the near term, there’s a lot suggesting that we should expect to see a small growth revival at first because growth stocks are significantly oversold from a technical analysis standpoint and have long since lost their status as being investor favorites. According to a survey of fund managers by BoAML, institutional investors are currently deeply underweight the technology sector to an extent last seen more than a decade ago. This jibes with the data from a recent analysis of the positioning of hedge funds by Goldman Sachs. A near-term comeback by growth stocks in parallel with a consolidation on the interest-rate market therefore wouldn’t be surprising. However, there’s something more important than these rather tactical considerations: the medium- to-longer-term perspective. With regard to that time horizon, we have to note that growth stocks are still relatively expensive despite their recent downward rerating, whereas value stocks remain on the cheap side despite their upward rerating. The value-to-growth ratio thus has a lot of upward leeway from a valuation standpoint. A resumption of the rotation from growth to value in the medium term would also be supported by corporate earnings. Analysts’ earnings estimates and revisions indicate that growth companies appear to be losing their exceptional status as being earners of much higher-than-average profits. But it’s bond yields that arguably have been and remain the biggest driver of an outperformance by value stocks. Here we see further upside potential in the quarters ahead. Even though we are close to peak inflation right now, long-term nominal and real interest rates look set to continue climbing, which would benefit the value factor. The upshot is that the recent outperformance by value stocks is more than just a flash in the pan. It accordingly may make sense to pursue a rather balanced style allocation with your investment portfolio and to neutralize potentially existing overweights in growth stocks in the weeks ahead. In any case, attractive value stocks from the energy, basic materials and financial sectors definitely belong in a diversified portfolio, in our view.
Still more upside potential in the medium term
MSCI World Value vs. MSCI World Growth
Sources: Bloomberg, Kaiser Partner Privatbank
US equity markets have been underperforming lately. Does this mark the start of a trend reversal? What are the implications for investors?
Kaiser Partner Privatbank: The S&P 500 index advanced 28% last year and once again outperformed other regions of the world by multiple percentage points. A look back at the last ten years is even more striking – during this period, the aggregate annualized return on US blue chips was double the return on the MSCI Europe index and was even three times higher than that of MSCI Emerging Markets index. So, the US market’s quite substantial underperformance year-to-date, which has a direct connection with the sector and style rotation describe above, is merely a small blip in the long-term trend. However, there’s some evidence now suggesting that if this trend doesn’t necessarily reverse, it should at least come to a halt and that the phase of US superiority is already over. The valuation of the USA relative to other regions stands at an all-time high, even when the different sector weights are taken into account, and is due for a correction. Moreover, technological innovations, which have long especially benefited US stocks given the country’s large number of technology companies, will continue to be a growth driver in the future, but is likely to increasingly give a boost to other sectors as well around the world. Meanwhile, the fundamentals have clearly improved for sectors like financials (higher interest rates), energy (higher energy prices), telecoms (less regulatory pressure) and utilities (energy transition), which have a higher weight in stock indices outside the USA. Altogether, the biggest driver of US outperformance – earnings growth – looks destined to converge between the USA and other regions. But the performance side of the medallion isn’t all that points to a tempering of US euphoria, so does the risk side because the high concentration of the US market increases its vulnerability. More than 20% of the weight of the S&P 500 index is made up by five giant technology companies, some of which are confronted with a risk of facing tightening regulations, higher taxes and headwinds to their business models (Facebook). Investors should be aware that US stocks make up almost 70% of the MSCI World index and that there is thus substantial concentration risk in this frequently used benchmark as well. In recent years, this has mostly helped the performance of passive index products. In the future, however, this growth and technology tilt and the single-stock risk in the US market could prove to be a detriment to passive index products and benchmark-tracking strategies. This makes a case for active strategies that can implement a deliberate deviation from reference indices.
The end of the outperformance…
…or a pause in the long-term trend?
Performance of regions year-to-date (in local currencies)
Sources: Bloomberg, Kaiser Partner Privatbank
Rising inflation, an impending interest-rate reversal, lofty market valuations and geopolitical conflicts – a lot of issues are worrying investors right now. Should stocks be underweighted in these uncertain times?
Kaiser Partner Privatbank: Contrary perhaps to some people’s personal perceptions, the times at the moment fundamentally aren’t all that unusual. There actually is always an array of macro data, geopolitical developments and media bluster that create a lot of noise and can deter an investor from rigorously sticking to his or her investment strategy. At the moment there is not much of a case for underweighting the equities asset class. Quite the contrary, in fact, stocks remain almost a compulsory investment for those investors who are striving to grow their wealth and even for those who are safety-minded and “only” wish to preserve the purchasing power of their assets because even though fixed-income yields have edged upward, the significantly negative real rate of interest and the expectation that market interest rates will tend to climb higher (which is synonymous with price declines) continue to make bonds very unattractive and not a genuine investment alternative. Furthermore, the prospects for stocks remain constructive, just a little less so than during the last two years. Monetary policy, for example, will remain accommodative in the quarters ahead despite the upcoming policy rate hikes by central banks, and corporate earnings will climb higher. However, the characteristics of the market change during a rate-hiking cycle: valuations tend to pull back, volatility picks up, and further share-price advances happen more slowly – investors need to be more patient. The time to underweight stocks doesn’t arrive until central banks raise interest rates to restrictive levels and the next recession looms. There are hardly any signs thus far that this scenario is in the offing in the next 12 to 18 months.
Do you have any further questions? Then please feel free to contact us.