Ask the experts – questions stirring our clients (and the financial markets) in August 2022
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.
Sustainability
The Democrats in the USA have pushed through the passage of the Inflation Reduction Act. What’s to be made of this legislative package, and how does it benefit our climate?
Kaiser Partner Privatbank: The Inflation Reduction Act implements major election campaign promises by President Joe Biden with regard to climate-protection, fiscal and healthcare policies. However, it is a compromise settlement and a significantly downsized version of the original Build Back Better program, and it ultimately passed the US Senate by a razor-thin 51-50 vote. Experts definitely have their doubts about the extent to which the act will live up to its name and whether it will noticeably lower inflation on balance (in part by reducing drug prices). However, it appears plausible that it will shrink the USA’s federal budget deficit by a total of USD 300 billion over the next ten years particularly by raising taxes. But by far the most important signal sent by the legislative package concerns global climate policy because the USA has demonstrated that the world’s biggest economic power intends to make a substantial contribution to limiting global warming and wants to uphold the credibility of the Paris climate agreement. The power of this signal shouldn’t be underestimated. One highlight of the legislation is its pursuit of the ambition to install 950 million new solar panels and 120,000 new wind turbines by 2030. If the legislation enacted to promote green technologies is successfully implemented, greenhouse gas emissions in the United States will reportedly drop 40% below their 2005 level by 2030.
What may sound like a lot at first actually is disillusioning on closer observation because compared to efforts by the European Union, where emissions are slated to be slashed 55% below their 1990 level by 2030, the USA’s target really is rather modest, amounting to “just” 30% of the EU’s planned emission cuts. Despite its positive signaling effect, the Inflation Reduction Act is insufficient to reach international climate goals. The act’s target figures arouse criticism, but so does the way in which the US government plans to reach those targets. Unlike the Europeans, who are relying on efficiency standards for industry, quotas for renewable energy and especially CO2 pricing, the Americans are concentrating on less efficient subsidies. Of the USD 370 billion of climate-related spending (over ten years) in the legislative package, more than half is earmarked for subsidies for solar, wind and hydroelectric power as well as for other renewable energy sources. Billions more are earmarked to fund new rebates on electric vehicles. The absence of CO2 pricing merits criticism and could cause problems in the medium term if the EU levies a CO2 emissions tariff on imports from 2027 onward, as it says it intends to. The aim of the tariff is to make CO2-intensive imports more expensive to protect European industry from cheap foreign competition. Any country that has a CO2 pricing system similar to the EU’s would have to be exempted from the tariff. But the USA doesn’t have one for now, so a new source of potential trade disputes looms soon.
Riding a political tailwind | “Green” ETF up year-to-date
iShares Global Clean Energy ETF
Sources: Bloomberg, Kaiser Partner Privatbank
Economic activity
Economic output in the USA contracted in the first and second quarters of 2022. Is America now in a recession, or will the US Federal Reserve succeed in engineering a soft landing?
Kaiser Partner Privatbank: Consecutive (annualized) contractions of 1.6% in Q1 and 0.9% in Q2 – according to the “two-down-quarters” rule of thumb, the USA is at least in a “technical” recession at the moment. But it’s far from certain and actually very unlikely that the National Bureau of Economic Research (NBER) – the official arbiter of recessions – will declare the current economic slowdown a recession because for one thing, preliminary GDP growth estimates, which are all we have at this point, are chronically prone to significant revisions. According to BCA Research, there’s a 35% probability that real economic growth for the second quarter will get revised upward into positive territory. Moreover, when determining a recession, the NBER doesn’t just take GDP growth into account, but also factors in a vast array of other economic data points including statistics on the labor market, consumer and business spending, industrial production and real income. All of those components have registered declining growth rates in recent months, but are still well in positive territory. So, the NBER is unlikely to retrospectively define the weak first half of 2022 as a recession.
Even the White House itself felt compelled to publish a blog post (“How Do Economists Determine Whether the Economy Is in a Recession?”) arguably to counter the recession chatter that has led to a new record-high number of Google search queries on the “R” word. The United States not being in a recession at the moment of course doesn’t mean that it won’t slip into one soon. Depending on the analyst and model consulted, there’s a 30% to 50% probability of a recession occurring in the next twelve months. We do not exclude ourselves from the probability guessing game and consider the middle of the aforementioned range a thoroughly realistic estimate because the balancing act that the Fed has to execute is tremendously difficult. In order to lastingly reduce price and wage pressure and push inflation back down to a level of 2% to 3%, the still-booming US employment market needs to be cooled down massively. However, it’s questionable that this can be done without further vigorous interest-rate hiking (possibly to far above the 3% level) and without significantly raising the unemployment rate by at least half of a percentage point, which in the past has invariably resulted in a recession. The path to a soft landing is extremely narrow.
Recession… | …or false alarm?
Economic growth in the USA
Sources: Bloomberg, Kaiser Partner Privatbank
Investment strategy
Equity markets rebounded significantly this summer. Is this merely a bear market rally, or is a new upturn already under way?
Kaiser Partner Privatbank: Bear market rally or new bull market? That’s the big crystal ball question, of course. After bottoming at a level down 24% for the year and pricing in a mild recession at that time, the S&P 500 index’s year-to-date drawdown has since pulled back to 11%. At this level, the market is currently pricing in a scenario in which inflation pressure abates and the US Federal Reserve’s further rate-hiking remains limited to a policy rate level of 3% to 3.5% at the most and then reverts to rate-cutting during the course of next year. This Goldilocks scenario in which economic growth is weak but not too feeble and monetary policy tightens just a bit more and then eases again seems a little optimistic to us. We therefore view the recent rally at best as an initial leg of a drawn-out bottoming process during which the summer lows will get partway retested at least once more. The vibrant dynamism of the rally in recent weeks is partly attributable to investors’ previous ultra-negative sentiment and their corresponding prior underweighting of stocks. Those extremes have since gone somewhat back to normal in the meantime, though, and the rally appears to have lost some air lately also from a technical analysis perspective. At the current share-price levels, many investors can exit the market relatively unscathed with only minor bruises. Meanwhile, the downtrend channels on the S&P 500 and Nasdaq 100 index charts remain intact.
Against this backdrop, we moderately reduced the tactical equity allocation in our portfolios in August. If we observe wide trading ranges in stock indices in the months ahead, which we consider likely to happen, selective buying opportunities are bound to reemerge. So, in this sense, our stance on stocks definitely remains constructive despite the lack of enthusiasm at the moment. We would anticipate a downslide to new lows and a pricewise extension of the bear market southward in the event that the Fed has to tighten the interest-rate screw much more forcefully contrary to expectations, which it would have to do if inflation proves much more tenacious than assumed in the quarters ahead. In such an event, a hard landing of the US economy arguably would be unavoidable. A sharp 20% or more drop in corporate earnings would then likewise be inevitable. A price target of 3,000 points for the US blue-chip index would absolutely be realistic in this scenario. We view this scenario as being more than just a tail risk and are pricing a 25% to 30% probability of it materializing. In light of this assessment, we continue to consider it sensible to use put strategies to hedge equity positions, preferably when they are cheap to acquire and allegedly aren’t needed. We likely find ourselves at such a point right now.
Big obstacle | (Still) intact downtrend channel
S&P 500 index
Sources: Bloomberg, Kaiser Partner Privatbank
Geopolitics
The conflict between China and Taiwan continues to heat up. How great of a risk does this pose, and how should investors position themselves?
Kaiser Partner Privatbank: Tensions between Taiwan and China intensified to such an extent in August that one can by all means speak of a Fourth Taiwan Strait Crisis. It was sparked by an early-August visit to Taiwan by Nancy Pelosi, who is the speaker of the US House of Representatives and thus third in line to the US presidency. Her visit was regarded as a provocation by China, which responded with multi-day military exercises, missile firings, a simulated naval blockade and economic sanctions against Taiwan. Those developments haven’t left any marks on the financial markets thus far, arguably partly because a sudden escalation complete with a Chinese invasion of Taiwan is very unlikely in the weeks ahead. We estimate the probability of such a scenario materializing at “only” around 10% at the moment. It is much more likely that this geopolitical hotspot will continue to simmer over a low flame in the months ahead.
The estimated rather low near-term risk of an armed conflict breaking out is backed by several compelling points. For one thing, China’s saber rattling must be viewed against the backdrop of the upcoming Communist Party Congress this autumn. President Xi Jinping is seeking to secure a third term in office at the party congress, so it is vital to him to stage a show of foreign-policy strength in the runup to the conclave. Moreover, China’s economy is intricately intertwined with Taiwan’s, and it especially is still extremely dependent on semiconductor chips from Taiwan. Harming the island’s economy would have immediate adverse backlashes on Chinese industry. That’s a major reason why the economic sanctions imposed by China to date have tended to be of a symbolic nature (bans on imports of certain food products and the suspension of exports of natural sand to Taiwan). Furthermore, although China has substantially expanded its military capabilities over the last decade, the People’s Liberation Army has little actual war-fighting experience, and a marine invasion is arguably the most difficult tactical military maneuver of all. So as things stand today, it’s likely that China in effect is not capable (yet) of taking the island of Taiwan through military force. And finally, Beijing appears either unwilling or unable to engage in an open confrontation with the USA. China, for instance, heretofore has invariably tended to react defensively to mounting pressure from the USA on trade, technology and financial-market issues and has refrained from resorting to “nuclear options” like selling off US Treasury bonds, embargoing exports of rare earth metals or imposing tougher sanctions on US companies. None of those actions would do much to strengthen China’s position or would even materially harm the country’s economy. Consequently, top Chinese officials have repeatedly warned against “decoupling” from the West and have stressed that China must remain open for business.
However, in contrast to economic matters, China has much less room for compromises on “national security” issues. So, China’s aggressive military exercises, which encroached across the mid-line of the Taiwan Strait and even violated Taiwan’s territorial waters multiple times, could mark the start of a “new normal” in which the danger of miscalculations increases and geopolitical risk thus remains permanently elevated. In the wake of Pelosi’s visit, Beijing appears to no longer recognize Taiwan’s territorial integrity, which significantly degrades Taiwan’s status in relations between the two sides. Chinese pressure against any drive for independence by Taiwan looks destined to increase considerably in the future. Politicians, activists and organizations that champion Taiwanese independence are likely to be punished with sanctions and criminal charges. China probably will continue to tenaciously block Taiwan’s presence in international organizations and will likely step up efforts to undermine Taiwan’s diplomatic relations.
As so often happens, political markets have short legs, and that’s definitely been the case thus far in the context of the China/Taiwan conflict. However, the business press’s interest in Taiwan is understandable because the island and its chip-making behemoth TSMC (Taiwan Semiconductor Manufacturing Company) control a more than 90% market share in leading-edge chips (i.e. chips smaller than 10 nanometers). Nevertheless, medium- to long-term price trajectories for Western semiconductor stocks and the Chinese equity market are determined far more by the economic activity outlook, earnings prospects and monetary policy conditions, which are likely to be unaffected even by continued Chinese saber-rattling at Taiwan. Investors with a long time horizon should therefore acknowledge the geopolitical risk in Asia and keep a close eye on developments there, but at the same time should stick with their investment strategy. We consider up-and-down tactical maneuvering of the risk budget and the equity allocation in line with news headlines an inexpedient and unpromising way to go.
Unfazed | Not an issue for equity markets (yet)
China’s CSI 300 stock index
Sources: Bloomberg, Kaiser Partner Privatbank
Inflation
Where is inflation headed, and is it worthwhile to hedge against rising energy prices?
Kaiser Partner Privatbank: The pleasantly surprising July print of 8.5% instead of the expected 8.7% indicates that US inflation has likely peaked by now. Meanwhile, business and consumers in Europe haven’t yet reached the point of maximum inflation pain, in large part because natural gas and electricity prices have surged again in recent weeks from levels that were already excruciatingly high. The question of whether it is possible to hedge against the high prices and further price hikes seems entirely justified. If it were possible to do so, it would make an economic actor’s budgeting more predictable and would help to set a cost ceiling. Unfortunately, though, this isn’t so easy to do, because in the world of finance, the maxim is “hedge when you can, not when you must.” Or more metaphorically: home fire insurance is very expensive to buy when your house is already burning.
Take natural gas, for example. In Europe it currently costs over ten times more than the average price in 2019 and 2020. The futures market is anticipating that the price level will still be very elevated even a year from now. So, whoever would like to hedge against persistently high natural gas prices can at best lock in a somewhat lower but still historically exorbitant price level. At the same time, though, opportunity costs accrue for such a hedge if the natural gas price a year later has fallen to a much lower level than the hedging price. In that event, you wouldn’t profit on the bottom line because higher prices than actually necessary would have to be paid. However, all of this reasoning is theoretical. In actual real-world practice, it is probably nigh impossible for private investors and all but the biggest companies to implement such a hedge and gain access to the market and the corresponding trading instruments. And even then, it is bound to be extremely difficult to compute the exposure needed to achieve the ultimate objective: a better calculable gas bill. There, in fact, is a much greater risk of saddling oneself with an additional element of uncertainty.
Hedging the price of oil or energy costs for driving a motor vehicle, which theoretically is a bit easier for private investors to do, likewise presents similarly difficult problematics in actual practice. Although gaining access to forward contracts like futures and options is no longer an obstacle nowadays, there’s still the question of how much hedging is needed to cap a personal fuel budget and whether the wholesale price of the crude oil that one would be trading has a direct connection with the gasoline or diesel price at the filling station (answer: it doesn’t). Other problems like roll losses, which go hand in hand with investments in commodity futures and often increase hedging costs, additionally complicate the hedging concept. And it’s generally true in this example as well that even if the hedging is successful, at best you will lock in an already high price level and an expensive cost item for fueling your car but will not effectively lower your expenses.
There is one way above all others to directly remedy and ease the strain on your wallet: by saving energy. Private households can save natural gas by lowering the thermostat setting at home and can save petroleum by forgoing a car trip or two. Saving energy is not as “easy” to do in the business sector in some circumstances, but there as well the current high price level is bound to spur a switch to alternatives and should ultimately lead to efficiency gains. Some companies, though, will likely fail to master this challenge.
No free lunch | The futures market is anticipating high prices also in 2023
Futures price and futures curve for benchmark European natural gas (TTF), in euros per MWh
Sources: Bloomberg, Kaiser Partner Privatbank
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