Ask the experts – Questions stirring our clients (and the financial markets) in August 2023
We are always available to our customers for concerns and questions about their portfolios. As a representative of this, once a quarter we summarize the most frequently asked customer questions and the answers provided by our experts, thus giving you direct insights into our asset management and investment advisory services.
Market interest rates (and bond yields) have risen substantially over the last 18 months. Should I as an investor (with the USD, GBP, or EUR as my reference currency) continue to take on any risk at all associated with stocks or alternative assets?
Kaiser Partner Privatbank: A similar question was asked of us back at the start of this year. At that time, we explained why investors shouldn’t put all of their eggs in a basket full of bonds despite the rise in market interest rates. To summarize the explanation: (1) the comparatively high indicative yields on bond funds and bond ETFs are not guaranteed, but instead depend on the future trajectory of interest rates, and (2) the act of buying and holding individual bonds until their maturity date entails its own set of pitfalls and risks. Central-bank policy rates and the yield levels on fixed-income markets have climbed higher since February. At the same time, equity markets have performed well, particularly in the USA, and have become even more expensive than before relative to bonds. Our reservations against holding a portfolio concentrated on bonds have lost none of their validity, however. On the other hand, though, a different asset category – cash and money market-like assets – that for years had practically been perceived as an unviable investment alternative has been moving increasingly into the foreground. Given the very short duration of cash and money market-like assets, investors in this asset segment receive high yields these days without having to put up with any notable volatility in exchange. In fact, rarely has parking one’s money in cash been as lucrative as it is today. So, should investors now go all in on cash? That wouldn’t be advisable, not just because doing so would violate a cardinal principle of any long-term investment strategy – i.e. diversification – but also because shareholdings in businesses, no matter whether via public or private equity, still promise substantially higher returns over a time horizon of more than five years. Moreover, the interest-bearing asset sector outside the money market is also very attractive at the moment. Government bonds, for example, are a good hedge against a recession – if one materializes, double-digit precent price gains on long-term sovereign debt securities can be expected. The private credit segment, in turn, is profiting from the increased policy-rate level just like money-market investments are, but it offers a hefty risk premium on top of that, making double-digit precent returns a reality already right now. The upshot is that every investor should hold a certain cash position in his or her portfolio at all times. It enables flexibility and allows an investor to seize sudden investment opportunities. Given the high interest-rate level, a cash position could currently make up even 10% to 20% of a portfolio at present. However, even larger holdings of money market-like assets aren’t advisable unless they are earmarked for other purposes (e.g. for investments or consumption) within the next two to three years.
Solid returns… | …can be had these days without taking on substantial risk
Indicative yields and volatility for iShares bond ETFs
Sources: iShares, Kaiser Partner Privatbank
The inflation rate in the USA ticked upward in July. Is the recent pullback in inflation already over?
Kaiser Partner Privatbank: The monthly (US) inflation data releases regularly contain heaps of data that allow inflation optimists and pessimists alike to cobble together their own arguments to fit their personal biases or intentions using the slice-and-dice principle. We, however, continue to try to take as neutral a standpoint as possible in the often heated inflation debate. In our outlook for 2023, we expected inflation in the USA to recede faster this year than many were anticipating. Eight months later, we can put an affirmative check mark next to that “forecast.” However, the positive-case scenario outlined in our outlook at that time, under which inflation moves back to within sight of the 2% target by as soon as toward the end of 2023, is unlikely to come true. The uptick in the US inflation rate to 3.2% in July (June: 3.0%) has interrupted the yearlong disinflation process for the time being, and the disinflation path looks set to remain bumpy in the months ahead.
Merely transitory after all in the end | Disinflation is making progress
Headline inflation and core inflation in the USA
Sources: Bloomberg, Kaiser Partner Privatbank
There are a number of reasons why. For one thing, the year-earlier comparison base effect, which has been exerting a disinflationary impact thus far, is petering out and will even turn inflationary again in the near term because the July 2022 comparison base for the annualized inflation rate in July of this year was distinctly low. A last fat chunk of inflation had dropped out of the statistics in June (see chart). From a strictly mathematical standpoint, in August, the addition of the last 12 monthly inflation readings versus July is likely to result in another small uptick in the next inflation report. Meanwhile, energy prices could likewise become a mild inflation driver again from autumn onward. The rate of change for the price of oil, for example, is already positive on both a three- and six-month comparison time frame. If the price of WTI crude oil holds steady at its current level of around USD 80 per barrel in the week ahead, a 12-month comparison would also resume exerting an inflationary effect from September onward. In all likelihood, it will take at least until spring 2024 before we start to see inflation rates of 2.5% and lower in the USA. But it is just as clear, though, that the disinflation trend has merely paused for the moment because more is definitely in the pipeline. If rent prices, which account for more than one-third of the total cost of the imaginary basket of goods, are stripped out of the inflation calculation, year-over-year headline inflation already stands at just 1.0% today. Since the rent-price component lags the trend in housing ownership prices (which is almost flat by now) by around a year, today it can already be projected that another burst of disinflation is just around the corner.
Bumpier again in the near future | Inflation looks set to stay stubborn in the near term
Monthly inflation rates in the USA
Sources: Bloomberg, Kaiser Partner Privatbank
However, it remains highly uncertain whether the US Federal Reserve’s 2% inflation target will actually already be reached during the course of next year, and much will probably depend on the recession question in particular. Inflation rates below 2% are practically a safe bet only in the event of a recession. If a recession doesn’t come to pass, drivers that we have cited in the past could cause inflation to plateau a bit above central bankers’ target level. Those inflation drivers will include rising costs for climate protection, a structural shift toward non-automatable services (in the healthcare sector, for instance), deglobalization, and increased statist (less efficient) industrial policy. For (large parts of) Europe, add a shrinking workforce to this list. The bottom line is that in the wake of a string of surprisingly lower-than-expected inflation readings in recent months, the near-term inflation outlook is now rather symmetrical again. But after some bumpy months ahead, we are likely to see a return to inflation figures with a 2 in front of the decimal point toward the end of this year at least in the United States. The Eurozone is lagging around a half-year behind this trend. One persistent exception is Switzerland, where inflation already stands at just 1.6% today, though admittedly the Swiss National Bank is pursuing the most ambitious inflation target (aiming more for 1% as opposed to the 2% level being sought by the Fed and the European Central Bank).
Darned mathematics | The base effect
WTI crude oil price and rates of change
Sources: Bloomberg, Kaiser Partner Privatbank
Private equity strategies dismally underperformed public equity markets in the first half of 2023. Are the best days over for this asset class?
Kaiser Partner Privatbank: The ever better known private equity asset class, which is becoming increasingly accessible to retail investors, has its peculiarities. In the last edition of “Ask the Experts”, we demonstrated that the valuations of privately held companies are not “artificial”, contrary to some skeptics’ suspicions. They in fact are the product of clearly defined (and rather conservative) valuation models that by design result in less volatile valuation fluctuations and a certain degree of inertia. Private equity thus stands in contrast to public equity markets, where a variety of near-term factors ranging from macro- and microeconomic news, central-bank decisions, and stock market TV shows to commentaries in financial blogs and Reddit chatrooms can influence stock prices during every trading day. Private-market assets’ valuation inertia is a feature, not a bug. In down markets, this actually is even an appreciated and desired advantage of this asset class. In 2022, when the world equity market ended the year in deep double-digit negative territory (–19.5%), private equity performed immensely better with a decline of just 4.3% (according to data from Cambridge Associates) thanks to its inherent valuation inertia and thus fulfilled its promise of being an outperformer in tough times. However, private equity assets are now lagging behind considerably this year.
Where are my returns? | A (further) example of the private equity inertia effect
Performance of private equity vs. public equity
Sources: Quarterly reports, Cambridge Associates, Bloomberg, Kaiser Partner Privatbank
Due to the slow reporting by private equity managers (there is a certain degree of inertia here as well), the performance figures for the first half of 2023 are not yet complete. However, it is already possible to conduct a preliminary performance evaluation based on the half-year results posted by the big US exchange-listed private equity firms (Blackstone, KKR, Carlyle, Apollo, and TPG). They reported respective average increases of 2.9% and 2.8% in the value of their private equity portfolios for the first two quarters of 2023, far behind the respective quarterly gains of 7.3% and 6.3% registered by the MSCI World index. What’s unusual about this performance trend is: nothing. In fact, in the past there have always been occasional 12-month periods during which public equity markets have significantly outperformed. Most of them have occurred in the wake of severe selloffs. Some prominent examples are the periods from April 2003 to March 2004 (after the bursting of the dotcom bubble), from April 2009 to March 2010 (in the wake of the great financial crisis), and from January 2019 to Dezember 2019 (after an almost bear market caused by the last US rate-hiking cycle). However, those periods were followed each time by a comeback by private equity, which then consistently went on to outperform over the somewhat longer term. A look at rolling ten-year returns over the last 22 years (encompassing a total of 32 years of performance data) reveals that there were only two brief points in time (2010 and 2018–2019) during which private equity fell behind liquid equity markets (see chart).
Outperformance… | …in the long run
Rolling 10-year returns
Sources: Hamilton Lane (January 2023), Kaiser Partner Privatbank
The current outperformance by public equity markets will likely prove once more to be just a brief episode in retrospect. Public equity markets’ “lead” at the moment will likely even facilitate a comeback by private equity. After the IPO market shut down almost completely in 2022 as a result of weak stock markets and the mergers-and-acquisitions market cooled down considerably last year, the recent turnaround looks set to revive IPO and M&A activity here and there, thus making it easier again for private equity managers to execute exits. The increased valuations of publicly traded companies not only strengthen their currency (namely, their stock price) for taking over privately held businesses, but also make it more tempting for the latter to sell themselves to interested buyers or to competitors for a high price. The upshot is that it is too soon to intone a funeral dirge for private equity. On the contrary, in fact, we expect that this asset class will be capable of continuing to outperform public equity markets by 300 to 500 basis points in the future on the back of its typical illiquidity and complexity premium. Since the US equity market in particular has already become comparatively expensive again as a result of the recent rally and its further upside potential is a bit on the constrained side for the next few years ahead, the relative performance outlook for private equity actually even looks exceptionally attractive at the moment (see chart).
Outperformance… | …especially in difficult times
Average 3-year excess return on private equity
Sources: Hamilton Lane (January 2023), Kaiser Partner Privatbank
US federal debt
Rating agency Fitch recently downgraded its assessment of the United States government’s creditworthiness to AA+. What are the near- and long-term implications of the rating downgrade on the financial markets? And is the triple-A club in danger of shrinking further in the future?
Kaiser Partner Privatbank: The only thing surprising about the decision by Fitch to downgrade the United States government’s credit rating to AA+ was the timing because the US economy is growing faster than expected at the moment and more and more economists are walking back their predictions of a dreaded recession (for now). In view of the last political spectacle surrounding the US debt ceiling, Fitch had already signaled in May that the top AAA rating was up for debate when the agency lowered the outlook for the USA to “negative” at that time. This means that of the big three US credit rating agencies, Moody’s is the only one that continues to grant the top rating to the United States. In 2011, analysts at Standard & Poor’s (S&P) were the first to turn their rating thumbs downward. That time as well, a fierce showdown in Washington, D.C., over the federal debt limit was a major reason for the credit rating downgrade. Aside from that, though, the market climate and macroeconomic environment were entirely different than today. Policy interest rates were close to zero, deflation risks prevailed, and the Eurozone was going through its own debt crisis.
Today the situation is completely different: “inflation” has been the name of the risk for the last two years, and it has prompted the US Federal Reserve to raise its benchmark lending rate by 5 percentage points in near-record time. Over the last 11 years, the US federal debt pile has swelled from 65% to around 100% of the country’s annual economic output. Despite the solid state of the US economy to date, the federal budget deficit looks set to continue soaring in the years ahead at a lofty level equal to around 6% of GDP, as high as during the great financial crisis. The US Congressional Budget Office (CBO) projects an increase in the US federal debt load to 119% of GDP by 2033. Its ultra-long-term forecast, which by nature is subject to a great degree of uncertainty, envisages an increase to a whopping 195% of GDP by 2053. The rise in the interest-rate level makes servicing that debt ever more costly for the US federal government. Annual interest payments look set to almost double to USD 1 trillion, or to 12%–15% of total federal tax revenue, over the next five years. Alongside these quantitative facts, the “quality” of US politics has also deteriorated markedly over the last decade. Polarization has continually intensified, and last-minute solutions have become a daily routine by now. Faith in the ability of Democrats and Republicans to ever get the USA back on a sound fiscal path is in the dumper.
Unsustainable | When will the mountain of debt become too big?
US federal debt load and debt service (including projections)
Sources: CBO, Kaiser Partner Privatbank
And yet, there is little cause for concern in the near term. A default by the US federal government is just as improbable as a lasting adverse impact on the US dollar, which remains the world’s reserve currency for the time being despite the deficits and piles of debt. The rating downgrade at the start of August accordingly sparked few reactions on the financial markets. But worry wrinkles may deepen soon. The federal budget for the next fiscal year must be passed by September 30, and the current acute focus on public finances could lead to renewed disputes over expenditures and spending cuts in the weeks ahead. Another government shutdown cannot be ruled out. As in the past, a shutdown would cause nervousness and volatility on the markets to spike, albeit temporarily. However, the most germane issue is the real long-term consequences of the continually deteriorating fiscal state of the USA. Unless there is a genuine change in fiscal course, in ten years the country could reach a point where mandatory expenditures and interest payments exceed total tax revenue and all discretionary spending must be funded through borrowing. Investors then may want to demand higher risk premiums in the future (and maybe even a lot sooner) for holding US sovereign debt securities, which would drive interest expenses even higher. In a (baseline) scenario of continually rising federal debt, the independence of the US Federal Reserve could even become endangered at some point. Perhaps the Fed would then have to lower interest rates under political pressure solely to safeguard the USA’s ability to service its debt.
Conclusion: The downgrade by Fitch is a reminder of the long-term challenges posed by the growing mountain of US federal debt. They will have to addressed someday (or else the country will have to accept the resulting consequences). The important thing is that the downgrade will not force most investors in the bond market to sell US Treasury securities. Most institutional asset management mandates have been amended since S&P’s downgrade of the USA’s credit rating in 2011. Within those mandates, US Treasurys are now expressly designated as risk-free assets when setting investment limits, which is a significant change from earlier rules that made it compulsory to hold triple-A-rated assets. Whoever nonetheless seeks alternatives on the US bond market will find slim pickings there. Johnson & Johnson, Microsoft, and Apple are the only issuers of US corporate bonds bearing a triple-A rating. The selection to choose from widens if other countries (and currencies) are included. There are still nine countries, mind you, that meet the gold standard and receive the top credit rating from all three major rating agencies. The public debt load in those nine countries amounts to a comparatively low 40% of GDP on average, and the rating outlook is stable for all of them. A further shrinking of the triple-A club is not in sight at the moment. The Principality of Liechtenstein, by the way, has a special status in this context. It possesses a triple-A rating from S&P and has no public debt. Investors, however, cannot capitalize on this unique set of circumstances through an investment in Liechtenstein government bonds because they accordingly do not exist. But they can arguably benefit from safe-haven Liechtenstein through the choice of their bank account location.
An exclusive club | And then there were nine
Countries with a triple-A sovereign credit rating (and the USA)
Sources: Bloomberg, Kaiser Partner Privatbank
The rise in interest rates has put the real estate markets in many industrialized countries under pressure. Is “concrete gold” still an attractive asset class (or has it become one again)?
Kaiser Partner Privatbank: There is hardly an asset class as confusingly complex variegated as the one called “real estate”. Strictly speaking, the real estate investment universe in the industrialized countries comprises dozens of regional markets and various categories (e.g. housing and commercial property), as well as a wide array of subcategories (e.g. office space, retailing properties, logistics properties, etc.). There are also oodles of possible investment options. Alongside a broad spectrum of exchange-traded and unlisted investment vehicles, one’s own home (if you own one) also counts as exposure to real estate from an investor’s perspective.
The global rise in interest rates over the last one-and-a-half years or so has affected the various real estate segments and investment vehicles to differing degrees and at different speeds. One of the most sensitive housing markets, for example, is Sweden, where a combination of high personal debt, soaring real estate prices, and a high penetration of variable-rate mortgages has already caused housing prices to drop 13% over the past year. Switzerland’s housing market is much stickier, in contrast, and has actually registered a slight increase in prices to date. Fixed interest rates are locked in for much longer on average in Switzerland, and there accordingly is considerably less sensitivity to changes in market interest rates. Moreover, the supply of housing in Switzerland is very tight, and immigration to the country is persistently high (and is even climbing further at present). So, any property-price correction in Switzerland in the quarters ahead is likely to be in the low single-digit percent range. The situation looks different, though, for real estate held not for a landlord’s own use, but instead for its function as “concrete gold”, i.e. as a financial investment asset for (institutional) investors. On one hand, the raised interest-rate environment has reopened many more opportunities for investors, and on the other hand, financing and building costs for new construction projects have risen considerably. The consequence of this for the investment property market (commercial real estate and multifamily apartment buildings), which is much more dynamic than the owner-occupied property market, has been a price decline of 12% even in Switzerland over the last 12 months.
Sideways | Swiss real estate was once more attractive
SXI real estate indices
Sources: Bloomberg, Kaiser Partner Privatbank
Now, what should (retail) investors to do with this bunch of information? It’s basically true for them as well that many more alternatives can be found today in traditional and alternative asset classes under the new interest-rate regime. So, unlike in times of ultralow interest rates, it is no longer appropriate to overweight real estate assets these days. But there are still opportunities here and there for some investors depending on one’s risk appetite and reference currency. For example, for investors with the Swiss franc as their reference currency, exchange-listed real estate funds focused on Switzerland are still more promising than Swiss Confederation bonds in view of their solid payout yields. Generally speaking, publicly traded real estate investment vehicles tend to be more attractive than illiquid products at the moment because they have already priced in the increase in long-term market interest rates, which is likely as good as over at the latest yield level of 4.3% on 10-year US Treasurys. Taking publicly traded US real estate investment trusts (REITs) as an example, one can already observe this year that liquid financial markets have constantly been looking ahead to the future and have separated the wheat from the chaff by now. Consequently, REITs focused on logistics properties or data centers have registered significant share-price gains since the start of this year while the share prices of office REITs have continued their downward adjustment, because alongside interest rates, major macroeconomic and societal trends also have an impact on asset prices in the different real estate segments. The above price trends, for instance, reflect the trend toward increased remote work from home offices and the rapidly growing importance of artificial intelligence. Meanwhile, the fact that opinion polls like the Bank of America fund manager survey indicate that market participants are very skeptical about REITs and are positioned lightly in them portends limited downside potential. Illiquid products like private real estate funds likewise should profit from these secular trends in the long run, provided they are properly managed. But in contrast to the liquid markets, illiquid real estate investment instruments are still in correction mode at the moment, so there’s no hurry for investors to snap them up right now.
Location, location, location… | …and property use class!
Performance of US REIT indices
Sources: Nareit, Kaiser Partner Privatbank
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