Ask the experts – Questions stirring our clients (and the financial markets) in November 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.
The Sahm Rule is frequently getting talked about these days in the context of the US employment market. What is the Sahm Rule all about?
Kaiser Partner Privatbank: A big part of an economist’s job profile is to predict the next recession. A whole slew of indicators and rules that have proven helpful in foretelling recessions have amassed over the course of decades. The resulting anthology of indicators and rules includes, for example, the oft-cited US yield curve, which gives reason to expect a recession when it inverts so that short-term market interest rates exceed long-term rates. Every recession over the last 50 years has been preceded by an inversion of the yield curve, albeit with considerable time variances ranging from a few months to up to two years. The Sahm Rule, named after former US Federal Reserve economist Claudia Sahm, bases itself on the US unemployment rate and has been an equally reliable recession indicator in the past. The Sahm Rule says that when the 3-month average unemployment rate rises a half percentage point or more above the low of the prior 12 months, a recession is about to start (or usually has already begun). The logic behind the Sahm Rule is an easily understandable self-reinforcing process: when unemployment increases (slightly), aggregate consumer spending decreases and businesses lose customers and thus need fewer workers. This causes more unemployment, and so on. The vicious cycle continues, the unemployment rate climbs ever higher, and a recession inevitably follows. Even in mild recessions like in 2001, this feedback loop caused unemployment in the USA to increase by at least two percentage points.
Upward henceforth? | The Sahm Rule will likely be triggered soon
US unemployment rate
Sources: Bloomberg, Kaiser Partner Privatbank
After the rise in the US unemployment rate to 3.9% in October, the 3-month average currently stands at 3.83%, 0.33 percentage points above the 12-month low. So, right now it’s unlikely that the US economy is already in a recession. But it would no longer take much to tip it into a recession. If unemployment climbs to 4% or higher in the months ahead, that in all likelihood would trigger the Sahm Rule – it’s purely a matter of mathematics. But will a recession then really materialize? This is not certain. Perhaps the Sahm Rule will even prove useless in the current post-pandemic economic cycle. It wouldn’t be the first time something like this happened. The US economy, for instance, contracted for two consecutive quarters last year without the National Bureau of Economic Research (NBER) officially declaring a recession – that, too, was a novelty. The contraction was sparked by a sharp plunge in net exports and by big fluctuations in inventories, which were both caused by global supply chain disruptions.
Recession indicators like the Sahm Rule are nothing more and nothing less than empirical regularities and are not laws of nature. The pandemic caused distortions and displacements that persist to this day. After more than two years of labor shortages, workers are coming back into the labor force faster than new jobs are being created at the moment. The labor force participation rate for women in their prime working age has reached an all-time high, and workers with disabilities and Afro-American men have also notched historic employment gains this year. Moreover, after an interruption during the pandemic, immigrants on work visas have resumed flowing into America now. An increasing supply of labor is perhaps necessary in the current cycle to restore an equilibrium in the labor market even if it translates into somewhat higher unemployment rates at first. On the road back to normalcy, unemployment could climb above 4% for a while this time, triggering the Sahm Rule, but not a recession. Next year it will probably become evident whether this indicator, too, is losing credibility.
Is cash still a good investment in the months ahead? Or have (Swiss) bonds now become (more) attractive again?
Kaiser Partner Privatbank: Money-market investments regained a good reputation during the interest-rate turnaround of the last one-and-a-half years. Prior to that, “cash is trash” had been a longstanding mantra. Now, however, cash had turned back into an investment alternative – particularly an interest-bearing one – seriously worth considering again. Investors could park part of their assets and wait for good investment possibilities without facing significant opportunity costs. Precisely for this reason, we consider maintaining a certain allocation to cash generally advisable, also in the months ahead. But the other positive aspect of holding an enlarged cash component in an investment portfolio – i.e. the protection it affords against bond-price drawdowns – is likely to become less relevant in the near future. This year through end-October, the yield on cash in US dollars amounted to 4.5% while the return on long-term US Treasury bonds was down 4.7%. The performance differential and the relative advantage for cash for the entire period since the start of the rate-hiking cycle in spring 2002 are even much bigger. One exception to the rule is the positive performance of Swiss Confederation bonds this year (+4.7%), which has significantly exceeded the yield on Swiss franc cash (1.2%).
Cash can be scaled back again now | Bonds look set to deliver a higher return
Relative performance of US bonds vs. cash after terminal policy rate has been reached
Sources: Bloomberg, Kaiser Partner Privatbank
Looking ahead, there’s a lot suggesting that the performance ranking order of bonds and cash will flip again also in other currencies. The major central banks have recently sent a relatively clear signal that policy rates have now reached their target level. From there they are likely either to hold steady next year, in keeping with the motto “higher for longer”, or to edge back downward slightly, as financial markets are pricing in at present. Bonds, regardless of whether short-term (1- to 3-year) or long-dated (7- to 10-year), would generate a much higher return than cash particularly in the second scenario. Whereas the yield on the money market decreases in times of falling interest rates, bonds beckon with price gains on top of their yields due to the duration effect – the longer the term to maturity, the bigger the added price gains. A comeback staged by bonds versus cash would also fit with the historical pattern. There were five noteworthy rate-hiking phases in the USA between 1987 and 2020. Each time after the federal funds rate reached a plateau, bonds consistently performed better than money-market investments for the next two years, usually by a wide margin (see chart above).
Bonds have thus become attractive again, particularly in the USA. Their risk/reward tradeoff is asymmetrical because the profit potential described above is juxtaposed by constrained downside potential in the event of a further rise in market interest rates since the high starting yields provide a certain buffer against price declines in the negative scenario. Moreover, whoever would like to earn an attractive return with bonds doesn’t have to take on high duration risk; even short-term bonds in the USA look set to generate an annualized return of more than 5% over the next three years (see chart below). How do the prospects look now for Swiss bonds? They, too, have brightened, but Swiss bonds offer less return potential compared to US-dollar-denominated assets (and Eurozone assets as well). However, the yield component shouldn’t be the sole criterion for an allocation decision. Whover invests in Swiss-franc-denominated bonds does so also always with the currency in mind. Since the Swiss franc should continue to tend to strengthen in the future, this likely will largely offset the lower performance potential.
Good performance prospects… | …with relatively low risk
Starting yield vs. annualized 3-year yield (Bloomberg US Government Bond 1- to 3-Year Index)
Starting yield vs. annualized 3-year yield (Bloomberg Swiss Franc Government Bond 1- to 3-Year Index)
Sources: Bloomberg, Kaiser Partner Privatbank
Is gold a good investment in light of the current geopolitical uncertainty? Should an investor buy physical gold (and stash it in a safe)?
Kaiser Partner Privatbank: Gold pays neither interest coupons nor dividends. This means that the opportunity cost of holding gold is low and the precious metal is all the more in demand during times of falling real interest rates, at least in theory. During the first two phases of quantitative easing by the US Federal Reserve (from November 2008 to June 2011) in response to the great financial crisis and again in the first two years after the termination of the US rate-hiking cycle in late 2018, this correlation was also clearly observable in real-world practice. However, the inverse correlation between the price of gold and real interest rates broke down a year ago. The 10-year US real interest rate has risen by 100 basis points since November 2022, but the price of gold has clearly decoupled from it and has gained around 20% since then. A look back at a longer span of history reveals that a divergence of this kind isn’t unusual. In fact, in the past there were protracted periods during which there often was no noteworthy correlation between the price of gold and real interest rates. For example, the gold rally from 2001 to 2008, during which the price of bullion quadrupled, took place amid a persistently high real interest rate level of around 2%.
Broken correlation | Stable gold price despite rising real interest rates
Gold price and real interest rate
Sources: Bloomberg, Kaiser Partner Privatbank
High and growing demand for gold on the part of central banks has been one of the driving forces behind the robust price increase over the past year. Their aggregate demand amounting to more than 1,000 tons in 2022 was around two times higher than the annual average for the previous ten years. Current data from the World Gold Council indicate that central banks upped their gold purchases by another 14% in the first nine months of 2023. The escalation of tensions in the Middle East was a recent additional catalyst for the price of gold. From a technical analysis perspective, a broad triple top at the USD 2,075-per-ounce level has formed over the last three years on the yellow metal’s price chart. There’s an elevated probability that the next attempt to breach that level will succeed since a quadruple top is a rarity in the art of technical analysis. The precious metal has proven its worth for decades as a diversifying and purchasing-power-preserving strategic additive to an investment portfolio. The tactical outlook for gold is now also favorable at the moment from both a fundamental and technical analysis standpoint.
So, gold? Yes. But how? Should an investor buy physical gold and stash it in a safe? The answer to that question depends on the individual investor. Whoever appreciates the cultural value of gold and likes to hold it in his or her hands every once in a while and wants to anonymously keep at least part of his or her assets close-by outside the financial system (or outside his or her private bank) may find that being in physical possession of the precious metal presents an added value, one that he or she is willing to pay a little extra for because this way of holding gold doesn’t come cheap. One at least incurs added costs for a safe and/or insurance. Storing gold in a bank vault also isn’t free of expenses for the same reason. Liquidity and unit denomination, however, do not pose an obstacle to holding physical gold. Buying and selling physical gold via a private bank is usually possible without any problems generally starting from as little as a single gold coin (with an equivalent value of almost USD 2,000 at present). Whoever makes an investment in gold mainly on the grounds of diversification and has a low opinion of personally holding physical gold for the aforementioned reasons may prefer to go the cheaper and more efficient route via an ETF that invests in physical gold. Buying and selling shares in a gold ETF works just as easily as trading conventional securities, though this way of safekeeping gold may not necessarily convey the same feeling that being in physical possession of the precious metal does. Whoever would like to experience a somewhat different type of good feeling may perhaps find special gold ETFs that tout diligent supply-chain verification and transparency and the promotion of environmental and social compatibility to be a suitable investment alternative.
Catastrophe (cat) bonds have turned in a stellar performance this year. What is the background behind this performance, and does this asset class remain interesting for the months ahead?
Kaiser Partner Privatbank: Cat bonds are a mostly overlooked niche in the alternative assets space, but with a year-to-date performance of almost +20% as measured by the Swiss Re Cat Bond Index, they have substantially outshone the better-known asset classes – with the exception of Bitcoin (up 100+%) – in 2023. Multiple factors are benefiting cat bonds at the moment. For one thing, cat bonds’ floating interest rates make them a direct beneficiary of the rise in central-bank policy rates. Moreover, a massive imbalance currently prevails in the (re)insurance market: demand for insurance coverage far exceeds the volume of (investor) capital available. Estimates suggest that there is a USD 80 to 120 billion capital gap in the reinsurance market. In order to secure an adequate supply of capital, catastrophe bonds must be brought onto the market today with correspondingly attractive high interest coupons to the advantage of investors. According to data from Artemis, the average coupon on new cat bond issues stood at 8.38% in the third quarter.
Tailwind | Continued good outlook for cat bonds
Swiss Re Cat Bond Index
Sources: Bloomberg, Kaiser Partner Privatbank
The cause of the big supply/demand imbalance is mainly attributable to two factors. On the one hand, insurers’ need for reinsurance coverage has increased significantly in recent quarters as a result of high inflation. Natural catastrophe events like Hurricane Ian additionally boosted this demand. On the other hand, the macroeconomic climate, the global turnaround in interest rates, and weak investment returns have put pressure on reinsurance companies’ balance sheets, causing refinancing costs to rise. On top of that, big book losses have been incurred on fixed-rate securities holdings. Since the industry is obligated to comply with strict Solvency II capital adequacy requirements, reinsurance companies have only limited and expensive capital procurement options available to them in the current environment. One alternative is the cat bond market, which accordingly is attractive right now from an investor’s perspective.
Do catastrophe bonds remain a favorite also for 2024? A repeat of this year’s performance is hardly probable, but since the fundamental backdrop won’t change rapidly, renewed double-digit percent returns next year are definitely realistic. Another sequence of better-than-average years might be lying ahead, similar to what happened in the aftermath of the “Katrina – Rita – Wilma” triple punch in 2005, when cat bonds delivered annual returns north of 10% in six of the eight years thereafter. Whether or not a strong series of that kind actually materializes will depend most of all on the magnitude of future extreme weather events – higher-than-average claims losses are the big unknown and are the main factor that could weigh on performance. Insurance-linked bonds are attractive, but not solely in view of their performance potential. Recent times have clearly demonstrated that unlike traditional bond markets, insurance-linked bonds are truly an uncorrelated source of return that makes a valuable contribution to diversifying a portfolio. Cat bonds also stand out for their particularly good risk/return profile (higher return than with conventional bonds and with less volatility at the same time). Even if traditional fixed-income investments have become interesting again in the meantime now that the rate-hiking cycle is nearing its end, blending cat bonds into a portfolio is nonetheless an advisable move for long-term-minded investors.
Endowment funds of elite US universities have performed poorly over the last two years. Has the “Yale model” of devoting a high allocation to alternative and illiquid assets outlived its usefulness?
Kaiser Partner Privatbank: When talk in recent years has turned to the high-yielding investments of large foundation endowment funds, all eyes have consistently swerved westward to the top universities in the United States, which invest their endowment funds mainly in illiquid assets like private equity, venture capital, and real estate, as well as in liquid alternative assets (hedge funds) following the role model established by Yale University. They surfed on a wave of success for a long time this way. In fiscal year 2021 (which ran from July 2020 through June 2021 for these university endowment funds), that success culminated in eye-poppingly high annual returns of +30% to +50%. Over the last two years, though, the performance of Ivy League endowment funds was far below average. In 2022, which was a weak year for stocks, their average return of –2.4% still managed to outperform the S&P 500 index (–11.1%) by a wide margin. But the real hangover hit with the numbers for fiscal 2023 ended on June 30. The eight university endowment funds were able to boost the value of their assets by 2.1% year-on-year on average, but lagged far behind liquid blue-chip stocks on the US equity market (+18.3%). It doesn’t take long to pinpoint the cause of the performance discrepancy – it’s the valuation inertia of private-market assets described in the last edition of “Ask the Experts” [Link zum Artikel]. This valuation inertia is a feature, not a bug, and it helped in the performance comparison during the stock-market correction. The flipside of this coin, though, is the current underperformance. The strongest gravitational effect is observable in the venture capital segment. It’s here where valuations overshot the most to the upside and thus have an accordingly long way to potentially fall now. Institutions that have sizable exposure to the venture capital segment will likely have a millstone around their neck also in the quarters ahead because the valuation correction in this riskiest of private-market asset segments probably isn’t over yet. The prospects look somewhat better for conventional private equity buyout funds, which may already have pulled out of their performance trough. But here, too, there are unlikely to be big fireworks in performance terms in the near future. Financing private equity transactions is much more expensive than before under the new interest-rate regime, and the arid market for IPOs has narrowed opportunities for profitable exits.
Hangover | Private equity and venture capital are dead weight for once
Performance of Ivy League endowment funds and the S&P 500
Sources: Prequin, Kaiser Partner Privatbank
Has the “Yale model” thus become outmoded? We don’t think so. On the contrary, we view the disappointing short-term performance as a reminder that investment strategies with high exposure to illiquid assets should have a (very) long-term investment horizon ideally stretching over at least three years, but even better over more than five years. Endowment funds’ infinitely long time horizons allow them to shrug off short-term periods of poor performance. What matters is the long-term performance potential of the strategic asset allocation. As things stand today, return expectations for the next ten years are in the double digits only for the private equity and venture capital segments – other alternative asset classes and liquid equity markets in particular are likely to be less profitable. Retail investors who have a correspondingly long-term investment horizon for part of their assets can take a page from the strategy of university endowment funds to profit at the moment from the improvement in the attractiveness of the investment environment for private equity and venture capital. Even though these asset classes are facing much tougher times than before, the current investment year looks set to go down in history as a better-than-average vintage year due to the better entry conditions for new deals. However, retail investors shouldn’t copy the assets allocations pursued by these multi-billion-dollar institutions one to one. A more than 30% allocation to hedge funds like in the case of Harvard University seems a little too exotic, for instance, even if hedge funds do tend to benefit from an environment of higher interest rates. At the moment, it’s advisable to deviate from the relatively inertial strategy of university endowment funds also in another area. The private credit sector, for instance, offers a very good risk/reward tradeoff right now. Although double-digit percent investment returns look realistic here over the next 12 to 18 months, the elite universities are not notably invested in private credit. Retail investors who have access to semi-liquid private-market assets (via Kaiser Partner Privatbank, for example) can react to this investment opportunity comparatively quickly and can thus outwit the purported investment role models.
High allocation to alternative assets… | …for maximum performance
Harvard Management Company’s asset allocation
Sources: Harvard University, Kaiser Partner Privatbank
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