Ask the experts: What is stirring our clients (and moving the financial markets) in August 2024

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.

Switzerland

What is the Swiss inheritance tax initiative all about, and what are its risks and side effects?

Kaiser Partner Privatbank: On March 4, 2023, the Swiss Young Socialists party handed in over 130,000 petition signatures, launching a federal popular initiative dually named “For a Social Climate Policy – Fairly Financed through Taxation” and “Initiative for a Future” (and also known as the inheritance tax initiative). The legislation proposed by the Young Socialists calls for the implementation of a 50% tax on estates and gifts exceeding CHF 50 million to go into effect on the date that the initiative is passed by the public (under a retroactivity clause). The expected extra tax revenue is to be earmarked to be used to “combat the climate crisis in a socially just manner” and to finance the “ecological transformation of Switzerland’s economy.” The wording of the initiative prohibits any exemptions, which means that a tax would also be levied on business successions (within a family) and on donations to charitable institutions. The initiative also mandates additional measures to prevent tax avoidance, particularly in the event of a relocation abroad. After passage of the initiative, lawmaking bodies would have to enact implementing ordinances within three years. The Swiss Federal Council recommends rejecting the initiative. It is conceivable that Switzerland’s federal parliament will draft a counterproposal, though it is unpredictable at the moment if one will actually come about and whether it would prompt the Young Socialists to withdraw the initiative.

The response in the Swiss media in reaction to the controversial initiative launched by the Young Socialists has been unmistakably loud and clear in recent months, and for good reason. Family-run businesses and SMEs (micro-companies and small and midsize enterprises) form the backbone of Switzerland’s economy. They generate billions in tax revenue, provide thousands of jobs, and are a fount of Swiss innovative prowess. For shareholders of family businesses, the wealth to be seized by the proposed “tax for a future” is usually largely tied up in the respective companies themselves, leaving little or no freely disposable funds available to pay a tax. To be capable of bearing the extra financial burden, when planning a business succession, many family entrepreneurs would have to sell all or part of their respective companies or would have to encumber them with onerous debt. Since the “tax for a future” is to be levied by the federal government alongside already existing cantonal taxes on estates and gifts, in extreme cases the total taxation rate on wealth could come close to 100%.

Figuratively speaking, the inheritance tax initiative urges the people of Switzerland to bite the hand that feeds them. It not only calls Swiss constitutional rights to freedom of establishment and property ownership into question and already creates legal uncertainty ahead of the balloting, but would also permanently disrupt entrepreneurial activity and would withdraw productive capital from Switzerland’s economy if it is implemented. That would be accompanied by a loss of prosperity across all of Swiss society. The initiative could make it impossible to transfer ownership of family businesses and could force proprietor families to radically reorganize ownership structures or to offshore jobs. Such moves away from Switzerland would wreak great financial harm on the country. Since the revenues from the “tax for a future” are earmarked for specific purposes, even in the event of a positive net effect there could still be tax hikes or entitlement cuts for the general population because the state might lack the necessary funding.

The retroactivity clause puts the inheritance tax initiative on shaky legal ground. There is also the question of whether it violates the constitutional principle of uniformity of taxation. Although the popular initiative has slim chances of winning at the ballot box, it is important for entrepreneurs to plan prudently for the future. There is a range of actions they can take to circumvent or at least lessen a potentially expanded estate tax. Temporarily or permanently moving away from Switzerland is the most radical option, but is not the only possible course of action. Other possible solutions are gifts (with or without reservation of usufruct) or the establishment of a foundation, for example. Whatever option bearers of responsibility decide to go with, they should examine the far-reaching consequences in detail from an entrepreneurial, legal, and tax law perspective and should act with farsightedness into the future and with the big picture in mind.

A mainstay | SMEs provide two-thirds of all jobs in Switzerland

Share of SMEs in the number of all enterprises and employees in Switzerland

Sources: STATENT business statistics on the structure of the Swiss economy (August 2023), Kaiser Partner Privatbank

Switzerland

Why is Switzerland currently able to decouple from Germany’s sawtooth-shaped economic activity? 

Kaiser Partner Privatbank: There’s no way to sugarcoat it: former growth engine Germany has turned into a veritable brake on growth for the Eurozone since the pandemic. The country’s economic growth curve has been sawtooth-shaped for two years now. The latest jag downward occurred in the second quarter of this year as Germany’s GDP growth rate once again fell short of the consensus forecast (+0.1%) and turned out slightly negative at –0.1%. The weak data from both the Ifo business climate index and the German manufacturing purchasing managers’ index do not necessarily give reason to anticipate a rapid improvement in the second half of this year. Germany’s economic output as of mid-2024 is back just at the pre-pandemic level. The country’s economic growth curve is sloped distinctly downward compared to that of the Eurozone and especially Switzerland.

Anyone searching for a reason for Germany’s sluggish growth need only cast a glance at the stock prices of the big German automakers, which are all down 10% to 20% in the midst of an otherwise buoyant year on the equity market. A challenging e-mobility transition combined with weak demand in China is hurting business not just at BMW, Mercedes, and VW, but also at hundreds of ancillary supplier companies. There have been some isolated bankruptcies in the upstream production chain in recent quarters. The importance of the automotive industry for Germany shouldn’t be underestimated – it directly and indirectly accounts for almost 8% of the country’s aggregate economic output. But other export-oriented subsectors such as the mechanical engineering industry, for instance, are also suffering as a result of ongoing weak demand in China. The massive energy price shock has been another challenge for many manufacturing companies in recent years. It has been overcome by now, but energy is still comparatively expensive in Germany, which inhibits not only production, but also investment.

Many an observer by now is of the opinion that Germany has turned back into the “sick man of Europe.” That moniker doesn’t seem entirely unwarranted. Compared to many other industrialized nations, Germany has undertaken less investment in recent years. The country now lags behind in digitalization (but also in other areas), which is a disadvantage in view of future trends like artificial intelligence. Overregulation in Germany also acts as a brake on growth. A study by the World Bank has revealed that it takes around 120 days to obtain a business license and 180 days to get a construction permit in Germany, which is far longer than in many other countries. While Germany occupies a respectable 22nd place in the World Bank ranking on ease of doing business, it ranks only 125th in the “starting a business” category. Germany’s debt brake mechanism, which constrains fiscal leeway, and its “traffic light” political coalition, which frequently thwarts itself, have also turned out to be a substantial drag on growth, particularly in recent years.

Last but (sadly) not least, demographics in Germany look set to present an additional challenge in the future. The International Monetary Fund projects that the working population in Germany will shrink by 0.5% to 1% per annum over the next decade (depending on the country’s immigration policy). The German Council of Economic Experts forecasts an average annual GDP growth rate of just +0.5% for the coming decade, due also in part to the low number of hours worked per year by German jobholders.

Switzerland is decoupling… | …and is growing not just on aggregate

Evolution of economic output

Sources: Bloomberg, State Secretariat for Economic Affairs, Kaiser Partner Privatbank

“When Germany coughs, Switzerland catches the flu” – this witticism was already very questionable during the last 20 years (see charts above), but is now sheer gibberish at least ever since the pandemic. In contrast to Germany treading water, Switzerland’s economic output at last look was a good 7% higher than it was at the end of 2019. There are good reasons for Switzerland’s evident decoupling from its neighbor to the north. For one thing, the energy-price and inflation shock was less pronounced in Switzerland, so it had less of an adverse impact on business activity and consumer confidence. Moreover, Switzerland’s direct dependence on its big trading partner has been decreasing for a long time now. Twenty years ago, 20% of all Swiss exports flowed over the country’s northern border, but today that figure stands at just 15%. The USA supplanted Germany as the most important export destination for Swiss goods back in 2021.

Moreover, the composition of Swiss exports has changed in recent years. To wit, the weight of the chemical and pharmaceutical industry has more than doubled over the last 20 years. Since those exports are less price-sensitive and less cyclical and are not specifically targeted at Germany, Switzerland has become more resistant to dips in German growth. Another driver of the decoupling of growth comes from the fact that other important pillars of Switzerland’s national economy, such as the real estate sector, the financial industry, and tourism, depend little or hardly at all on Germany. A look at per capita GDP growth particularly illustrates just how strong Switzerland’s economic performance has been over the last four years. This refutes the criticism often leveled that Switzerland only is growing on aggregate solely as a result of high immigration. Per capita economic output in Switzerland was 2.4% higher at the end of 2023 than it was prior to the pandemic. Neither the Eurozone as a whole (+2.1%) nor Germany in particular (–0.9%) has kept pace with that.

However, despite the recent good performance, Switzerland does not have an invulnerable “Teflon economy.” That’s because the strong Swiss franc regularly causes worry wrinkles at least in export-oriented industries, particularly among small and midsize enterprises that manufacture exclusively in Switzerland. In the midst of a steady appreciation trend for the franc, what amounts in the long run to good fitness training and an incentive for continual innovation and efficiency gains can become a real near-term stress test when turbulence on financial markets causes the safe-haven franc to appreciate sharply and profit margins in Swiss industry to contract within a very short period of time. Switzerland’s manufacturing sector is in the midst of exactly this kind of situation at the moment. The sharp appreciation of the franc against the euro since mid-July (by a good 5% for a time until early August) dealt a substantial blow to sentiment that was observable in the latest purchasing managers’ index print for large companies as well as in the one for SMEs.

Nevertheless, Switzerland’s predominantly eminently adaptable and crisis-tested industrial sector will likely weather even this storm. So, the growth gap between Switzerland and Germany probably won’t change much for the time being. While the Federal Government Expert Group on Business Cycles expects economic growth in Switzerland to come in at +1.2% for 2024, the federal government of Germany forecasts GDP growth of just +0.3%. The Swiss Confederation looks set to stay in the lead next year as well (+1.7% vs. +1.0%), according to government projections.

Economic activity

The Sahm Rule is flashing red. How great is the risk of a recession in the USA?

Kaiser Partner Privatbank: We wrote about the Sahm Rule and its teetering reputation as an excellent recession indicator last year in this space. Since 1970, whenever the three-month moving average of the unemployment rate has risen by 0.5 percentage points or more relative to the minimum of the three-month averages from the previous 12 months, the US economy either has already been in a recession or will have sunk into one within the next six months (like it did in 1959 and 1969). The Sahm Rule has even spotted soft landings in the past; the unemployment rate in the years 1967, 1985, and 1995 turned back downward before the trigger point. The weak July 2024 US labor market report has now re-triggered the Sahm Rule for the first time since the COVID-19 pandemic. The three-month moving average of the unemployment rate stood 0.53 percentage points (or 0.49337 percentage points on the basis of unrounded data) above the 12-month minimum at last look. However, there is still no sign of a recession, at least not at the moment.

Unemployment rises gradually at first… | …then abruptly

Pre- and post-recession change in US unemployment rate (since 1960, excluding COVID-19 recession)

Sources: Bloomberg, Kaiser Partner Privatbank

To get to the bottom of the US unemployment rate enigma, economists in recent weeks have carefully examined every detail of the complex labor market statistics. The results of that research activity reveal that US unemployment figures are abnormally distorted in the current cycle because around 40% of the increase in joblessness is attributable to people who have rejoined the labor market or have entered it for the first time but have not yet found a job. Layoffs account for a smaller share of the increase in unemployment compared to previous recession cycles. There is widespread agreement that the flashing of the Sahm Rule this time is mainly attributable to the high immigration to the USA over the last three years. It has not been completely absorbed by the employment market. Even Claudia Sahm, whom the rule is named after, prefers at the moment to speak of an economic downturn rather than an acute recession. Other indicators validate this assessment. For example, employment, industrial output, and real income contracted during the four months prior to the triggering of the Sahm Rule warning signal in the recession years 1990, 2001, and 2008. In recent months, though, all of those indicators have risen – in contradiction to a classic recession cycle.

However, one shouldn’t hastily write off the Sahm Rule and its underlying concept because a deterioration of the employment market happens gradually at first and then abruptly. Although the question arises whether one should search for a better trigger point, the US unemployment rate inherently is an extremely cyclical (mean-reverting) data series. When it falls, the movement doesn’t end until economic activity is already booming, and when it rises beyond a certain level, it ends in a recession. That’s why it would be very abnormal if the unemployment rate were to hold steady in the quarters ahead without a recession occurring. In fact, a distinct cooling of the employment market can already be objectively attested. Before businesses lay off workers, they first start to cut back on hiring new employees. The number of new hires in the first seven months of this year was down 43% compared to the same period a year ago. The hiring rate by now is lower than it was prior to the onset of the pandemic. Although initial jobless claims remain comparatively low, continuing jobless claims are continually on the rise, an indication that those who have lost a job are having a hard time finding a new one. This is precisely the feedback that more and more households are giving to the surveys regularly conducted by the Conference Board.

The deterioration of the employment market is also being taken seriously by the research departments of Wall Street investment banks, which recently have tended to dial back up their estimations of the probability of a US recession occurring within the next 12 months. We, too, are not viewing the economic situation in the United States through rose-colored glasses, and we estimate the risk of a recession at around 50% at the moment. Financial market participants look set to continue dissecting upcoming labor market reports in minute detail. Since the Sahm Rule has lost predictive power, the question arises as to what might be an alternative fever thermometer for the US labor market. The employment rate could fit the bill. Modeled on the Sahm Rule calculation, the US employment rate sends a recession warning signal when its three-month moving average drops more than 0.5 percentage points below the maximum of the three-month averages from the previous 12 months. At –0.33 percentage points at present, this alternative calculation is around two-thirds of the way to flashing a recession warning signal. We will keep a close eye on this indicator in the months ahead.

Alternative fever thermometer… | …flashing amber

Deviation of US employment rate (3-month moving average) from 12-month maximum

Sources: Bloomberg, Kaiser Partner Privatbank

Currencies

What is the carry trade, and why has it been making headlines again lately?

Kaiser Partner Privatbank: “Up with the escalator, down with the elevator” best visually describes the profit and loss statement of a classic carry trade. And that’s exactly the picture you’ll see at the moment on the forex charts of the US dollar, the Mexican peso, and other currencies against the Japanese yen. It’s no coincidence that the yen consistently appears on one side of the aforementioned currency pairings. Due to the ultralow to negative interest rate policy pursued by the Bank of Japan (BoJ), the Japanese yen has been the currency with the world’s lowest interest rates for years (actually even for decades). This thus created a powerful temptation to borrow money in Japan on cheap terms (virtually for free) and to invest it in higher-yielding assets. The carry trade works precisely on this principle of earning a profit merely by holding (or carrying) a position in some asset – as long as nothing interferes with that, because (to try a different analogy) this strategy is akin to picking up pennies in front of a steamroller – turbulence can nullify gains eked out over several months in a flash. Turbulence is more a feature of the carry trade than a bug and is a risk that most carry-trade speculators are well aware of and are repeatedly willing to take.

The last bout of turbulence and the latest large-scale unwinding of the carry trade were recently observable in late July and early August of this year. They were initially sparked by a lower-than-expected inflation data print in the USA on July 19. Then a surprise rate hike by the BoJ on July 31 massively accelerated the yen’s appreciation. Finally, the tentative climax and the low point in the USD/JPY exchange rate thus far came on August 2 on the heels of weak US employment market data. All three occurrences above have one thing in common: they indicate that the interest-rate divergence between Japan and the USA will narrow in the future. That throws the calculations of carry traders awry because, on one hand, changing interest-rate expectations also bring more volatility into play and, on the other hand, the yen weakness that heretofore had made paying back JPY-denominated debt an ever less expensive matter now is no longer guaranteed.

In the wake of the yen’s intermittent 14% advance against the US dollar, which erased all of the year-to-date carry profits, the storm has likely passed for the time being. At least the speculative part of the carry trade that was transacted on the spot market and via forward contracts (particularly by hedge funds) had already shrunk to 30% to 40% of its original size by early August, according to estimates by JP Morgan. Meanwhile, the vastly more voluminous part of the carry trade is probably still in place for the most part. It concerns foreign investors who have borrowed money from Japanese banks, as well as Japanese investors themselves: individual private investors, insurance companies, pension funds, and even government-run pension funds. JP Morgan calculates that the carry trade volume for those two groups combined amounts to around USD 4 trillion. Given the sheer size of that sum alone, it would take months or even years to unwind this carry trade. The unwinding is unlikely to gain momentum until Japan definitively sheds its image as the world’s preeminent ultralow-interest-rate country, but the BoJ has to prove that it is capable of accomplishing that.

Japan’s central bank officials do not have an enviable job at the moment. After they had engaged in interventions in the billions last spring to prop up an overly weak yen, the currency’s strength now has become a problem. BoJ Deputy Governor Shinichi Uchida even saw himself compelled to declare that interest rates won’t be raised further until financial markets have stabilized again. An overly strong yen will probably continue to pose a bigger challenge than an overly weak yen in the months and quarters ahead. The peak in interest-rate differentials is likely in the rearview mirror by now. Hence, the USD/JPY exchange rate’s July high at the 162 level could mark the apex of the carry trade in the long run in a dual sense. The “fair” value of the exchange rate is probably more in the ballpark of JPY 115 to 120. Whether this range will be reached anytime soon depends on the future rate-hiking path in Japan, but mainly also on the question of whether the USA will slip into a recession in 2025 or if the US Federal Reserve will succeed in engineering a soft landing after all. In the event of a (severe) US recession, interest-rate differentials are likely to decrease to such an extent that the carry trade would become utterly unattractive. That would give the Japanese yen a chance to climb out of the deep valley of undervaluation.

It works… | …until it doesn’t

US dollar and Mexican peso vs. Japanese yen

Sources: Bloomberg, Kaiser Partner Privatbank

Currencies

Donald Trump promises to devalue the US dollar if elected to a second term. Can that succeed?

Kaiser Partner Privatbank: “The US dollar is our currency, but your problem.” This quote from former US Treasury Secretary John Connally is over 50 years old by now, but the allusion to the greenback’s status as a global anchor and reserve currency is still valid to this day. Commodities, trade, and supply chains are all predominantly priced, calculated, and financed in US dollars. The world loves dollar-denominated assets, even if the borrower isn’t an American (which is why an enormous Eurodollar market came into being). The US dollar actually became a problem in the mid-1980s because it was too strong. So, in September 1985 at a meeting at the Plaza Hotel in New York City, the USA, France, Germany, Japan, and the UK agreed to arrange a coordinated intervention to weaken the dollar (the Plaza Accord). In the quarters that followed, the greenback depreciated substantially, due in part also to monetary-policy developments. Then in February 1987, the Louvre Accord called for a return to a stabilization of exchange rates. Today, at least since the mid-1990s, the USA implicitly pursues a “strong dollar policy” that eschews artificial devaluations.

However, Donald Trump, who is seeking to win a second term as US president in November, and J.D. Vance, his potential vice-president, believe that the US dollar is (much) too strong at the moment. In their eyes, the greenback is not just putting an immense strain on US industry, but is also the cause of the USA’s large trade deficit. But a president can’t ordain the direction of a currency’s value at the press of a button, even if – as in the case of Trump – he considers himself an expert on economic matters and purports to have better gut instincts than the US Federal Reserve does. If Trump wins the presidency, what realistic options, and what less realistic ones, would Republicans have at their disposal to weaken the US dollar, and what are their merits and drawbacks?

• Talk down the dollar: Verbal interventions have only a short half-life and are mostly prone to cause undesired volatility on financial markets. They do not have a long-term effect unless there is a change in the macroeconomic climate at the same time.
• Unilateral intervention: Trillions change hands on the global currency market every day. As long as the Fed doesn’t start to print dollars, the ways and means for a unilateral intervention are limited. An intervention attempt would not be looked on kindly by other economic powers.
• Modern Plaza Accord: Within the G7 and G20, there is a unanimous commitment these days to letting the open market determine currency exchange rates. The European Central Bank, the Bank of England, and the Bank of Japan are unlikely to take part in an attempt to devalue the dollar.
• Pressure on the Fed: The USA’s central bank has a clear mandate aimed at price stability and maximum employment, but not at managing the external value of the dollar. As long as the Fed retains its independence, it will not move to weaken the US dollar for political motives. If Trump challenges the Fed’s authority after his election, that potentially could result (indirectly) in a weaker dollar. A study by the National Bureau of Economic Research shows that political pressure (measured in terms of meetings between US presidents and Fed chairs) leads to rising inflation and inflation expectations. That usually is a means of weakening a currency.
• Restrict capital inflows into the USA: Capital controls or similar restrictions would reduce the attractiveness of the US financial market and undermine America’s openness. That could jeopardize the US dollar’s role as a reserve currency, a status that the Republican Party election platform, though, expressly still wishes to maintain.

Evidently, there is a dearth of “good” options for structurally weakening the US dollar. Trump’s fascination with tariffs is also unhelpful to his desire for a weak currency because economic theory and academic evidence suggest that raising tariffs on imports leads to a stronger domestic currency either because the central bank hikes interest rates in reaction to higher prices (inflation pressure) or because the tariffs cause import volumes to contract and demand for foreign currencies to decrease (which in turn would strengthen the dollar).

A problem for whom? | The greenback is relatively expensive

 US dollar index

Sources: Bloomberg, Kaiser Partner Privatbank

Donald Trump is right, though, on one count: the US dollar is indeed richly valued, as evidenced not just subjectively by the many US tourists thronging Europe this summer, but also objectively on the basis of the US dollar index. In nominal terms, the greenback currently is 10% to 15% less expensive than it was at the last cyclical peak in 2002. However, in real terms (factoring in the inflation trend), it has about the same purchasing power as it did back in 2002 and is not far from the all-time high recorded in 1985. But such blatant deviations from the mean do not last for long on the currency market. On the contrary, a certain convergence toward the mean is regularly observable throughout history. It normally takes around three years for a real overvaluation to pull back by 50%. The necessary impetus for a valuation correction of that kind is usually provided by macroeconomic changes such as shifts in interest-rate differentials, for example. If the Fed initiates a substantial rate-cutting cycle soon in the event of a significant slowdown in economic activity, that could spark a turnaround on the currency market. Trump then might possibly get his desired outcome in the end (without his actual involvement), though he afterwards probably would boastfully take personal credit for succeeding in weakening the dollar.