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

Crude oil

Despite production cuts by OPEC and turmoil in the Middle East, the price of petroleum has only been moving in a rangebound manner in recent months. Has the oil cartel lost its influence over the oil market?

Kaiser Partner Privatbank: The disinflation process over the past year happened surprisingly quickly in the eyes of more than a few economic observers, but it was a big relief in any case for consumers and businesses. However, alongside the wide array of beneficiaries of receding inflation, there also was at least one group of losers: oil producers. That’s because a large part of the pullback in inflation was caused by the falling price of petroleum in a decline that saw the price of Brent crude oil plummet from a high above USD 135 per barrel in March 2022 to a low of around USD 70 in March 2023. That level is too low for the financial conditions in many oil-producing countries including Saudi Arabia, the opinion leader and largest producer in OPEC. Saudi Arabia needs an oil price of around USD 85 per barrel to maintain a balanced public budget. The (typical) reaction by OPEC to the drop in the price of oil didn’t take long to arrive. In April 2023, the cartel in coordination with Russia (OPEC+) announced an initial curtailment in its oil production volume by 1.7 million barrels per day. However, the cutback’s boosting effect on the price of oil fizzled out within a span of four weeks. In June and then again most recently in November, the oil cartel further upped the ante with additional cuts totaling 2.2 million barrels per day. Saudi Arabia is shouldering the brunt of the production cuts to the tune of 1.5 million barrels per day – at a current output of 9 million barrels daily, the Saudis are utilizing only 75% of their oil production capacity at present.

An ineffective cartel | Oil production cuts have fizzled to date

Brent crude oil price, in US dollars

Sources: Bloomberg, Kaiser Partner Privatbank

Looking at the evolution of the price of crude oil over the last ten months alone, it appears that the strategy of cutting output hasn’t generated the desired effect. At a price of a good USD 80 per barrel at last look, Brent crude oil has been trading lately at roughly the same level as it was at the time of the first production cut. What went wrong for OPEC(+)? For one thing, non-OPEC countries like the USA, Canada, Brazil, and Norway have expanded their production over the course of the past year, by a lot in some instances. The output expansion has been particularly impressive in the United States, which has ascended on the back of the shale oil boom in recent years to become the world’s largest oil producer by far and further increased its production over the past year by around another 1 million barrels per day. The oil cartel’s efficiency and price-setting power have gradually diminished as a result. Moreover, OPEC itself is its own worst enemy because some members’ compliance in implementing agreed production cuts evidently leaves a lot to be desired. In May of last year, OPEC convened a meeting in Vienna aimed at bringing members back into line with production quotas, but the cartel’s success was fleeting once again. The pressure caused by the cuts was too much for some members to bear. This prompted Angola to exit OPEC at the end of last year. Meanwhile, other countries likely haven’t been taking their quotas all that seriously.

The United States is producing more… | …at the expense of OPEC

World oil output in millions of barrels per day

Sources: DOE, OPEC, Bloomberg, Kaiser Partner Privatbank

Saudi Arabia is thus bearing the biggest burden within the oil cartel. The question is whether and when the most important OPEC country will lose its patience and start to use its spare capacity to massively expand its output and maximize its oil revenue. If that were to happen, a price war with manifold consequences would loom. For one thing, the price of oil would plunge, sending a deflationary shock wave around the world. Moreover, OPEC(+) would permanently lose its importance. This would mark a geopolitical win for still oil-thirsty industrialized nations because all at once it could make freer oil trade and/or bilateral production agreements possible with countries like Iraq, Kuwait, Nigeria, etc. Saudi Arabia, the de facto leader of the oil cartel, particularly would obviously rank among the losers. But also Russia would be ill-prepared to face a more competitive oil market. In the end, though, a complete dissolution of the OPEC cartel would have detrimental effects on all member countries because the pursuit of revenue optimization by each producer would necessitate increased output (which would cause prices to fall).

An end to OPEC(+) in its present form cannot be entirely ruled out in the long term, but a price war initiated by Saudi Arabia that might trigger a breakup of the oil cartel is very unlikely in the near to medium term. That’s because not even that oil titan can afford a price war at the moment since Saudi Arabia’s Vision 2030 plan requires an estimated investment volume of USD 3.3 trillion (equal to 300% of the kingdom’s gross domestic product). Moreover, a price war would probably be to no avail anyway because unlike in 2014, when Saudi Arabia threw open the spigots on its oil wells with success at that time, US shale oil producers these days are on a sounder financial footing and are much less price-sensitive than before. They would no longer be so easy to squeeze out of the market. So, there’s a lot suggesting that Saudi Arabia’s current strategy of pursuing price maximization rather than volume maximization is the better of the two not entirely ideal options.

Asset allocation

The year 2023 saw substantial price movements in stocks and bonds. How does this affect capital market expectations for the next five years?

Kaiser Partner Privatbank: It’s tough to make predictions, especially about the future. There’s a lot of wisdom in that statement. Nevertheless, (point) predictions about equity indices or individual stocks, for example, enjoy enormous popularity “Predictions: Popular, but not very helpful” despite their incertitude and the scant added value they provide. Future return forecasts, on the other hand, are not entirely dispensable despite the obviously justified reservations regarding them. That’s because formulating capital market expectations, i.e. five- to ten-year return estimates for individual asset classes, is an essential input to building an optimal investment portfolio. But compared to the widely propagated and wildly inaccurate year-end predictions, forecasters of capital market expectations have an advantage: a much longer time horizon, because the longer the time frame, the more that prices on the financial market are driven by long-term trends and risk premiums and less by momentum and economic activity. However, despite this advantage and the quite sophisticated forecasting models sometimes employed, estimating capital market expectations ultimately is more akin to an art than a science. That’s because even with forecasts on a five- to ten-year horizon, there’s a roughly 50% probability that the estimated return will deviate from the actual realized return by more than three percentage points in the end.

Bonds have become (more) relevant again | Private-market assets remain the most attractive

Capital market expectations (Kaiser Partner, 5 years)

Source: Kaiser Partner Privatbank

Under the caveat that our estimates are highly uncertain and are unsuitable for timing the market and instead should best be used to determine the relative attractiveness of the various asset classes, we have recently updated our capital market expectations for the next five years. In the final analysis, stocks remain the highest-returning conventional asset class (developed markets: 7.3%; emerging markets: 8.0%). However, since equity valuations have risen, their return potential is 20 to 30 basis points lower than a year ago. Bonds, in contrast, have become more attractive across all fixed-income categories as a result of the upward shift in the yield curve compared to a year ago. This development has particularly turned high-yield (6.6%) and insurance-linked bonds (6.3%) into serious competitors to stocks. The improved attractiveness of bonds relative to stocks is likely to prompt many investors to resume giving interest-bearing assets a higher weight in their investment portfolios in the future.

In the alternative assets category, gold (2.3%) and Swiss real estate (3.3%) appear to have a rather unattractively low expected absolute rate of return. Investors should bear in mind, though, that these assets nevertheless are a sensible additive in a portfolio context mainly due to their comparatively low performance correlation to stocks and bonds. Meanwhile, (market-neutral) hedge funds (5.4%), which particularly profit from the increased interest-rate level, have tended to gain return potential lately “Is now the time for… hedge funds?”. In the end, though, private-market assets once again promise the greatest performance potential across all asset classes. A diversified portfolio of private-market assets constructed with four building blocks – private equity, private credit, private real estate, and infrastructure – is likely capable of earning an annualized return of 11% per annum over the next five years. However, those kinds of numbers won’t show up in an investor’s portfolio unless he or she implements private-market exposure in a manner suitable for retail investors “Private markets – the right way”.

China

A brake on growth, a collapsing house of cards, a systemic risk – various labels have been pinned on the Chinese real estate market in recent years. Is an end to the crisis in sight?

Kaiser Partner Privatbank: In the global financial architecture, trust is a vital asset. Once trust has been lost, it is hard to win it back. It is precisely this fact that explains why the real estate crisis in China “The Achilles’ heel of China’s economy” has been dragging on for two-and-a-half years now and no end is in sight yet.

The Chinese public’s faith in the country’s banks remains as steadfast as ever. For a long time China’s banking system even did without deposit insurance. Although depositor insurance now exists, to this day the public’s trust in banks stems from the fact that around 90% of the assets in China’s financial system are in the hands of state-owned institutions that possess an implicit government guarantee. In contrast, the level of trust in the real estate market and in private property developers is in the cellar. The reason for that owes to a Chinese peculiarity: 80% to 90% of new home sales in China are pre-sales of housing units that haven’t been built yet. Housing pre-sales are common worldwide, but only in the form of down payments or installment payments. In China, however, households pay the full price in advance and thus bear all of the risk if a property developer doesn’t complete the construction project. Around 85% of those liabilities are on the books of risky private-sector real estate companies.

It’s not astonishing that public trust has vanished and real estate sales have collapsed, because ever since the bankruptcy of Evergrande, the former largest property developer in China, the streak of insolvencies in the sector hasn’t stopped. Thus far, 54% of publicly traded property developers in China have already defaulted on payments owed to creditors or have restructured their outstanding debt. In light of that statistic, households likely may be doubting that their receivables claims will be settled anytime soon through the handover of finished housing units. In a classic run on a bank, households would express their loss of trust by demanding their cash back. The loss of trust now on the real estate market is reflected in other households being less willing to buy a housing unit that may never get built to completion. Pre-sales of housing units have plunged in half since mid-2021.

If one regards the Chinese real estate crisis as being primarily a crisis of confidence as outlined above, it becomes clear why the government’s interventions have been to little avail thus far. To make it more attractive to purchase a home, the government of China initially focused on demand-side measures such as cutting mortgage interest rates (to the lowest level of all times) and removing a number of restrictions and administrative obstacles. But cheaper financing conditions haven’t helped thus far to overcome the crisis – the loss of trust in the pre-selling principle has disrupted the monetary policy transmission mechanism. China’s political leadership has indeed tried to restore trust in pre-sales by repeatedly promising “bao jiao lou” (“guaranteed delivery of buildings”), but has never substantiated that promise. A mechanism that would ensure that 100% of all housing units that have already been sold get handed over to buyers has been missing thus far. To date there has only been stepped-up pressure by regulators on banks to issue more loans to property developers, which hasn’t ended the spate of bankruptcies but has further intensified the collapse in confidence.

Plummeting mortgage rates… | …can’t halt the crisis

Weighted average mortgage interest rate for consumers

Sources: PBoC, Kaiser Partner Privatbank

Is there still hope for China’s real estate market? During the last half-year, Beijing’s rhetorical emphasis has shifted to the government’s “three major projects”: expanding construction of subsidized social housing, renovating neglected urban shantytowns, and strengthening resilience to natural catastrophes by building corresponding civil infrastructure. This expansion of public construction spending could contribute to offsetting part of the contraction in investment spending by private property developers and could thus alleviate the negative impacts on economic activity. But programs of that kind do not directly address the root causes of the loss of trust in the pre-sale system. A more suitable approach would be to directly buttress the finances of real estate developers, as an array of Chinese and foreign economists have already proposed. There are many different ways to structure a support measure of that kind: (1) Pre-sold housing units could be covered by a mandatory insurance program that would ensure the completion and handover of homes in the event that a property developer goes bust. (2) Government agencies could buy pre-sold housing units from distressed property developers at a discount and finish the construction work themselves. (3) Government-backed investment funds could acquire stakes in distressed property developers, though the exact stakeholder structure would be less important than the implicit state guarantee. Chinese policymakers took the first steps in the right direction after the turning of the year. On January 12, a new “coordination mechanism for real estate financing” was unveiled. The new mechanism now specifically makes local governments responsible in the future for ensuring a sound financing situation in the real estate sector. Since this means that banks will now be acting at the explicit behest of policymakers, they are likely to increase their lending, at least to state-owned real estate companies. A second measure followed on January 24 when financial supervisory authorities eased restrictions on operating loans to property developers. In the past, such loans were only allowed to be used to finance expenditures related to the management of commercial real estate. Under the new regulations, property developers can instead use the funds also to retire other loans and redeem bonds. This is likely to contribute marginally to getting more idle construction projects completed in the quarters ahead. However, it remains to be seen whether that will be enough to win back the public’s trust.

There’s a lot at stake in the debate over the right real estate policy. The ongoing plight has been putting a constant strain on economic activity in China for two-and-a-half years now. But despite the idiosyncratic mechanics of the country’s economy, one lesson from previous financial crises nonetheless applies even to China. The crux of that lesson is: once a loss of trust in the system impedes the conduct of financial transactions, the government must use its sovereign resources to get the system back up and running.

Fixed income

The financial media in recent months have been reporting more frequently about “basis trades” and have been flagging them as a risk for financial markets? What is this all about?

Kaiser Partner Privatbank: “Basis trades” are arbitrage transactions on the US Treasury bond market through which hedge funds bet on a convergence of prices between more expensive Treasury futures and cheaper cash Treasurys. On paper, a basis trade doesn’t entail any significant risk because the bet isn’t placed on rising or falling interest rates or on shifts in the yield curve, but instead is market- and duration-neutral. However, due to the use of enormous debt leverage, the multibillion-dollar speculative bets by hedge funds definitely can pose a risk to financial market stability, specifically when liquidity for financing basis trades dries up.

The architecture of basis trades takes the following form: Hedge funds borrow money from a broker/dealer and use it to purchase US Treasurys. They then deposit the acquired government bonds as collateral. All of that happens practically simultaneously. As a counterpart to that long position in Treasurys, they sell Treasury futures (short position) at the same time. Since hedge funds can borrow at a loan-to-value ratio of 98% to 100% against the bonds and hardly have to deploy their own capital, they can leverage the bet by a factor of 50 to 100 times. The incentive for hedge funds is obvious: the capital leverage employed in this trade enables them to parlay the tiny price discrepancies between the securities into huge profits. The transactions, in turn, are also lucrative for brokers/dealers because the lending involved allows them to earn the repo rate, which in normal times is higher than the interest that the US Federal Reserve pays brokers/dealers for liquidity.

Why are basis trades so incredibly popular right now that they threaten to turn into a risk? Multiple underlying causes make the bets especially profitable at the moment. For one thing, the supply of government bonds has increased in recent quarters as a result of stepped-up issuance activity by the US Treasury (keyword: huge fiscal deficit). In addition, quantitative tightening by the Fed has also enlarged the supply of bonds on the market, which has to be absorbed by the private sector, mainly by banks and asset managers. Those market participants, however, are precisely the ones that lack incentives to increase their Treasury bond holdings. Banks have been tending to reduce their exposure to Treasury bonds because regulations require them to hold (expensive) equity capital for these inherently risk-free securities. Positions in physical bonds, in turn, are less interesting also for asset managers because the current inverted yield curve makes cash relatively more attractive. They therefore prefer synthetic exposure via Treasury futures, which is boosting demand for them. All of those factors combined are causing significant price differences between US Treasurys (lower prices) and Treasury futures (higher prices) that can be arbitraged profitably.

Explosive growth | A good environment for bond arbitrage

Volume of leveraged short contracts on US Treasurys (2-, 5- and 10-year notes), in USD billion

Sources: CFTC, Kaiser Partner Privatbank

Estimates of the aggregate volume of basis trades placed range between USD 500 billion and USD 1 trillion. Basis trades per se theoretically do not pose much of a systemic risk to the financial system. However, their massive leverage effect can considerably intensify any market volatility that emerges. The events of spring 2020 serve as a cautionary tale in this regard. Shortly before the outbreak of the pandemic, basis trades were almost as popular as they are today due to the similar conditions that prevailed at that time. But as the need for liquidity rapidly surged in the midst of the March 2020 bond crash, hedge funds found themselves forced to quickly unwind their bets. Securities exchanges demanded higher collateral for futures positions, and brokers/dealers were no longer willing to keep on lending money for bond purchases. This triggered a phased selloff (at almost any price) on even the highly liquid and safe market for US Treasury bonds. The turbulence didn’t come to an end until the Fed announced a massive securities-buying program.

In retrospect, it seems clear that if basis trades had been less popular and liquidity-consuming in spring 2020, the dislocations on the bond market would have caused less of a stir. That’s why policymakers are trying all the harder right now to avert a repeat of a market crash of that kind. However, the Fed lacks the means to reduce the incentive to place basis-trade bets on bonds. Worse yet, the Fed actually has even increased the attractiveness of basis-trade bets because ever since the central bank’s intervention four years ago, market participants today are counting on a “Fed put” in the event of a repeat situation. It thus has been left to the Securities and Exchange Commission (SEC) to do the heaviest lifting. The SEC has proposed a 2% safety margin on repo transactions involving Treasury bonds. Theoretically that would limit the maximum leverage effect for hedge funds to 50 times. However, those changes won’t go into effect until the second quarter of 2025 at the earliest. In the meantime, the volume of basis trades will probably increase further. Signs of stress in the refinancing market could mount during the course of this year in the form of interest-rate jumps on the money market, for example. If the friction becomes acute and renewed major turbulence looms, the Fed is likely to completely halt quantitative tightening in 2025.

Cryptocurrencies

In January, the US Securities and Exchange Commission gave Bitcoin ETFs the green light for the first time to start trading. Does this mark the breakthrough for cryptocurrencies?

Kaiser Partner Privatbank: The moment finally arrived on January 10 when the US Securities and Exchange Commission (SEC) gave its approval to what Bitcoin fans had long been yearning for: a spot Bitcoin ETF, or more precisely, a whopping 11 of them at once, including ETFs from many big names in the US asset management industry such as Blackrock and Fidelity Investments. (US) investors thus now are getting direct access to Bitcoin without having to purchase it and hold it in safekeeping themselves. For crypto enthusiasts, this maps out the path forward for digital coins. In the bullish scenario, one can expect to see massive net inflows into the new exchange-listed investment vehicles in the quarters and years ahead. The exuberantly optimistic estimate from Galaxy Research even stretches to up to USD 100 billion within the next three years. Growing demand for bitcoins coupled with a limited or even shrinking supply of them would put constant upward pressure on crypto prices – even six-digit prices are the inevitable outcome in the eyes of Bitcoin bulls. Moreover, a return soon to falling central-bank interest rates would enhance the relative attractiveness of cryptocurrencies again. Last but not least, the ever more extensive regulation of the crypto universe is viewed by many fans as an added plus and ultimately as the driving force for mass adoption.

Déjà vu all over again | Another short-lived top?

Bitcoin and Ethereum, in US dollars

Sources: Bloomberg, Kaiser Partner Privatbank

Nevertheless, the SEC’s long-deferred admittance of Bitcoin ETFs to securities exchanges didn’t ignite price fireworks. Quite the contrary, in fact, at least for the time being it marked the apex of a torrid rally that had tripled the price of Bitcoin within 14 months after the end of the second crypto winter. Profit-taking of that kind is nothing out of the ordinary in Bitcoin’s still-young trading history (see chart above). In the present instance, there was demonstrable profit-taking particularly in the Grayscale Bitcoin Trust, which was converted into an ETF. Grayscale Bitcoin Trust had already been in existence for many years, but always had a shortcoming in that its traded share price deviated substantially from Bitcoin’s price. Its now completed move to “change skins” reduced this discount, and some investors pocketed lucrative arbitrage profits. More than a few others alternatively decided not to realize profits yet and instead opted just to switch into a different investment vehicle because the new ETFs launched by the competition engaged in a price war right from the outset and, with fees amounting to 20 to 30 basis points per annum, are much cheaper than the Grayscale Bitcoin ETF (1.5%). Even though some of the new spot Bitcoin ETFs amassed triple-digit million-dollar inflows during their first few days of trading, on the bottom line the new product genre hasn’t generated any substantial net capital inflows yet into the crypto universe as a whole.

We view the current breather in the price action as nothing unusual in the volatile crypto sector, which had gotten a bit overheated again lately, and regard it more as being another healthy reality check. It is becoming clear that the new Bitcoin ETFs alone aren’t sparking a surge in demand for crypto. Whoever wanted to invest in Bitcoin and the like already had different ways to do that in the past. The target group of institutional investors new to the crypto space, such as hedge funds and family offices that had been waiting for simpler and better-regulated access to cryptocurrencies, typically doesn’t rush headlong to invest in a newly approved product, but instead takes its time. Meanwhile, the second target group – investors who thus far haven’t considered Bitcoin a part of their investment universe – have to be inspired to invest in the cryptocurrency through targeted information and awareness-raising work. The marketing machinery needed to do that has only just been started up by the ETF providers. It seems evident that the ongoing evolutionary process in the world of crypto will inexorably continue. Mid-January, for instance, already saw the launch of the first covered call Bitcoin ETF, a vehicle that tries to exploit the high volatility of Bitcoin to generate recurring premium income. Applications for the approval of leveraged and inverse Bitcoin ETFs have also already been submitted. And behind the scenes there is also already speculation about the impending approval of an ETF on the cryptocurrency Ethereum.

The rollout of spot Bitcoin ETFs undoubtedly marks another major milestone in professionalizing and institutionalizing the crypto market. It appears destined to increase the leading cryptocurrency’s market depth and liquidity in the medium term. But whether investors should seize the latest developments as an opportunity to jump aboard the crypto bandwagon remains a personal decision that should depend mainly on one’s own risk preference and ability to bear risk. Viewed objectively, the prices of cryptocurrencies are still subject to wild fluctuations. And even though the SEC gave the green light to Bitcoin ETFs in the end, at the same time SEC chief Gary Gensler issued a statement worth remembering, pointing out that Bitcoin is “primarily a speculative, volatile asset.”

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