Ask the experts – Questions stirring our clients (and the financial markets) in February 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.

Economy

No natural gas shortage in Europe and an overheating job market in the USA – has the recession been called off?

Kaiser Partner Privatbank: Electricity and natural gas prices have fallen, peak inflation is in the rearview mirror, and the “reopening” of China’s economy promises to give a boost to growth in the quarters ahead. This has banished the specter of a recession in Europe. After hitting bottom last autumn, business (and consumer) sentiment has since improved significantly (or at least has found a floor). More and more economists are scrapping their recession forecasts and raising their growth projections for 2023. GDP growth data for the Eurozone for the fourth quarter of 2022 already came in better than expected with a mini-uptick of 0.1%. Only Germany saw a surprising downward revision for the final quarter of last year and might actually experience a “technical” recession this winter.

So, of course, one cannot simply draw the curtain over the recession question. It continues to be a valid one for the US economy and remains a perplexing mystery for the analyst community because established macro indicators like the US yield curve and the Conference Board’s leading indicators index continue to signal a heightened risk of a recession. Announcements of mass layoffs, particularly at big tech firms and in the financial sector, appear to fit with this picture. But it is contradicted by very robust US labor market data (which are prone to undergo substantial revisions, though): 514,000 new jobs were created in January while the US unemployment rate fell to a 54-year low (3.4%). The number of job openings recently resumed rising while initial unemployment claims decreased. This conflicting set of data is also reflected in the recession projections in the Wall Street Journal forecaster survey. In the latest survey, the expected probability of a recession within the next 12 months ranged widely from 10% to 100%, but the median projection stood at a relatively high 65%, which means that the consensus does not believe in a soft landing.

Predominantly pessimistic | Wall Street does not believe in a soft landing

Estimated probability of a US recession (within the next 12 months)

Sources: Wall Street Journal, Kaiser Partner Privatbank

We, however, tend to side with the optimists. Our expectation expressed in our outlook for 2023 remains intact: a recession looms in the USA probably later than the majority is anticipating and is likely to turn out relatively mild. A recession most likely is unavoidable in the end because the many uncertainties and numerous variables (and a poor track record) make it too hard for the US Federal Reserve to keep on finely recalibrating its monetary policy, but it will take some more time before a recession arrives. There are currently 1.9 job openings for every unemployed person in the USA, and almost every industry is reporting more vacancies than usual. Anyone who was laid off recently and/or is currently looking for work will probably find a new job in the quarters ahead with relative ease. Moreover, US households are still sitting on USD 1.4 trillion of excess savings from the pandemic. Based on the current personal saving rate, it would take 15 months to completely use up those savings. The US consumer-spending engine therefore won’t start to sputter so quickly. However, in mid-2024, the probability of a recession is bound to surge because the knock-on effects of the Fed’s rate-hiking cycle should become increasingly palpable then. Moreover, a scenario in which the current phase of disinflation is followed by a second wave of inflation cannot be ruled out. The reopening of China’s economy could exert an inflationary impact, as could a future return to rising real wages (thanks to the current pullback in inflation). The Fed would then be forced to keep interest rates at a very restrictive level for a longer time. This scenario would automatically result in a sharper rise in unemployment and a recession.

Monetary policy

Fixed-income market participants are speculating that the US policy rate will pull back soon. Isn’t the proverb “Don’t Fight the Fed”?

Kaiser Partner Privatbank: The US Federal Reserve and the financial market were long in disagreement. Financial market participants specifically were anticipating that the Fed would revert to cutting interest rates by as early as the second half of this year either because inflation will recede very quickly in the months ahead or because the USA will soon slip into a recession. But the very robust January employment market data and the slower-than-hoped-for subsiding of inflation recently prompted them to change their thinking. So, have they decided not to fight the Fed after all? Fed officials’ dot plot sees the federal funds rate at 5.1% at the end of 2023 (median estimate). Current trading in federal funds futures contracts indicates that financial market participants now likewise see the policy rate at 5.1% in December, but they expect it first to climb much higher than that level this summer. The market prices basically imply that the interest-rate level temporarily will (needlessly) be raised too high and that the Fed will thus make a monetary policy mistake. There is also agreement that interest rates will soon start to fall again and that the current level is already well in restrictive territory. The Fed’s median projection sees the US policy rate at just 4.1% at the end of 2024 while the financial market’s expectation is situated not far from that forecast estimate.

So, the financial market is not necessarily positioned against the Fed and its monetary policy anymore. Investors should position themselves the same way because the best way right now to interpret the motto “Don’t Fight the Fed” is as follows: The Fed is still in the middle of a rate-hiking cycle, and the stock-market rally in recent weeks has been thwarting its efforts to make the monetary environment more restrictive. In fact, various financial conditions indices have recently been showing a substantial easing. Investors should contemplate doing at least some profit-taking because the already small probability of a soft landing by the US economy won’t come true unless the Fed immediately reverses course. But that’s not the Fed’s plan. If interest-rate cuts do come sooner or later, they too wouldn’t necessarily be a reason for investor euphoria because if a recession actually turns out to be the cause of falling policy rates in the future, a dip to new share-price lows likely lies ahead on equity markets.

Headed backwards soon? | The financial markets expect the Fed to reverse course soon

(Implicit) expected change in federal funds rate

Sources: Bloomberg, Kaiser Partner Privatbank

Equities

Equity markets started the new year with big gains, with European and Chinese stocks significantly outperforming. Can these trends continue?

Kaiser Partner Privatbank: The performance of equity markets this year is not following the script penned by most strategists. In their outlooks for 2023, many predicted a weak first half and good buying opportunities at mid-year, but the actual progression has been exactly the opposite. The robust rally broke stock indices in the USA and Europe out of their downtrend channels that had been in place since the start of 2022, sending a bullish technical signal. Reliable long-term momentum indicators are also flashing buy signals. However, a certain degree of caution is called for over the next several weeks because prior bearish sentiment and oversold conditions were a key driver of the share-price advances, and they both have now flipped. After a record-long 44 weeks of bears outnumbering bulls among US retail investors, majority sentiment has shifted back to the bull camp since the start of February. According the NAAIM Exposure Index, active managers have recently ratcheted their investment exposure to equities back to as high as it was before the start of last year’s bear market. Meanwhile, corporate insiders have taken advantage of the elevated stock prices in recent weeks to shed some shareholdings. So, from a tactical perspective, there are mounting signs that the now three-month-old stock-market upturn is about to undergo a correction.

European and Chinese stocks have performed particularly well year-to-date on the back of the market’s move to price out its worst fears (of an energy crisis and a recession) and as they benefited from the reopening of China’s economy after the dismantling of the country’s zero-COVID policy. Will the outperformance continue? Our stance on China is on the cautious side. Although we expect to see a sizable burst of growth there this year, the country’s lingering challenges and unsolved problems, particularly in the real estate market, make it uncertain whether sentiment toward the Chinese stock market will lastingly improve. Moreover, the Chinese market is still in an intact downtrend channel despite the recent rally. Anyone who nonetheless would like to bet on China bullishness can do that also indirectly in his or her investment portfolio via Western stocks like Swatch, Richemont and Nestlé, for example.

Europe’s outperformance (versus the USA), on the other hand, could continue in the medium to long term on the back of more than just the tailwind from China, and the more than decade-long relative downtrend may have reached its end. The European stock market’s much lower valuation (even after adjusting for its different sector composition compared the USA) and the improved earnings outlook for value sectors like financials, energy and basic materials argue in favor of Europe. US stocks, meanwhile, have lost prospective attractiveness. The US dollar may have carved out a long-term top in 2022 and may work off its overvaluation over the coming years (which reduces performance for European investors). Furthermore, the profit margins enjoyed by US technology giants could come under pressure in the future as their growth models reach their limits and they face challenges from new disruptors and increasing scrutiny from antitrust authorities. An enduring outperformance by growth stocks like the one seen over the last decade is unlikely to happen in the new macro and interest-rate climate these days.

However, an above-average performance by European markets requires a certain degree of stability in the global macroeconomic environment and ideally calls for slightly stronger-than-average economic growth. Europe then could pull up and away from a potentially rangebound US market like it has done in previous outperformance phases. But in the event of a major drawdown on the US stock market, investors would hardly be able to find shelter in Europe. In such an adverse scenario, European stocks’ higher beta and the US dollar’s frequent tendency to appreciate during periods of stress would cause Europe to underperform as it has so often in the past.

The US tech turbocharger… | …could start to sputter

Stock indices with and excluding the technology sector

Sources: Bloomberg, Kaiser Partner Privatbank

Asset allocation

Are (US) government bonds still a valuable diversifying element in an investment portfolio?

Kaiser Partner Privatbank: In 2022, the classic American portfolio of 60% stocks and 40% bonds turned in its worst year since the Great Financial Crisis of 2008–2009. At that time, government bonds were able to offset at least part of the plunge in stock prices. Last year, however, both asset classes plummeted as rampant inflation and the Federal Reserve’s tightening monetary policy caused their performance correlation to suddenly turn positive. This was an unusual occurrence at least for young to middle-aged investors because ever since the turn of the millennium, a regime under which stock and bond prices constantly moved inversely to each other had prevailed on the markets, enabling bonds to produce a pleasing “parachute effect” during times of crisis on the equity market. Is this regime now history, and does it still make sense to diversify with bonds?

A year to forget | Is it comeback time for the mixed portfolio?

Rolling 12-month-performance of a US 60/40 portfolio

Source: Bloomberg, Kaiser Partner Privatbank

A look back at the past 100-plus years reveals that the last two decades were an anomaly. Never before had there been a similarly long period of a persistently high inverse performance correlation between stocks and bonds. Quite the contrary, in fact, the correlation was mostly positive over the past century or so. Since we expect to see sustained higher inflation rates of 2%–3% (instead of 0%–2%) in the years ahead and since an ultralow to zero interest-rate environment is unlikely to return anytime soon, the “old” regime of a positive correlation between stocks and bonds could stage a lasting comeback. But whether bonds would provide added value as a diversifying element in such an environment would depend on an investor’s risk profile and investment objectives. If the aim is to optimize a portfolio’s risk-adjusted return, then it would make sense to blend bonds into a stock portfolio. In nominal terms, the Sharpe ratio (a measure of investment return against risk) of a 60/40 portfolio has consistently exceeded that of a pure equity portfolio over long periods of time. The picture looks different, though, when the calculation is adjusted for inflation. Since bonds, unlike stocks, are not real assets, they have reduced the risk-adjusted return on a mixed portfolio during times of high inflation (and rising interest rates). Long-term investors who are striving to increase their purchasing power (by earning a positive real return) and are able to tolerate somewhat higher volatility should tend to aim for a smaller bond allocation or should shun bonds altogether in the future under the new “old” inflation and correlation regime.

Interest-rate and inflation trends… | …have an impact on stocks and bonds

Nominal, real, and risk-adjusted returns in the USA

Sources: BCA Research, Kaiser Partner Privatbank

Asset allocation

Why should a person continue to invest in stocks when a return of 4% to 5% p.a. can be earned with short-term investment-grade bonds (denominated in US dollars)?

Kaiser Partner Privatbank: In the new TARA world – a world in which there are reasonable alternatives – investors are no longer forced to stand on the high upper end of the risk ladder. The interest-rate turnaround initiated by central banks a year ago now allows investors to climb back down a few rungs. Attractive yields can now be earned again with conventional corporate bonds (particularly those denominated in US dollars) because today they substantially exceed equity dividend yields. So, should a person simply ditch stocks and rotate his or her assets into bonds? After all, our five-year annualized average return expectation of +6.8% for stocks is no longer all that much higher than the yields to maturity on investment-grade bonds (approx. 4%–5%). But it’s not as simple as that because in order to book attractive bond returns, not only would you have to buy individual bonds and hold them to maturity, but the borrower would also still have to be solvent at the end of the multiyear bond term, otherwise losses loom. The size of minimum transaction amounts (and the low trading liquidity in some case) makes it harder for retail investors to invest directly in individual bond issues. On the other hand, the popular way of investing in debt securities via bond funds or ETFs doesn’t always deliver a return equal to the yield to maturity because the market value of bonds depends greatly on how interest rates evolve. In the event of a rising interest-rate level, it’s occasionally possible to suffer price losses with bonds even though they were acquired at an attractive yield level. So, against this backdrop, it makes little sense to bet solely on bonds in the future. You will hardly be able to at least spare your nerves by investing exclusively in bonds because a certain degree of volatility is inevitable. However, a higher allocation to bonds within a mixed portfolio does make more sense today than in the past because stocks’ attractiveness advantage relative to bonds has markedly diminished.

A choice is better than none | Bonds have become an alternative again

Dividend yield vs. bond yields in the USA

Sources: Bloomberg, Kaiser Partner Privatbank

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