Ask the experts – Questions stirring our clients (and the financial markets) in November 2022
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 outcome of the US midterm elections turned out tighter than expected – the “red wave” didn’t materialize. What are the implications for politics, the economy and the financial markets?
Kaiser Partner Privatbank:
Joe Biden’s election victory can’t be trivialized. The US president was up against more than just historical election statistics, according to which the party of the sitting president traditionally loses a large number of congressional seats in mid-term elections. Biden’s historically low public approval ratings were also a liability, and soaring gasoline prices, generally exorbitant inflation and flagging economic activity posed additional obstacles. Democrats nevertheless held their ground in the US Senate, where they continue to control a de facto majority when Vice President Kamala Harris’s tie-breaking vote is factored in. If they also win the runoff election in Georgia on December 6, the final score would be 51 seats to 49, giving the Democrats the upper hand also on Senate committees. Although the Republicans were able to gain the upper hand in the US House of Representatives, their majority is much smaller than was expected by pundits and projected by polls in the runup to the midterms. The list of election losers includes former President Donald Trump (which didn’t stop him from announcing a renewed candidacy for the 2024 presidential race), the MAGA Republicans and the so-called election deniers. That last group failed to win any of the key secretary of state seats that were up for grabs in 27 states, which, if they did, would have been a bad omen for the next presidential election. So, it’s entirely justified to construe the midterm election outcome also as a “victory for democracy.”
Political uncertainty now looks set to subside for starters in the near term. On the other hand, though, the end of the 2022 midterm elections means that the 2024 presidential election is around the corner, and a divided Congress isn’t devoid of risk looking ahead to the upcoming electoral battle. Success in fighting inflation or in averting a recession would boost Biden’s chances of winning reelection. The Republicans therefore are bound to have little interest in working out real solutions. Obstructionism and renewed brinkmanship on the debt ceiling issue are more likely to loom. However, the Republicans, in turn, will hardly be able to advance their own agenda of aims such as pursuing deregulation of the economy and the energy sector and appropriating more funding for the military, the police and border security while implementing spending cuts elsewhere. Only one thing seems certain: Republicans will block any further tax hikes. Effective corporate taxes look destined to stay low, which is marginally beneficial to profit margins and investors. The Democrats, for their part, will be unwilling to make cuts to the social safety net or to curtail Biden’s legislative initiatives that have already been enacted. Against this backdrop, the US budget deficit looks set to stay at its current high level or even increase further. In any event, budgetary retrenchment is nowhere in sight in the impending gridlock scenario.
What does the election outcome mean for the financial markets? Caution is called for when answering this question, not only because the importance of elections and politics in general is overrated, but also because historical analysis of the correlation between different constellations of power in Congress and market performance tells little about the future. Macro (economic growth, inflation, interest rates) and micro (corporate earnings, valuations) variables are bigger determinants of asset prices than the colors red, blue and purple in Washington, D.C. are. The prevailing hypothesis among many investors that political gridlock is good for the equity market has proven true since the dawn of the Ronald Reagan era in the early 1980s, but is false for the high-inflation period from 1966 to 1982. Whoever absolutely needs historical patterns as a guide could take a look at the presidential cycle, which presages an above-average performance for stocks for the year between midterm elections and the next presidential election year regardless of which party holds the majority in Congress.
In fact, it’s mainly the inflation trajectory in the months and quarters ahead that is likely to have the biggest impact on the equity market as a whole in the near future. In this regard, the stalemate in the US Congress is mildly disinflationary in the near term (no new economic stimulus programs), but will tend to be somewhat inflationary in the medium term (due a to a tendency to nudge up spending). The job of combating inflation and kick-starting economic activity in the event of a recession thus falls to the US Federal Reserve. Looking at individual business sectors, the divided US government could definitely produce winners and losers. Sectors like “dirty energy” (mainly oil and gas) and pharmaceuticals, which would have faced significant regulatory or legislative crackdowns under a Democratic majority, will probably receive a reprieve. Sectors like renewable energy and infrastructure, on the other hand, could lose a bit of momentum, but nothing more than that because legislation like the Inflation Reduction Act that has already been passed can’t be overturned by the Republicans since they lack the two-thirds majority needed to do that.
Glimmer of hope | The presidential cycle presages a positive performance
Average performance of the S&P 500 index since 1950
Sources: Bloomberg, Kaiser Partner Privatbank
Energy storage facilities in Europe are filled to near capacity, and the coming winter no longer appears to pose a problem. Does a natural gas shortage loom in winter 2023/2024?
Kaiser Partner Privatbank: Thanks to mild autumn weather and frantic (and expensive) efforts in recent months to import natural gas, gas reserves in Europe are very well filled at the moment at a level far above the norm. EU-wide gas storage was filled to more than 95% capacity as of mid-November, and storage sites in Germany were almost 100% full. This comfortable situation owes in large part to a reduction in demand. Businesses and households have cut gas usage, switched to alternative sources of energy and/or scaled back production in response to the high prices. The German manufacturing sector, for example, consumed 27% less natural gas than usual in October. Since the risk of a gas shortage this winter has diminished significantly, natural gas prices have plummeted in the meantime. Since peaking at almost EUR 350 per MWh in late August, the price of gas has retreated by around two-thirds and has stabilized at a level a little above the EUR 100-per-MWh mark. This has beneficial implications for the economic outlook in the Eurozone: the unavoidable winter recession will be less severe (we anticipate a cumulative contraction of 1% to 2% from Q4 2022 to Q2 2023), and households and businesses will need a bit less support (which will ease the strain on national budgets somewhat).
So far, so good. But winter 2022/2023 will eventually be followed by winter 2023/2024. Our analysis of scenarios for the cold season after next indicates that a certain gas shortage risk lingers, but only in the most adverse and unlikely scenario. In the baseline scenario of a (1) normally cold winter, (2) 10% to 15% lower natural gas consumption by households and industry compared to the average in recent years, and (3) continued elevated or mildly rising imports of (non-Russian) gas, natural gas stocks in the EU are still likely to be filled to more than 60% capacity in spring 2024. Even if Russia were to completely turn off the gas spigot to the West, the supply inventory situation under the above conditions, at a projected good 40% of storage capacity, would likely still reassuringly far exceed the minimum fill level since 2015 (approx. 20%). The risk scenarios, in contrast, envisage a colder-than-average winter and/or flat imports of non-Russian gas (limited supply of liquified natural gas). In our estimation, shortages and a need to ration gas are unlikely to arise unless both adverse conditions cited above occur in tandem. But even if the worst case probably won’t materialize in the end, one thing seems certain: the era of cheap natural gas in Europe is over. The manufacturing sector will have to adapt to this new reality in the quarters ahead, and the inflationary pressure caused by high energy prices will likely persist for a while longer.
Comfortable | The coming winter does not (yet) pose a problem
Natural gas storage fill level in the European Union
Sources: AGSI, Kaiser Partner Privatbank
How much higher will central banks raise policy rates?
Kaiser Partner Privatbank: Central banks continue to have to walk a delicate tightrope between persistent rampant inflation rates at the moment and mounting risks to economic activity. With benchmark lending rates standing at 2% in the Eurozone and 4% in the USA at last look, the monetary policies being pursued by the European Central Bank and the US Federal Reserve are already exerting a forceful restrictive impact, in our view. The 200 basis points of rate hiking thus far by the ECB and the almost 400 basis points of hiking to date by the Fed have dealt a delayed-action shock to many submarkets (real estate, corporate finance, etc.). More and more central bankers in recent weeks apparently have come to share this view; voices advocating a slower pace of rate hiking in the near future have predominated lately. The minutes of the last central-bank policy meetings also point in this direction.
Receding inflation rates would make it easier for central banks to initiate the pivot that financial markets have been hoping for. The disinflation process appears to be long since underway in the USA. Headline inflation there in October surprised well to the downside at 7.7% (consensus estimate: 8.0%). Prices actually even declined month-on-month when the volatile energy and food components and the sticky rent component are stripped out. It wouldn’t astonish us if US inflation continued to ebb much faster than expected in the months ahead. The year-earlier comparison base effect suggests that it will, and so do the continued easing of supply-chain bottlenecks, rising inventory levels, waning demand and significantly slowing rent price momentum, which also is likely to start showing up in inflation figures from spring onward. Inflation in the Eurozone, meanwhile, will peak later on, probably in the next two to three months, but a recession there is already a sure thing and the economic climate in the Eurozone is more fragile. The ECB, too, thus has limited room to raise interest rates further. On balance, we see potential for the world’s two most important central banks to ratchet rates higher by another 50 to 100 basis points. We thus see the terminal policy rate in spring 2023 at 2.5% to 3% at the ECB and at 4.5% to 5% at the Fed. The policy rate in Switzerland looks set to end up at a somewhat lower level of 1.5% to 2%. However, the strong franc gives the Swiss National Bank an additional tool to employ to combat inflation pressure, and the SNB will likely make active use of it.
The rhetoric from central banks, which is slowly but surely becoming more cautious, is also being reflected on the interest-rate markets, where terminal rate expectations have already fallen considerably since Fed Chairman Jerome Powell’s emphatically hawkish performance at the last FOMC meeting on November 2. The question of where policy rates will peak is a hard one to answer, but an even tougher one is what trajectory rates will take afterwards. The interest-rate markets are anticipating a return to rate cutting by as early as the second half of 2023 and are thus pricing in a monetary-policy mistake by central banks, i.e. overaggressive hawkishness that will have to be corrected soon. There, in fact, is a high probability from today’s perspective that this will happen. However, if a recession in the USA doesn’t come to pass, the federal funds target rate could stay at a very restrictive level between 4% and 5% for a longer time because the Fed will probably want to avoid an overly swift and economically needless easing of monetary policy since that would significantly increase the risk of sparking a 1970s-style inflation spiral.
Waiting for the pivot | Interest-rate expectations have already pulled back
Market expectations for the US federal funds target rate in June 2023
Sources: Bloomberg, Kaiser Partner Privatbank
Interest rates have risen sharply. Have fixed-income assets now become attractive again?
Kaiser Partner Privatbank: The fastest synchronous global rate-hiking cycle in more than 40 years had dramatic impacts on bond markets 2022, resulting in drastic price drawdowns that were often in double-digit percent territory. The flipside of the coin, though, is that the sharp increase in yields means that investors in the meantime are once more being compensated for taking on risk and may even soon be richly rewarded for doing so. The massive mountain of negative-yielding bonds last year has since shrunk to the size of a molehill these days. “There is no alternative” (TINA) has now given way to “there are reasonable alternatives” (TARA). One example of this is US Treasury inflation-protected securities. If you buy 10-year TIPS today, you can lock in a 1.5-precentage-point real gain in purchasing power. (Nominal) government bonds in the USA and Europe are the ones offering the best risk/reward tradeoff at the moment. Two-year US Treasurys, for example, are currently yielding more than 4%. But longer-dated debt securities are also becoming attractive now because inflation has peaked in the USA and policy-rate expectations have likely pivoted. The yield highs to date of 4.3% for 10-year US Treasury notes and 2.5% for their German sovereign counterparts may thus mark the absolute top of the current cycle or at least are likely to be exceeded only marginally if at all. Looking particularly at the expected weak economic growth next year and the increased risk of a recession, falling bond yields (and rising bond prices) appear to be the path of least resistance.
Investment-grade corporate bonds are also becoming more and more interesting. In terms of risk, the elevated credit spreads are already pricing in some bad (macroeconomic) news and provide a certain buffer against potential further yield increases. On the rewards side, meanwhile, credit spreads and market interest rates on medium- and long-term maturities look set to pull back over the course of the next 12 months (in the baseline scenario). Investment-grade corporate bonds would get a dual boost from this and could deliver double-digit returns next year. The same mechanism works in principle also for high-yield bonds, but we are still a bit more cautious toward this segment at present. Looking at the existing risks to economic growth in the next two to three quarters, we still see considerable credit-spread risk in the high-yield space. However, opportunities are likely to arise here as well in 2023. For whoever who would like to invest in the high-yield bond segment, it definitely makes sense to build exposure in a staggered manner. The bottom line is that there are good chances of a fixed-income comeback in 2023. The venerable classic balanced portfolio of stocks and bonds, which has been pronounced dead by many pundits, also looks set to resume achieving success. The risk-adjusted (expected) return for bonds is better than that for stocks, in our opinion. Risk-parity strategies with leveraged exposure to bonds therefore also look destined to perform well.
Attractive returns… | …and increasingly limited risk
Yields to maturity
Sources: Bloomberg, Kaiser Partner Privatbank
Value stocks have substantially outperformed growth stocks this year. Will they continue to do so in 2023?
Kaiser Partner Privatbank: The year-to-date performance differential between value and growth is quite sizable. While value stocks as measured by the MSCI World Value Index are down “only” around 10% for the year at last look, growth stocks are down by around 25%. Interest rates have been the biggest driver of the massive underperformance by growth stocks this year. A year ago, only two small 25-basis-point rate hikes by the US Federal Reserve had been expected for 2022 and not even a single rate hike was priced in for the Eurozone. In actual fact, however, the Fed has raised its benchmark lending rate six times since then in a sequence that has included four oversized 75-basis-point hikes. Market interest rates at the long end of the curve have also shifted upward sharply. A year ago, a quarter of all government bonds were yielding negative interest rates, but today investors have reverted to receiving a yield of around 3.8% on US Treasurys, and some Japanese government bond tenors are now the only ones left still yielding negative interest rates. These interest-rate movements have been fatal to the valuations of growth stocks because the revenue and profits that growth companies by their very nature won’t begin earning until far into the future (long duration) must now be discounted with a much higher interest rate than before.
On top of that, however, the macroeconomic climate has also inverted. In the years ever since the Great Financial Crisis until recently, growth stocks were more attractive than average in the face of sluggish nominal economic growth (and low inflation) and low profit growth in other sectors. The earnings growth reported by growth companies was exceptionally high, particularly in the USA. The low cost of capital was also a positive driver and disproportionately boosted the valuations of long-duration stocks. Traditional value sectors, meanwhile, encountered headwinds (such as tighter regulations on banks and falling commodity prices for natural resource companies). Seemingly attractive dividends thus became value traps. Today the macro picture looks completely different. Nominal economic growth is high (due to soaring inflation) and the earnings of classic value companies are robust while big tech firms are reporting disappointing profits. The cost of capital has risen sharply. Previous value traps are now turning into value opportunities because the increase in interest rates and commodity prices translates into high earnings, high free cash flows and ultimately attractive, reliable dividends. Sectors with a direct tie to inflation (commodities) and beneficiaries of higher interest rates (banks) have accordingly performed well lately.
But what’s next? There won’t be a return to the post-financial-crisis environment for the foreseeable future. Ultra-accommodative monetary policy is unlikely to experience a renaissance anytime soon, and inflation looks set to stay above central banks’ 2% target even in the best-case scenario. So, it would be unrealistic to expect the exceptionalism of growth stocks to make a lasting comeback. However, this doesn’t mean that growth stocks will enduringly underperform in the future. Looking ahead to 2023 from a tactical perspective, it’s once again (long-term) interest rates that will exert a crucial impact. Our estimates on bond yields (the peak perhaps has already been reached) and interest-rate expectations (central-bank pivot in sight) laid out above indicate that the downward pressure on stock valuations in the growth segment looks set to abate significantly. If, in the event of a rapidly darkening economic climate, the Fed starts to backpedal as early as in the second half of 2023, at least a brief revival of the growth investment style would be conceivable.
In the future, however, long-term investors should no longer look solely through the growth lens or make binary choices between growth and value. In times of elevated interest rates, revenue growth becomes not just less valuable – higher economic growth also makes it less rare at the same time. Meanwhile, higher input costs (for energy and labor) put downward pressure on profit margins. So, what’s called for are companies that are capable of sustainably boosting their revenue and earnings year after year. Attributes such as stable, high profit margins, sound corporate balance sheets and steady dividend growth will stand in the foreground in the future. Diversification will also become more important again in the future. Investments outside the US technology sector tended to detract from returns during the past decade, but regional and sector diversification now look set to resume paying off again in the new macroeconomic climate of the future.
An unaccustomed sight | Growth lags far behind in 2022
MSCI World Value vs. MSCI World Growth
Sources: Bloomberg, Kaiser Partner Privatbank
My portfolio is in deep red territory this year. My prime objective is to protect my capital. How can I protect myself from incurring (further) losses next year?
Kaiser Partner Privatbank: Conservative investors and their portfolios suffered stinging losses in 2022. In a year of soaring bond yields (and correspondingly plummeting bond prices) and concurrent price drawdowns in almost every other liquid asset class, the desire for capital protection couldn’t be met, not even by top-notch asset managers. The additional erosion of the purchasing power of wealth caused by rampant inflation doesn’t help matters. Price gains in individual sectors (such as energy stocks) and illiquid asset classes (such as private real estate) and the resurrection of attractive interest yields on US dollar savings accounts will probably console few investors because hardly anyone is likely to be invested exclusively in niches or is likely to have shifted all of his or her capital into a savings account at the start of this year.
Instead, many investors are bound to be an owner of a more or less well-diversified portfolio, and they should stick with that. In fact, diversification is arguably one of the best and a relatively inexpensive means of protecting capital, particularly looking ahead to investing in 2023, in large part because bonds should soon resume fulfilling their role of providing portfolio insurance. Particularly in the event of an adverse macroeconomic scenario, government bond prices are likely to rise substantially and would act as a buffer against any further stock-price drawdowns. Whoever wishes to play it safe can of course also resort to classic hedging techniques such as employing simple put options or more complex option strategies. However, these don’t come for free and are actually on the pricey side at the moment due to current relatively high volatilities. This elevated volatility, however, is beneficial for structured products. It enables attractive opportunities with (conditional) capital protection that can be taken into consideration as additional diversifiers. Finally, private-market assets should also be considered to round out a portfolio’s diversification. Private-market assets do not have built-in capital protection, but have regularly outperformed in the past during difficult market phases. Private credit particularly possesses defensive attributes. This segment actually even benefits from the rise in interest rates that has inflicted severe harm on most other asset classes this year.
You have further questions?