The European stock index Stoxx 600 recorded its worst relative performance compared to the American S&P 500 since 1995. The MSCI World Index, which represents around 1,400 companies from 23 industrialized countries by market capitalization, achieved an excess return of 11% compared to the same index with equal weighting of stocks, also a record value. A key factor behind these differences is that the world’s eight largest companies*, all headquartered in the United States, now account for more than one-fifth of the MSCI World Index. In 2024, they contributed 40% to the index’s performance. Their impact is even more pronounced in U.S. indices. The current economic environment is challenging, which makes growth particularly valuable and expensive. Leading technology companies benefit both from their dominant market position and the general technologization. The profit and valuation development of these companies, as well as their high share of the total market, reflect these trends.
Regional Developments and Political Changes
At the same time, economic prospects vary significantly in different parts of the world. In Europe, economic problems have shifted from the periphery to the center. France now faces similarly high interest rates on government bonds as Greece due to problematic state finances and tense domestic political conditions. Germany is grappling with various economic and political challenges. Its negative economic growth stands out clearly both in European and international comparisons. The fact that the German benchmark index DAX remains largely unimpressed is mainly because the companies included in the index generate a large share of their revenues abroad and benefit from a weak Euro. China’s economic development continues to fall well short of expectations. The weakening real estate market is weighing on consumption, which cannot be sufficiently offset by exports. Comprehensive measures have now been announced to stimulate the economy again. Whether these will be sufficient also depends on how seriously the U.S. government takes possible import tariffs.
With Donald Trump’s clear election victory, the U.S. has opted for a decisive policy shift both domestically and abroad. Deregulation and tax cuts are intended to bolster competitiveness, while Elon Musk is to ensure the stabilization of state finances. Given that interest expenses are now higher than total military spending, this idea is not far-fetched. The case of Argentina illustrates how swift and bold reforms can drive change, as initial signs of progress emerge through deregulation and the streamlining of government bureaucracy is revitalizing the nation’s economy. In Europe, a comparable development is not yet foreseeable. From a market perspective, it will be interesting to see how the different policy paths affect economic growth, which already differs greatly. Positive economic impulses can be well-used in the current environment, regardless of their geographical origin, and are in the interest of all investors.
Valuation Discussion and Company Analysis
In addition to economic differences, valuation disparities between the USA and Europe are among the most discussed topics currently. Based on our own evaluations and experience, however, regional valuation discussions are too narrow. The sector composition of the two regions is very different, and the dominance of the large technology corporations distorts both perception and the valuation of the technology sector and the overall market. Upon closer examination, one finds that there are hardly any two companies that can be directly compared. Lindt is not Hershey, and SAP is not Microsoft. Even when two companies have similar products, like Adidas and Nike, there are differences in sales markets and company-specific challenges. Accordingly, we assess each company individually in terms of quality, track record, and valuation. Within our investment universe, we see no significant regional valuation differences that cannot be explained by economic and company-specific factors. Internationally active companies with market-leading products and services adapt to global challenges and are often more agile and less restricted in their decision-making than investors. We take this into account by investing in companies with a leading market position regardless of the location of their global headquarters.
Conclusion and Outlook
While the dominant tech companies now reflect high expectations in their valuations which they must meet in the future, we find companies worldwide where this is not the case. Should the growth differential between major corporations and the rest of the market narrow, which is statistically likely, it could have a noticeable impact due to the high expectations already priced into valuations. In the medium term, we consider it realistic to see a return to the long-term trend in which equally weighted indices outperform those weighted by market capitalization. Any positive economic surprises could serve as a catalyst for this shift by enabling more broadly based earnings growth. Conversely, it is possible that the revenues and earnings of the dominant technology companies will fail to meet lofty expectations, leading to a corresponding correction in valuations.
Currently, a passive investor is more dependent than ever on the stock performance of just a few large corporations. Active asset management, on the other hand, offers the opportunity to invest selectively where quality and valuation are in an attractive ratio, without relying on the realization of high growth expectations. In times of heightened uncertainty and concentration risks, we believe that discipline and an active approach are especially rewarding. With confidence in our principles and strategy, we look to the future with steadfast optimism.
Zurich, end of Dezember 2024
*as of 31 December 2024: Apple, Nvidia, Microsoft, Amazon, Meta, Tesla, Alphabet, Broadcom (excl. Saudi Aramco, as it is not part of the MSCI World)
Heavyweights dominate index performance
In our latest investment report, we addressed the question of whether the technology sector is overvalued and concluded that this is not fundamentally the case. Looking back at the first half of the year, it is tempting to examine this issue from a different perspective.
In particular, the large technology companies, after another strong rise, are not only highly weighted in the benchmark indices but also responsible for a large part of this year’s performance. This is most pronounced in the Nasdaq technology index, where the 10 largest companies have a weight of 52% and are responsible for 94% of this year’s performance. In the more broadly diversified MSCI World Index, the 10 largest companies make up 25% of the index and have contributed 62% to the performance.
Economic growth is low, interest rates are high, and the outlook is uncertain. At the same time, we are experiencing euphoria in the field of artificial intelligence, and in the middle of it are the largest corporations, which have the financial means to invest in the data centers that produce the necessary computing power. Even without earnings from artificial intelligence applications, the earnings growth of these large corporations is already considerable. The combination of these factors has raised investor expectations, and as a result, the 10 largest companies are now twice as expensive as the overall market. At the same time, the weighting in the indices has risen sharply. As recent as 2018, the 10 largest companies in the MSCI World had a weighting of 12%, compared to 25% today.
Analysis of the valuation dynamics
Meanwhile, there are countless indices that weight all stocks in the index equally to achieve a broader distribution of invested capital. Interestingly, these indices outperform cap-weighted indices in the long term. However, the phases in which cap-weighted indices generate excess returns are often long. This can possibly be explained by the fact that fundamental earnings drivers first justify the price increase of dominant companies, but are then replaced by exaggerated expectations, which consequently lead to a valuation correction. It has yet to be definitively assessed which phase we are currently in. The potential of artificial intelligence appears promising, the possible changes are far-reaching. But the risks are also multifaceted, from technological disruption to new competitors to government intervention.
A high index weighting and valuation premium do not necessarily mean that these companies are overvalued. They may be fairly valued in view of the potential scope of artificial intelligence. However, fairly valued also means that a positive scenario for earnings growth is already discounted in the price. If the priced-in scenario proves to be realistic, the future price increase will be driven more by actual earnings growth than by a further widening of the valuation premium. Therefore, the probability of a renewed development on the scale of the past few years is significantly lower. The risk/return ratio, which is essential for investing, has deteriorated accordingly.
This poses various risks for investors. Passive investors are disproportionately invested in highly valued large caps. Active investors are often measured against benchmark indices whose weightings are based on the market capitalization of companies. If the performance of these benchmark indices, as is currently the case, is driven by a few stocks that additionally and because of their strong price performance have a high media presence, the pressure increases to weight them in a similar way to the benchmark indices.
Added value through active asset management
As a Swiss investor, one is well aware of the downside of index dependence. Nestlé, Roche, Novartis, and UBS make up more than half of the SMI Index and are partly responsible for the fact that the index has not been able to keep up with the performance of the MSCI World Index for years. The fact that large corporations have a dominant weighting in indices is not unusual globally and in historical context. However, the fact that they outperform the overall market in the long term is. Away from the media attention and expectations of trend investors, a multitude of companies are generating attractive profit growth without having to pay a valuation premium for it.
Active asset management can again become crucial in the near future if one takes an independent path away from benchmark indices and can withstand the occasional strong pressure to neglect diversification and valuation criteria. We at Valvest Partners do not consider the current time to be opportune to weight the large companies analogously to the benchmark indices. For this reason, we have made reallocations and reinvested in companies where we see a more attractive risk/return ratio.
Zurich, end of June 2024
With the euphoria surrounding the topic of artificial intelligence and the strong performance of the technology sector since the end of 2022, concerns have grown that the sector may now be too expensive. The issue in assessing this question is multifaceted. The technology sector consists of the three sub-sectors: software, hardware, and semiconductors. Each of these three sub-sectors has different demand dynamics, margin profiles, growth rates, and valuations. Both the sector and the sub-sectors are dominated by Apple, Microsoft, and NVIDIA, which together make up about half of the technology sector with market capitalizations of several trillion USD each. Since 2018, large technology companies like Alphabet (formerly Google) and Meta (formerly Facebook) have also been allocated to the communication sector rather than the technology sector. Broad overall assessments at the level of an overarching sector do not do justice to these circumstances.
The same can also be said for regional evaluations. A statement like ‘Europe is attractively valued compared to the USA’ is not meaningful without considering the different composition of the sectors. While in Europe the finance and industrial sectors each account for about 15% of the total, in the USA the technology sector, with around one-third, is by far the most significant sector. It is undisputed that the financial sector, especially since the financial crisis, does not have the best track record, while the technology sector continues to gain importance. From the trend towards smartphones, cloud computing, and most recently artificial intelligence, no consumer and no company can escape digitization. Accordingly, their share of economic output has increased, which is rightly reflected in market capitalization.
For a specific assessment of valuation, the widely used price/earnings ratio falls short. The price reflects not only the current earnings but also their growth prospects. The entire technology sector shows a significant growth premium compared to the overall market. Especially in economically challenging environments, this is valuable and essential to at least keep pace with inflation. Thus, a valuation premium based on current earnings compared to the overall market is justified.
Additionally, important is that profit growth can be achieved both through revenue increases and efficiency gains. The latter, due to scalability, leads to above-average high margins in the technology sector. According to our assessment, these could be even higher, especially for the large technology companies, since efficiency was not a priority until recently due to strong growth.
Considering all the above-mentioned circumstances, the valuation of the technology sector has indeed become more demanding compared to the overall market. At the same time, the excess growth has accentuated in the current environment. Occasionally, future expectations regarding artificial intelligence may have led to valuations that have somewhat outrun earnings development. Overall, we consider the valuation to be in an appropriate relation to the growth.
As active investors, we have the privilege of not having to buy the entire sector. Our focus is exclusively on finding companies where the earnings prospects are in an attractive relation to the valuation.
Zurich, end of March 2024
Review
Even though the end of the year is arbitrary, it is a good opportunity to reflect on the past and learn for the future. In the past year, we were once again able to see how much the consensus can lead us astray on complex issues. The majority of market participants and economists predicted a negative economic development for 2023. Even our assessment, in hindsight, was not positive enough to do justice to the strong market development. A variety of challenges shaped the economic landscape. The extraordinarily high inflation forced central banks to raise interest rates sharply and pursue a restrictive monetary policy. After a long period of low interest rates, companies, consumers and states were suddenly confronted with rising interest rates and their diverse effects.
Meanwhile, the global supply chain bottlenecks have largely normalized. This has mitigated a major driver of inflationary pressure and allowed central banks to pause interest rate hikes in the second half of the year and adopt a wait-and-see stance. Therefore, an important factor of uncertainty has stabilized, which benefits the valuation of the financial markets. The risk premium of equities over fixed-income government bonds, a measure to judge the attractiveness of equities vs bonds, has therefore remained at a low level despite all the uncertainties. The strong stock market increases reflect, on the one hand, the declining long-term interest rates and the anticipated interest rate cuts by central banks for 2024. On the other hand, corporate earnings for the overall market have continued to grow and have already reached new highs, unlike the stock market. These two factors have made valuations both absolutely and relatively more attractive and have accordingly made the surprisingly positive performance possible. Most companies were able to pass on price increases to their customers and increase sales despite a weakening economy and partly declining sales volumes. A less impressive picture emerges when purchasing power is considered, but nominal growth feels better than nominal stagnation nonetheless.
Statistical context
As active investors, our goal is to invest in the world’s best companies, which not only preserve purchasing power, but also generate a long-term excess return compared to the market. We take into account the comprehensive earning power, which includes earnings growth, dividends, share buybacks and debt. Based on these factors, we regularly scrutinize all listed companies that are eligible for investment. We are always fascinated by how successful many companies generate added value for both customers and owners through innovation and efficiency. When we underpin these fundamental impressions with historical data, we do find it difficult not to look positively into the future. A statistic that supports this feeling is the number of years it takes on average for a portfolio to reach new highs. The graph below shows that balanced mandates reach a new valuation high every three years on average. Especially after strong corrections, it is worthwhile to keep this in mind.
A lower equity exposure further shortens this duration, but at the expense of long-term returns. A variety of dangers, whether inflation, geopolitical events or fundamental economic changes, are not unusual in the historical context and are represented in this data set. For evolutionary reasons, we tend to overestimate dangers, because this was essential for survival. However, equally natural is the desire of all market participants to maneuver the current environment as best as possible. Accordingly, the best companies emerge stronger from difficult phases.
Outlook
What can we expect for 2024? The current economic indicators continue to paint a bleak picture and the long awaited recession remains possible. With certainty we know, that 2024 will be a record year for politics. In more than 50 countries, a new government will be elected. Election years not only provide ample controversial topics for discussion but are also, at least in the short term, a positive driver for the economy. Several studies indicate that governments tend to increase spending in election years. As a result, government debt is expected to increase due to higher expenditures, possibly accompanied by measures from central banks. These measures, including interest rate cuts, may contribute to an expansion of the central banks’ balance sheets. As always, there are therefore sufficient reasons to justify both a positive and negative assessment. The decisive factor is how the actual development differs from the expectations embedded in the market prices. In this regard, we observe that market participants while less pessimistic compared to a year ago, show no signs of widespread euphoria. This is also reflected in the valuation differences of the various equity sectors. Specifically, the valuation in the technology sector already factors in substantial anticipated growth rates, whereas significant portions of the markets anticipate declining profits instead. This provides us with the chance to benefit from relative valuation differences and make corresponding adjustments in the portfolio. In view of the dynamic market conditions, we remain committed to our strategy of generating long-term value for our investors through careful analysis and selective investments.
Zurich, end of December 2023
The overall market includes all companies and is thus, by definition, average in terms of quality, valuation, and performance. Comparing one’s investments to the overall market appears to be a reasonable starting point because the goal should be to achieve above-average returns. However, from time to time there are exaggerations that lead to certain areas of the market being disproportionately represented at the least favorable times. At the turn of the millennium, it was technology companies. During the 2007 financial crisis, it was the financial industry, and in 2021, it was expensively valued growth stocks and long-term bonds. The opposite is also true. Neglected and undervalued areas are temporarily underrepresented in the overall market.
When the investment strategy simply replicates the market, or the asset manager is measured against it in the short term, the risk of being exposed to these temporary exaggerations is particularly high. The fact that these periods are often accompanied by intensive media coverage and correspondingly high interest from private investors further complicates the situation.
The past year serves as a good illustration. When interest rates reached their lowest levels, it was the general expectation that this situation would persist. Consequently, equity valuations played a negligible role due to the absence of opportunity costs. The investors’ focus was on stocks with the most compelling growth stories and equities with steady earnings, which were used as substitutes for bonds. Accordingly, their valuation was very demanding. With the return of higher interest rates, the mathematical laws of gravity returned to the markets as we outlined in our investment letter in the second quarter of 2022. Current earnings and future financial prospects must once again compete with considerable fixed-income alternatives.
When it comes to bonds, particular attention should be paid to the duration risk, which is a measure of how long capital is committed. As in the stock market examples mentioned earlier, once again market positioning was at its most extreme at the least favorable time. When the Swiss bond market in 2020 showed a negative yield to maturity, the duration of the fixed income market reached its peak. Replicating the market or the benchmark indices would have tied up capital for almost eight years at negative interest rates. The other major currencies also exhibited a similar pattern during this time period.
Yield-to-Maturity vs. Duration
(SBI AAA-BBB)
The graphic above illustrates how bond market duration had steadily increased as interest rates had fallen Companies have used the low-interest-rate environment to issue long-term bonds and secure the low-debt costs for the foreseeable future. The resulting low coupon payments have meant that investors not only provided capital for an extended period but also received minimal cash flows during this time. Consequently, long-term bonds have corrected significantly to reflect the new interest rate environment.
As active and independent investors we see our role in constantly challenging the market’s proposition as well as our own positioning. In order to do what is right for our clients in the long run, we must scrutinize risks and withstand short-term pressure This allows our portfolios to circumvent temporary exaggerations and stay true to the suitable strategy throughout the entire economic cycle.
Due to the significant increase in interest rates, we have experienced in a short period of time, we consider the current environment to be challenging. The delayed impact on governments, businesses, and households is multifaceted and complex besides being fundamental for asset valuations. As a first consequence, we witnessed the bankruptcy of Silicon Valley Bank and the acquisition of Credit Suisse, accompanied by government interventions. Governments are facing significantly higher interest costs, further increasing their steadily growing debt burden. Consumers are not only forced to cope with higher interest rates but are additionally grappling with increased costs of living and the gradual depletion of their excess savings accumulated during the Covid lockdown. The current market volatility reflects these circumstances and also the major shifts in consensus expectations among market participants.
For us, the robustness of our investments, regardless of the scenario that unfolds, is of utmost importance. The companies we hold in the client portfolios have proven time and again that they can successfully overcome difficult markets. Thanks to their leading market positions, rising costs could be passed on to end consumers. Structural growth in products and services lead to scale efficiencies and low levels of indebtedness keep interest expenses in check. Both the yields on our selected stocks and bonds have increased over the past months, which is generally positive for expected returns. For now, it will be decisive when and at what level interest rates stabilize or reach their peak. This, in turn, depends on the path of inflation and the economy. Instead of making a conclusive forecast, we focus on staying agile, analyzing the constantly changing data situation and taking advantage of opportunities that arise from the challenging environment. The key is to distinguish between the assessment of the environment and what is already reflected in current prices.
Zurich, end of September 2023
An important parameter for assessing the market valuation is the risk premium, which represents the difference between the yield of corporate earnings and risk-free government bonds. As interest rates remain elevated, equity markets approach previous highs and have risen disproportionally to corporate earnings. As a result, the risk premium is low despite the difficult market environment.
At present, inflation poses a significant source of uncertainty. However, the growth in corporate earnings demonstrates that companies have successfully tackled this challenge and have managed to partially offset the impact of inflation. On the other hand, fixed rate government bonds lack this characteristic, which justifies a lower risk premium for equities. To truly understand the risk-premium of stocks, it is important to consider the corporate earnings yield in relation to the inflation-adjusted real yield of government bonds. This perspective provides a more balanced view of the real risk premium and offers a more concise assessment of the current valuation of the stock market.
However, there are significant variations in the risk premiums among different sectors and individual stocks, reflecting investors’ expectations regarding their ability to thrive in the current environment. Companies are continuously striving to enhance efficiency and achieve economies of scale through increased sales volumes.
This serves as a partial offset to the impact of low inflation rates. During periods of elevated short-term inflation, as we have recently experienced, companies are compelled to pass on higher costs (such as materials, labor, and energy) directly to end customers in order to protect their profitability. Companies that are well-positioned and have high-demand products are more successful in this endeavor compared to those offering easily substitutable products. However, even some companies with weaker positioning have managed to achieve growth in sales and profits, as price increases have more than compensated for declining sales volumes.
The latter impressively illustrates the distorted perception that can arise from high nominal growth rates. Short-term wage increases, although initially positive for consumer sentiment, also contribute to this phenomenon. The concept of money illusion highlights the tendency for people to concentrate on nominal figures while paying insufficient attention to inflation. As a result, the effective loss of purchasing power is often neglected or recognized with a delay. Consequently, nominal economic growth of 5% with 7% inflation feels better than 0% growth with 2% inflation.
Higher interest rates have undeniably made the current environment more challenging. Expensive valuations must be consistently justified with profit growth, as any disappointments are swiftly penalized by the market. This was evident in parts of the health sector, which had benefited greatly from the effects of the Covid-19 pandemic but has since struggled to sustain the previous growth and has underperformed the market as a consequence. Nonetheless, the first half of the year demonstrated that economic prospects were overly pessimistic, and the anticipated slowdown was premature.
It takes time for the effects of higher interest rates to fully unfold. It is important to note that higher interest rates do not necessarily indicate rates that are too high for sustainable economic growth. Currently, the various economic indicators present an inconsistent picture. Central banks are likely to maintain higher interest rates until inflation appears to be firmly under control. The trajectory of inflation plays a vital role in determining real interest rates. As interest rates stabilize, the risk premium benefits from reduced uncertainty, enabling a stronger emphasis on profit growth.
The economic and investment landscape remains challenging, demanding thorough and nimble analysis of assets to be well-prepared for various scenarios. By exclusively investing in direct investments, we closely monitor the progress of all companies held in our portfolio and can promptly respond when needed. Additionally, we prioritize a balanced distribution of company characteristics to ensure the resilience of our portfolio. The past year highlighted the importance of not solely relying on growth but also considering valuations for sustainable long-term performance. A relative valuation discount to the market and comparable companies provides a margin of safety to better withstand unpredictability. In the current environment, we do not compromise on quality and valuation.
Despite the presence of various risks, adhering to our long-term strategy, maintaining disciplined ownership of the best companies in our portfolio, and trusting in their ongoing pursuit of growth and efficiency, regardless of the market conditions, has once again proven successful. We capitalized on the divergent performance of individual positions by realizing profits from volatile cyclical stocks and reinvesting them in attractively valued, more defensive opportunities.
Zurich, end of June 2023.
Business models, consumption and investment behavior as well as the valuation of assets are all influenced by the most important driver of the economy – the price of money, i.e. interest rates. Interestingly, in the so-called free market economy, this is not left to the market, but is controlled by the central banks. This is done in an attempt to stabilize the economic cycle and keep inflation constant. Events in recent weeks have shown that the free-market economy does not fully live up to its definition in other ways either, as once again several banks were rescued with state intervention. Banks are particularly fragile due to their low equity in relation to the overall balance sheet, which is why the first consequences of the sharp rise in interest rates have now become apparent in this sector. If something is fundamentally fragile, it is dependent on external factors such as trust or hope. One of our quality criteria when investing is to ensure that dependencies on individual external factors are as small as possible. Robust earning power over the entire economic cycle in combination with low levels of debt in relation to the stability of earnings is essential. When it comes to our investments, we do not rely on visions, lenders or even the state.
The side effects of low borrowing costs are multifaceted. On the one hand, thanks to low interest rates, borrowers with leasing, mortgages or corporate loans have been able to benefit from negligible borrowing costs, which has strongly stimulated consumption and investments. On the other hand, this has enabled consumption and business models that cannot be sustained at normal interest rates. This leads to a misallocation of resources, particularly with regards to labor, which is detrimental to long-term economic development. Savers, on the other hand, had to invest their money to maintain the prospect of a return. Accordingly, demand for assets was high and, as a result, their valuation increased. With higher interest rates, the initial situation has changed noticeably. Investments in bonds, money market funds and even savings accounts are once again yielding interest. Although these do not compensate for the current high inflation rates, they make a noticeable contribution to reducing the general increase in cost of living. At the same time, borrowers are faced with higher capital costs and the population in general with higher prices due to inflation. All this is a drag on economic development. Nevertheless, the consumer is still in good shape, also thanks to low unemployment, while seemingly still having some catching up to do after the Covid withdrawal.
Central banks across the globe are currently grappling with determining the appropriate magnitude of interest rate increases required to align demand with supply and stabilize prices. The impact of elevated interest rates is not immediate, as the full effects may take time to materialize. While listed asset valuations are known to respond promptly to shifts in interest rates, the efficacy of interest rate increases on borrowers’ interest expenses can take years to fully manifest, contingent on the maturity of the outstanding debt.
In light of the banking sector’s instability, central banks are now confronted with the challenge of effectively balancing the objectives of combatting inflation and stabilizing the financial system. The repercussions of failing to achieve this equilibrium would be significant, encompassing a range of economic and social impacts resulting from both elevated inflation rates and destabilized financial systems.
Given the prolonged period of low interest rates and the rapid pace of the recent rate hikes, it is plausible that additional vulnerabilities may arise over time. The upcoming quarters will provide greater clarity on the extent to which the shift in interest rates will endure over the long term or represent a transitory phenomenon. During times of heightened uncertainty, it is critical to rely on steadfast principles. In our situation, this involves utilizing the superior quality of our investment holdings and the relatively short-term maturities of our bond portfolio to maintain our flexibility.
Zurich, end of March 2023.
Review
A balanced investment profile aims to offset various influencing factors and stabilize the return. An investor in bonds provides debt capital to companies and is usually compensated with a fixed interest rate. An investor in equities is a co-owner and thus participates in the profits or losses of a company. If the economy grows, corporate profits tend to rise and equities yield a higher return than fixed-interest bonds. In uncertain times, on the other hand, investors seek the safe returns of bonds. Typically, bonds gain in value when stocks perform badly.
Not so this year. Balanced investment portfolios had one of the worst years on record. The reason for this was that the market’s perception changed within a very short period from persistently too low inflation to fear of lasting high inflation. In this context, the very low interest rates of the recent past lost their justification, which caused a strong correction of fixed-interest bonds. Consequently, equities also faltered, because their valuation or earnings yields, are in direct competition with bond yields.
Development of global equities vs. bond yields
The trend of falling interest rates lasted 40 years, peaked with negative nominal yields in some currencies last year and now experienced a dramatic reversal. Accordingly, previous beneficiaries of this trend suffered the most, especially long-dated bonds, expensively valued defensive quality and growth stocks.
Outlook
Now that the U.S. Federal Reserve has raised interest rates at an unprecedented pace, and other central banks around the world have followed suit, the question is how well this interest rate level can be absorbed by consumers, companies and governments. On the one hand, higher interest rates and the increased prices of many goods are straining the budget. On the other hand, the labor market continues to be very robust, wage negotiations are promising, and demand is stagnating at a high level. With China now also easing covid measures, the full impact on demand is difficult to assess at present.
In case the economy weakens, interest rates should stabilize, which would have a supportive effect on equity valuations. However, the development of corporate profits is then likely to be less positive. The various interdependencies between growth, inflation, interest rates and valuations make the current situation challenging. In contrast to the starting position one year ago, bond yields are once again contributing to portfolio returns. The valuation of the stock market reflects the higher interest rate level and, at least partially, the economic slowdown expected by most economists next year.
Conclusion
It is advisable to be prepared for various scenarios and to take a long-term perspective. Current interest rates offer a stable source of income, which is why we have increased the bond allocation and extended our maturities slightly. Due to the sharp rise in interest rates and the resulting changes and risks for the market and the economy, we consider a neutral equity weight to be appropriate at present. Nevertheless, valuations are less demanding and offer good entry points for long-term investors. We expect uncertainties to persist and market developments to remain challenging. However, times like these always offer good opportunities to identify new investments that are at a valuation discount due to the current environment. The resilience of our portfolios remains the upmost priority.
Zurich, end of December 2022
Low inflation rates accompanied by low interest rates have favored high asset valuations. After some 40 years, this trend has reached its temporary peak with the Covid crisis. The structural drivers of low inflation rates are facing headwinds for the first time in many years. Globalization, in particular the full outsourcing of production, has been challenged by geopolitical tensions. Energy supply dependencies have revealed underestimated risks. Technological progress continues to be unstoppable but is currently being held back by supply bottlenecks and is not fast enough to counteract the abruptly changing circumstances. In addition, low unemployment offers employees a promising negotiating position for wage increases.
While the supply side is facing various challenges, the demand side has fully recovered, also thanks to government support, putting additional strain on already troubled supply chains. Various studies have addressed this issue and have concluded that both supply and demand contribute significantly to the current high inflation. Unlike demand, the supply side needs time and investments to overcome these challenges.
The U.S. Federal Reserve is currently trying to curb demand with exceptionally high interest rate hikes, and the other central banks are following suit to varying degrees. From corporate and consumer loans to mortgages, a more restrictive monetary policy is hitting consumers, investors and companies. Until recently, almost cost-free debt capital has enabled financing endeavors that are no longer profitable or sustainable at higher capital costs. Combined with higher prices, especially energy costs, this is expected to cool economic activity until supply chains return to normal and supply can keep pace with demand. Flattening demand is also intended to counteract the tight labor market. This is because broad-based wage increases on the scale of current inflation could set the undesired inflation spiral in motion.
The consequences of higher interest rates on asset prices are very apparent, as we have seen significant corrections. With interest rates and thus capital costs close to zero, there were hardly any opportunity costs in recent years. Accordingly, good marketing was sometimes sufficient to drive up a company’s valuation. Tangible near-term profits and sound financial valuation seemed to be less important.
The U.S. Federal Reserve is currently trying to curb demand with exceptionally high interest rate hikes, and the other central banks are following suit to varying degrees. From corporate and consumer loans to mortgages, a more restrictive monetary policy is hitting consumers, investors and companies. Until recently, almost cost-free debt capital has enabled financing endeavors that are no longer profitable or sustainable at higher capital costs. Combined with higher prices, especially energy costs, this is expected to cool economic activity until supply chains return to normal and supply can keep pace with demand. Flattening demand is also intended to counteract the tight labor market. This is because broad-based wage increases on the scale of current inflation could set the undesired inflation spiral in motion. The consequences of higher interest rates on asset prices are very apparent, as we have seen significant corrections. With interest rates and thus capital costs close to zero, there were hardly any opportunity costs in recent years. Accordingly, good marketing was sometimes sufficient to drive up a company’s valuation. Tangible near-term profits and sound financial valuation seemed to be less important.
This year has been a stark reminder to investors that it is not enough to simply buy good companies with attractive growth prospects. The price at which it is being bought is just as crucial to the success of an investment in the long term. With the end of the low interest rate environment, the valuation is once again taking center stage. Higher interest rates mean higher opportunity costs and lead to a lower present value of potential future profits. The higher the valuation, the more this base effect comes into play. The speed at which individual companies recover from this correction is thus directly related to how high the valuation was in the first place. Another complicating factor is that the current environment with higher input costs and cooling demand is making it more difficult for companies to increase profits in the short term.
Valuation plays a central role in the selection of our investments. We invest exclusively in above-average quality, but always put this in relation to the valuation. Only if this ratio is attractive, we consider making an investment. We are convinced that a disciplined focus on both factors produces the best results in the long term. This applies to both equities and bonds. As a result of higher interest rates, fixed-income investments are once again a more attractive complement to equities and allow to generate reliable and stabilizing returns in economically and geopolitically uncertain times.
Zurich, end of September 2022
Review
Record-low interest rates coupled with record-high inflation are leading to deeply negative real interest rates. To correct this situation, either interest rates must rise or inflation rates must fall. Since inflation has turned out to be less “transitory” than central banks had hoped, they now see themselves forced to raise interest rates substantially.
Whereas valuations in recent years were justified by low, and in some cases negative, interest rates, this valuation correction based on sharply rising interest rates is also justified. Capital is always looking for the most attractive return in relation to the given risks. Thus, if the yields of reliable and steady bonds increase, this also requires an increase in the yield of equities in order to keep the risk premium over bonds constant. This can be done either by increasing the yields or by correcting the valuation.
The current problem is that interest rates have risen very quickly and corporate earnings growth has not kept pace. There is also the problem of the base effect. Because of low interest rates, small increases in interest rates are large increases in percentage terms. The same applies to company valuations: the more expensive a company is, the higher the earnings growth must be to compensate for the rise in interest rates and maintain the risk premium compared with fixed-interest investments. As higher interest rates also have a slowing effect on economic development, companies’ earnings growth tends to slow down. Ongoing cost pressure due to strained supply chains and labor shortages further exacerbates this problem.
The risk premium on equities is therefore under pressure on both sides. Higher interest rates combined with presumably lower earnings. Particularly hard hit by this situation are companies with demanding valuations, which have to grow disproportionately in order to correct their own valuation. These are precisely the companies that have benefited in recent years from steadily lower interest rates and positive economic development and have received a lot of attention from the media and trend investors.
Outlook
Whereas historically central banks could be relied upon to counter an economic slowdown with interest rate cuts, this time the starting position is reversed. Central banks are forced to raise interest rates due to high inflation rates and to accept an economic slowdown. Depending on the intensity of the growth slowdown, the current high inflation rates should fall and bring about a stabilization of interest rates. It cannot be ruled out that the current investments by companies to eliminate the supply shortage could even lead to a supply surplus and renewed deflationary tendencies as the economy weakens.
Much depends on the further development of inflation rates and the resulting interest rates. On the positive side, after a long wait, investors in fixed-income investments are once again receiving a return, even if this is not yet keeping pace with inflation. In the event of a return to lower inflation rates, the current interest rates could prove to be an attractive opportunity. The money in the account, on the other hand, is fully exposed to the high inflation rates, but allows at least temporarily to benefit from better opportunities to buy assets.
The challenging initial situation makes it necessary to focus on proven features in the stocks, which help to survive a more difficult situation. A leading market positioning secures earnings despite rising costs. Structural growth areas cushion the economic cycle somewhat, and an attractive valuation makes it easier to compensate for any interest rate rises. Temporary profiteers such as commodity companies do not meet our quality requirements in the long term any more than overpriced growth companies did before the correction began this year. Short- to medium-term market dislocations, on the other hand, are a part of investing and offer attractive opportunities to profit from valuation deviations in the long run.
Zurich, end of June 2022