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