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.
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.
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
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.
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.
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.
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.
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
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.
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