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)
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