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