Asset Allocation

Notes from the Investment Committee

After a rally, a correction often lurks around the corner, and in fact, the risk/reward tradeoff on equity markets has recently worsened. This further intensifies the competition posed by bonds as a result of their high yields. But attractiveness varies even within the fixed-income sector. Thanks to high interest rates entirely without any risk, cash is king now more than ever.

Asset Allocation Monitor

Cash

Fixed Income

Sovereign bonds

Corporate bonds

Microfinance

Inflation-linked bonds USA

High-yield bonds

Emerging-market bonds

Emerging markets

Alternative Assets

Insurance-linked bonds Gold

Convertible bonds

Duration

Currencies

US dollar

Swiss franc

Euro

British pound

Equities: Advantage Europe

• In the wake of a three-month-long rally, the air became much thinner on equity markets in February. While European markets drifted sideways, share prices on US stock exchanges dipped markedly. The S&P 500 index’s uptrend channel in place since October 2022 is a current topic of debate in the USA. A breach of the support zone would be a first sign of weakness and would put a potential retest of last year’s lows on the agenda. The recently observed outperformance by European markets could continue in the months ahead (see also “Ask the experts” on page 16).

• The recent flurry of macro data surprises to the upside was no longer supportive for the US markets in February. On the contrary, it portends that the US Federal Reserve’s interest-rate path is headed higher for longer, and the accordingly higher discounting factors are putting downward pressure on stock valuations. The earnings reporting season for the fourth quarter of 2022 also hardly generated any positive impetus. High inflation enabled corporations to boost their profits on aggregate, but when the energy sector is stripped out, earnings at US large-cap compa-

Real estate

Hedge funds

Structured products

Private equity

Scorecard nies actually contracted by around 10%. Profit margins accordingly remained under pressure and have now fallen for six consecutive quarters (to 11.3%) since peaking at 13% in summer 2021. Earnings momentum may also remain negative in the near future. Many companies issued cautious guidance regarding US consumer spending.

• From a behavioral finance perspective as well, stocks at least no longer have a tailwind behind them at their current price levels. Not only has sentiment returned to normal (see “Chart in the Spotlight”), but so has investors’ positioning. Institutional investors in the USA have significantly reduced their cash allocations in recent weeks while trend-following strategies (CTAs) have flipped their positions from short to long. Meanwhile, a short squeeze has forced hedge funds to pare back their bets on falling share prices for particularly speculative stocks. So, further (buying) demand is now missing from this side as well in the near term.

Fixed income: Cash is king

• Many analysts consider 2023 the year of the comeback for bonds, and investors see it the same way. They invested a record-breaking sum of more than USD 20 billion in investment-grade corporate bonds around the world in January and

February. At yields north of 5%, this asset class is indeed interesting, particularly in the USA. But it all depends on an investor’s time horizon. Now that credit spreads have tightened further recently and given the prospect that the Fed may continue to raise the federal funds rate and keep it high for longer than expected, immediate upside potential for bond prices appears constrained. Meanwhile, bonds are also facing competition from moneymarket investments. Cash is king now more than ever given the high rate of interest amid an environment of elevated economic uncertainty.

With yields above 5%, the asset class is indeed interesting, especially in the USA

Gold demand from central banks and sovereign wealth funds up twoand-a-half-fold

• (US) high-yield bonds are also currently trading at more attractive yield levels compared to the average for the last five or ten years. Here too, however, spreads over (safe) government bonds have tightened since the start of this year and are vulnerable to a correction in the event of deteriorating economic data. Any entry into the high-yield segment should therefore be done in a staggered manner. This strategy is likely to pay off for investors over an extended time horizon.

Alternative assets: Semi-liquid inertia

• Stocks posted a very good start to 2023 marked by high single-digit gains. Semi-liquid private-market funds could not keep up with that pace. Their unit price performance tends to be slow-acting by design. Their delayed reporting also contributes to a relative underperformance during times of strong equity markets. This circumstance can cause cognitive dissonance among some investors. They, however, should focus on the long-term nature of their investment strategy. Over the course of the year, the performance differentials are not only bound to diminish, but private-market assets are even likely to resume delivering a disproportionately high contribution to portfolio performance. We see good investment opportunities at the moment particularly in the private-equity secondary market and in the private credit space.

• According to data from the World Gold Council, demand for gold on the part of central banks and sovereign wealth funds surged two-and-a-halffold year-on-year in 2022, presumably on the back of increased interest mainly on the part of Russia and China but also other countries in diversifying away from the US dollar. Public-sector demand for gold looks set to stay robust in the future. Investment demand for bullion, however, may remain weak because gold has lost attractiveness as a safe haven relative to government bonds (and cash).

Pessimists were in the majority among US retail investors for a record 44 weeks in a row. The resulting underinvestment in stocks was a driving force behind the equity rally since autumn of last year. Against their convictions, many investors had to jump on the moving train to keep themselves from falling too far behind their respective benchmarks or peer groups. Sentiment has since returned to normal in the meantime, but there are no traces of euphoria. In fact, the bear camp already started to grow larger again in late February. Moreover, more than 60% of US fund managers consider the recent share price advances merely a bear market rally, and more than a few analysts expect stock prices to fall to new lows during the course of this year. So, the chances are good that things won’t turn out that badly. Only in the event of a recession would we too consider a drop below last year’s lows practically inevitable this year.

Currencies: The SNB needs to up the ante

• EUR/USD: Europhoria reached an interim climax in early February uncoincidentally at the psychologically important 1.10 mark against the US dollar. Since then, US macroeconomic data have surprised on the upside, and the market has come to the opinion that the Fed has caught back up to the European Central Bank with regard to its further rate-hiking potential in the months ahead. From a longer-term perspective, though, the euro remains substantially undervalued. We expect the euro to embark on another upleg after the current consolidation phase.

• GBP/USD: Among the world’s major central banks, the Bank of England is the one facing the most precarious economic climate. After having raised its policy rate by 50 basis points in early February to 4%, the BoE is probably close to the top of the flagpole now. This means that it will soon fall behind the Fed and the ECB from a relative interestrate standpoint. The British pound’s underperformance in recent weeks already reflects this.

• EUR/CHF: The EUR/CHF exchange rate’s excursion above parity turned out to be a temporary blip for the time being. The markets these days appear to be betting on more than just a small (final) rate hike by the Swiss National Bank. SNB President Thomas Jordan will, in fact, likely try hard to avoid overly dovish rhetoric and attendant overly hesitant actions because an excessively large interest-rate differential between the euro and the Swiss franc and resulting currency weakness would be counterproductive in the fight against inflation.

Chart in the Spotlight