Asset Allocation

Notes from the Investment Committee

Artificial intelligence is the topic of the hour on equity markets these days, so the rally on (US) stock exchanges has accordingly been one-sided and limited to just a handful of companies. From a valuation perspective, stocks are less attractive today in both absolute and relative terms than they were a half-year ago. So, taking profits and positioning oneself a bit more defensively going forward are likely to pay off in the near future.

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Equities: AI – bubble or no bubble?

• The major equity markets edged down slightly (in Europe) or treaded in place (in the USA) in May. The exception to the rule was US technology stocks, which gained more than 7% for the month, as measured by the Nasdaq 100 index. The following numbers paint an even more striking picture of the narrow market breadth: while the top ten stocks in the S&P 500 index rose by a combined 8.9% last month, the other 490 stocks in the blue-chip index fell by a combined 4.3%. Stocks associated with AI were practically the only ones that benefited in May. Meanwhile, a growing number of voices are already talking about an artificial intelligence bubble. Closer observation, though, reveals that the valuations of technology stocks associated with AI are still much lower today than valuations were in the days of the 2000/2001 internet bubble. We therefore do not see any potential for a crash at the moment. However, some air looks set to escape soon from some overheated stocks, so investors should at least do some profit-taking.

• Valuations across the broad market have also risen in the wake of the vibrant equity upsurge since au-

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05/2023

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Investor sentiment tumn 2022. The US market in particular is no longer cheap in absolute terms. European stocks are relatively less expensive, but have likewise experienced a strong rally and have since priced in a lot of pro arguments. The risk/reward tradeoff is now much less attractive compared to the situation a half-year ago. We therefore recommend a more defensive bias in equity portfolios. There is potential for disappointment in the near future. For instance, it remains to be seen whether companies can match or better their good first-quarter earnings figures in the second quarter. Besides that, the US Federal Reserve could disappoint market expectations of imminent interest-rate cuts.

Closer observation, though, reveals that the valuations of technology stocks associated with AI are still much lower today than valuations were in the days of the 2000/2001 internet bubble.

The Nikkei index surged in May to its highest level since 1990.

• We see somewhat better prospects for the Japanese stock market, which has recently been rediscovered by international investors and ranks among the frontrunners year-to-date both in local currency and even after the weaker yen is factored in. The Nikkei index surged in May to its highest level since 1990. Structural factors (the end of deflation, companies’ increasing focus on shareholder value, an undervalued currency, low political risk) look set to facilitate a continued outperformance in the medium term.

Fixed income: Asymmetrical risk profile in the government bond space

Alternative assets: Gold has not broken out (yet)

However, in the event of a recession and an attendant anticipated yield pullback to below 2.5%, one could expect to earn a profit well in double-digit territory.

• Money-market funds have also enjoyed immense popularity in recent weeks. Since conditions have become much more attractive, and in view of the unignorable latent risk of a recession in the USA, cash-like assets remain a sound investment alternative or at least a good “parking option” for investment money that isn’t allocated elsewhere for the short term. But given a potential further slowing of US economic activity, (US) government bonds also look very interesting at the moment because their risk profile is extremely asymmetrical. Proceeding from a 10-year US Treasury yield of 3.8% at last look, an (improbable) increase in the yield level to a new cycle high of 4.3% on a 12-month horizon would lead to a loss of “only” 1%. However, in the event of a recession and an attendant anticipated yield pullback to below 2.5%, one could expect to earn a profit well in double-digit territory. In view of these attractive parachute properties, which should at least stabilize a mixed asset portfolio in an adverse macroeconomic scenario, we recommend overweighting government bonds and targeting a longer-than-average duration. Meanwhile, given the increased yield levels and higher credit spreads, we now see a better risk profile also for high-yield bonds as well as an extended buffer in the event of an adverse scenario. However, it is still too soon for a broad entry into this asset class.

• The price of gold didn’t benefit in May from the US federal debt ceiling showdown. On the contrary, its attempt to lastingly surpass its all-time high at around USD 2,075 per ounce failed as a result of a briefly reinvigorated US dollar and an uptick in bond yields. The robust demand for the yellow precious metal on the part of (emerging-market) central banks is not enough as a sole driver to propel a technical upward breakout on gold’s price chart. Since no other catalyst is in sight in the near term, continued rangebound movement around the current price level seems the most plausible scenario. Sources of impetus are also absent in the cryptocurrency space. Bitcoin and the like have not been infected by AI hype – the performance correlation with US technology stocks has been low lately. A Bitcoin price above USD 31,000 would be what’s needed to spring the cryptocurrency free.

Currencies: The force of gravity is working on the EUR/CHF cross

• EUR/USD: Macroeconomic data in recent weeks have come in stronger in the USA than in the Eurozone. This is also reflected in economic surprise indices, which lately have turned out clearly in favor of the US dollar. The EUR/USD exchange rate followed this cue and corrected by 3 cents in May to 1.07. Now that the European Central Bank has recently exhibited a bit more caution with regard to the pace of further rate-hiking, the single currency lacks a springboard of interest-rate speculation from which to launch a successful run at a new year-to-date high. The EUR/USD cross looks set to tread sideways for the time being.

• GBP/USD: The British pound, in contrast, is currently riding a tailwind emanating from the interest-rate component. Compared to other industrialized nations, the UK has the least deflationary impetus and the greatest need for higher interest rates. The Bank of England’s terminal interest-rate level could end up exceeding the US Federal Reserve’s peak policy rate. Historically, such a setup wouldn’t be unusual and could induce a revaluation of the still “inexpensive” pound.

• EUR/CHF: The Swiss franc has slowly but steadily appreciated against the euro in recent weeks – gravity in the form of superior fundamentals and lower inflation has been exerting its force. The Swiss National Bank looks set to reclose the interest-rate gap to the Eurozone somewhat with another big rate hike in June. Looking ahead to the second half of this year, we see the EUR/CHF exchange rate moving in rangebound fashion between 95 centimes and parity.

The (market capitalization-weighted) S&P 500 index was up around 10% year-to-date at the end of May, but this solid performance hides substantial discrepancies. To wit, the gain owes almost exclusively to around a dozen big technology stocks. This becomes evident when looking at the equally weighted S&P 500, which exhibits only a marginal gain since the start of this year. The hype around artificial intelligence (AI) and its potential disrupting effects on the world of work and society at large has particularly sent the technology sector soaring lately, especially benefiting the semiconductor chip industry –chipmaker Nvidia by now has joined the club of companies with a market cap of more than USD 1 trillion. Is the rally built on sand? We see a certain degree of exaggeration in the near term that will correct to some extent. In the medium term, however, Big Tech will continue to dominate the market action in the USA.

Chart in the Spotlight

“Big” and “tech” | Market breadth leaves much to be desired Comparison of US stock indices