Asset Allocation

Notes from the Investment Committee

Asset

Fixed Income

Equities

Europe

Microfinance UK

Inflation-linked bonds

High-yield bonds

Emerging-market bonds

Insurance-linked bonds

Convertible bonds

Duration

Currencies

US dollar

Swiss franc

Euro

British pound

Equities: The bears throw in the towel

• The past several weeks have proven once more that hardly anything has a bigger influence on investor sentiment than market prices do. In the wake of the torrid rally in (US) technology stocks in the second quarter, which, nota bene, propelled the Nasdaq 100 index to its best-ever performance for the first six months of a year, the bears definitively threw in the towel. Bulls have now clearly been in the majority since June among US retail investors and American investment newsletter authors alike. Another driver of the months-long rally – investors’ light positioning in stocks – has recently returned to normal and is unlikely to continue exerting the same amount of upward thrust in the second half of this year. Now that the VIX volatility barometer has recently been hovering at a level as low as just 13 at times, reflecting pronounced investor complacency, the weeks ahead could get a bit bumpier on the equity market in the middle of the summer news doldrums. The risk/reward tradeoff has worsened lately in any case.

USA

Japan

Emerging markets

Alternative Assets

Gold

Real estate

Hedge funds

Structured products

Private equity

Private credit

Nothing stirs investor sentiment as much as market prices do. In the wake of a lengthy rally, sentiment on equity markets in recent weeks has accordingly gone from depressed and wary to cautiously optimistic for a while and from there most recently to mildly overheated and euphoric about AI. The near-term risk/reward tradeoff has worsened in any case. Scorecard -

+ Macro Monetary/fiscal policy Corporate earnings Valuation

Trend

Investor sentiment multiple expansion. At a forward price-to-earnings multiple of almost 20x, the broad US market (S&P 500) in particular is already very expensive in historical comparison. While consensus earnings estimates for 2023 have already become more or less realistic and imply flat corporate profits for this year, analysts are still very optimistic about 2024. The current profit growth forecast of almost +10% for the world equity market (MSCI World) harbors potential for disappointment on the downside, in our opinion. Another persistent critical factor is the narrow market breadth, which is most glaringly evident on the US market, but also prevails elsewhere. The 15 biggest stocks in the S&P 500 index are up by approximately a third year-to-date, whereas the median

Kaiser Partner Privatbank AG | Monthly Market Monitor - July 2023 13 performance of all stocks in the US blue-chip index has merely been flat thus far this year. The top 15 stocks in Europe are up 9% year-to-date while the median performance of all stocks there is likewise much lower at just +4% for the year thus far.

Investors would be well advised to take profits on the recent high flyers and to position their portfolios a bit more defensively going forward.

• Investors would be well advised to take profits on the recent high flyers and to position their portfolios a bit more defensively going forward. Stocks sensitive to changes in economic activity look destined to have a tougher time in the near term, especially if deteriorating economic conditions cause bond yields to fall. Defensive sectors like consumer staples and healthcare, on the other hand, could outperform in such an environment, which would also make the recently sluggish Swiss equity market, with its typically low beta, more attractive again.

Fixed income: Government bonds offer an asymmetric risk profile market investments. The effect of inflation additionally impacts the price of gold because the recent pullback in inflation has also driven up real interest rates, which explains the recent dip in the price of the yellow precious metal. Interest rates have had a smaller influence on the alternative currencies in the crypto universe. Bitcoin’s 20%-plus rally in June was driven much more by news reports that BlackRock, the world’s largest asset manager, had filed an application for permission from the US Securities Exchange Commission to launch a Bitcoin ETF. But among the alternative asset categories, private credit is also a clear beneficiary of higher interest-rate levels. Due to the variable interest-bearing nature of private credit, any increases in policy rates to which interest benchmarks for private loans (such as the Secured Overnight Financing Rate (SOFR)) are pegged land directly in the pockets of investors.

On the one hand, inflation has substantially pulled back from its peak and the risks to economic activity are on the downside. On the other hand, though, central-bank officials have not yet communicated an end to the rate-hiking cycle, and the US Federal Reserve has at most signaled merely a pause.

• The Bank of England’s 50-basis-point policy rate hike in June was the exception to the rule. Other central banks (the Fed, the ECB, and the SNB) tightened the interest-rate screw only by a quarter of a percentage point, as most observers had expected. This hardly left any notable marks on long-term yields, which for weeks have been hovering around the 3.7% level for 10-year US Treasury notes and at around the 2.4% level for German Bunds. The tightly rangebound yield movements reflect market drivers that are balancing each other out at the moment. On the one hand, inflation has substantially pulled back from its peak and the risks to economic activity are on the downside. On the other hand, though, central-bank officials have not yet communicated an end to the rate-hiking cycle, and the US Federal Reserve has at most signaled merely a pause. This means that there is still an opportunity right now to bump up the allocation to government bonds in portfolios at attractive conditions to strap on a parachute for an adverse macroeconomic scenario. In any event, the important thing is to keep a cool head in another hot summer. June registered a resumption of net outflows from US money market funds for the first time in eight weeks, which means that the euphoria has recently also gripped fixed-income markets. Investors would be well advised not to chase this “hot” money.

Alternative assets: Higher (policy) interest rates benefit private credit

• Rising policy interest rates and bond yields have a differing effect on each asset class, including within the universe of alternative assets. Increases in bond yields are detrimental to real estate and gold because they reduce those assets’ attractiveness relative to interest-bearing securities and cause the opportunity cost of holding them to rise relative to money

Currencies: Interest-rate speculation is the main driver of exchange rates at present

• EUR/USD: The global rate-hiking cycle is currently in its final stage. The European Central Bank is still lagging a bit behind the Fed and looks set to at least implement another small rate hike in July. Anticipation of a narrowing interest-rate differential caused the EUR/USD exchange rate to turn around and head back upward toward the 1.10 level in June. We, however, do not see much further upside potential beyond the year-to-date high of 1.11. The weak macroeconomic dynamics in the Eurozone argue against the euro. Even in the event of a US recession, the euro would be at a disadvantage due to its cyclical characteristics.

• GBP/USD: The surprisingly sharp policy rate hike by the Bank of England in June lifted the British pound to a new year-to-date high of 1.28 against the greenback. Over the longer term, though, the aggressive actions by the UK’s central bank, which could provoke a hard landing of the British economy, threaten to boomerang. A necessary swift move to undo the latest rate hikes in the event of a hard landing would substantially hurt the pound. But the current combination of interest-rate momentum and a cheap valuation is still a positive for sterling for the time being.

• EUR/CHF: The governing board of the Swiss National Bank wasn’t out to spring a surprise with its latest interest-rate decision and opted for a small policy rate hike, as expected, but that presumably doesn’t mark the end of the road yet. Although inflation in Switzerland has pulled back to a level just north of 2%, the SNB, unlike most other central banks that are pursuing a 2% inflation target, is striving to whittle inflation down to a little above the 0% line. A stronger nominal Swiss franc exchange rate against the euro would help to reach that goal.

In the last issue of Monthly Market Monitor, our “Chart in the Spotlight” cast an eye on the narrow market breadth on the US equity market. In the wake of the rally in recent months, the ten biggest stocks in the market-cap-weighted S&P 500 now make up more than 30% of the overall index, which is a new record. The equal-weighted S&P 500 index has now caught up a bit in recent weeks on the back of a rebound by small- and mid-cap stocks. This jibes with the very long-term trend – the performances of both indices over the last 20 years are practically dead even – as well as with the theory that shares of smaller-cap companies shouldn’t underperform (but instead should outperform) in the long run thanks to their faster growth and superior growth potential. This “law” has been suspended temporarily by the current AI hype, but the statistics suggest that the force of gravity will soon start to apply again to the top 10 because it becomes difficult to lastingly outperform once a stock joins the pantheon of the titans.

Chart in the Spotlight

Big is beautiful? | It gets progressively harder for behemoth stocks to outperform Average annual outperformance of US stocks before and after joining the top 10