Monthly
Market Monitor
August 2024
In a Nutshell
Our view on the markets
The US Federal Reserve stayed loyal to itself at its July FOMC meeting and refrained from wrong-footing financial markets.
of the Month
The Fed is paying no heed to Trump
The US Federal Reserve stayed loyal to itself at its July FOMC meeting and refrained from wrong-footing financial markets. It accordingly kept its policy rate unchanged at the high reached a good year ago, as market participants had priced in. In return, Fed Chairman Jerome Powell tried all the harder to verbally prime the starting gun for rate-cutting in September. If there is no unanticipated reacceleration of inflation, we expect to see a 25-basis-point rate cut at the Fed’s September FOMC meeting. Donald Trump’s wish for a rate cut preferably not until after the election thus is likely to go unfulfilled.
Disenchantment with AI
The rally in (US) Big Tech stocks came to at least a temporary halt in July. The escape of some air from the purported AI bubble is a healthy development that helps to alleviate the overbought conditions in the market and to reduce investors’ heavy positioning in the star performers of recent months. Government bonds are a hedge against a US recession that is not on the consensus radar at the moment. Investors additionally should diversify into inflation-linked bonds as a hedge against a Trump 2.0 scenario.
Geopolitical Heatmap
Given the numerous geopolitical risks afoot, many a pessimist is likely to be of the opinion that financial markets have become completely uninvestable by now. But whoever stuffs his or her money under a mattress for that reason can only end up a loser – of purchasing power in any case. As an asset manager, we have a special duty to analytically examine the most important macroeconomic and geopolitical risks of our times, to gauge their probability of occurrence, and to infer their implications for financial markets. This routine exercise frequently results in the realization that a risk is improbable, is already priced in or, if it does materialize, is relevant only to rather exotic assets and niche markets.
Small caps on the sidelines, but for how much longer?
Small caps have been overshadowed by large and mega-caps for the last two-and-a-half years, but their underperformance phase may now be nearing its end. In Europe in particular, the risk-reward tradeoff is good for those investors with a medium-term perspective. However, active management is necessary in order to be able to profit from the dynamism of the hidden champions. Meanwhile, many star performers are staying away from stock exchanges these days, but investors nowadays can nonetheless participate in the performance of those privately held growth companies.
The countdown to the US presidential election has slipped below the 100-day mark. In the wake of Joe Biden’s poor performance in the first televised debate and after the assassination attempt on Donald Trump, the latter’s chances of winning the US presidency surged to as high as 65% on the betting market by mid-July. However, Biden’s virtually inevitable withdrawal from the race has now reshuffled the cards. Trump still holds a big lead over his putative rival Kamala Harris, but she has the momentum on her side. She raked in over USD 200 million in election campaign donations in the first week alone. Harris is much younger than Trump, and enjoys a lot of goodwill in the Democratic base as America’s first Afro-American vice president. However, she inherits Biden’s political baggage, is considered too leftist by many, and has had few shining moments in office thus far. Uncertainty looks set to continue to run high in the weeks ahead, as likely will volatility on the markets.
Trump in the lead | Democrats are hoping for a Harris effect Election victory probability priced in on the betting market
Chart
Macro Radar
Taking the pulse of economic activity
The Fed is paying no heed to Trump
The US Federal Reserve stayed loyal to itself at its July FOMC meeting and refrained from wrong-footing financial markets. It accordingly kept the federal funds target rate unchanged at the high reached a good year ago, as market participants had priced in. In return, Fed Chairman Jerome Powell tried all the harder to verbally prime the starting gun for rate-cutting in September. He emphatically emphasized that there are risks by now on both sides – of persistent overly high inflation and a further slowing of the employment market. If there is no unanticipated reacceleration of inflation, we expect to see a 25-basis-point interest-rate cut at the Fed’s September FOMC meeting. Donald Trump’s wish for a rate cut preferably not until after the election thus is likely to go unfulfilled.
US labor market enigma
Only a minority of economists at present still have a US recession on their radar. According to a survey by the Wall Street Journal, only 28% of those polled still expect to see a hard economic landing. The consensus, on the other hand, sees robust growth of +1.9% for 2025 – a soft landing, in other words. The employment market, though, is unmistakably cooling down. Although businesses are not laying off workers on a large scale yet, a variety of indicators reveal that job openings are continually on the decline (see chart). The US unemployment rate has risen from a low of 3.4% in April 2023 to 4.3% at last look. This has caused the Sahm Rule to flash red. This well-known recession indicator
potentially could send a false signal in the current cycle (as a result of high immigration). However, uncertainty remains about whether the labor market enigma will solve itself in this fashion (and that easily).
Germany still lagging behind
Economic growth in the Eurozone surprised mildly on the upside in Q2, rising 0.3% from the prior quarter, but that increase was solely attributable to the notoriously volatile data on Ireland’s national economy. The overall macroeconomic picture remains on the gloomy side. The economic activity curve in Germany, for example, remains sawtooth-shaped in the wake of another round of disappointing data (Q2 GDP growth: –0.1% vs. consensus estimate of +0.1%). Moreover, leading indicators came in disappointingly weak in July, which means that the economic recovery that the Eurozone is hoping for in the second half of this year could turn out weaker than desired. Booming tourism in southern Europe is unlikely to supply enough growth stimulus on its own. The European Central Bank might view this as another argument for implementing a further interest-rate cut in September.
Disappointing Third Plenum
In the past, the quinquennial Third Plenum in China was a forum for getting trailblazing reform initiatives off the ground. This time, though, there were no (positive) surprises. Industrial policy and the promotion of high-tech exports were propagated instead once again. Even the leadership in Beijing seems to recognize that this is possibly too little given China’s disappointing second-quarter GDP growth (+4.7%). That’s why in the wake of the mega-event, a number of interest-rate cuts were undertaken and policies were proposed to stimulate consumer spending, which is urgently needed to correct China’s lopsided economy. Analysts are increasingly doubting China’s ability to reach its 5% growth target, but the country’s official statistics are hardly trustworthy anymore anyway.
*LinkUp/Indeed, indexed & Job Openings and Labor Turnover Survey (JOLTS), in millions
Cooling US employment market | Back at pre-pandemic level
Number of job openings in the USA*
The rally in (US) Big Tech stocks came to at least a temporary halt in July.
Asset Allocation Monitor
Cash
Fixed Income
Sovereign bonds
Corporate bonds
Microfinance
Asset Allocation
Notes from the Investment Committee
Inflation-linked bonds 07/2024
High-yield bonds
Emerging-market bonds
Insurance-linked bonds
Convertible bonds
Duration
Currencies
US dollar
Swiss franc
Euro
British pound
Equities: Disenchantment with AI
• The rally in (US) Big Tech stocks came to at least a temporary halt in July. The escape of some air from the purported AI bubble is a healthy development that helps to alleviate the overbought conditions in the market and to reduce investors’ heavy positioning in the star performers of recent months. Additional evidence of this being a healthy correction is provided by a look at the equal-weighted S&P 500 index, which gained around 5% in July and outperformed the market-cap-weighted S&P 500 (+1%) by a wide margin. Just how forceful the rotation was is reflected as well by the sudden massive widening of market breadth: 70% of all stocks in the S&P 500 outperformed the index in July, setting a 30-year record.
• However, the fundamentals need to improve if the rotation from large caps to small caps is to become anything more than just a flash in the pan. In particular, small caps need to close their recent huge earnings-growth gap to large caps. An improvement of that kind has not been visible thus far in the reporting season for second-quarter profits – the large caps in the S&P 500 have once again held the edge in upside earnings surprises. However, there are signs suggesting that the high momentum in Big Tech will slow down in the quarters ahead. The latest outlooks presented by Microsoft and the like, which were on the disappointing side due to declining
Equities
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Emerging markets
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Scorecard
Macro
Monetary/fiscal policy
Corporate earnings
Valuation
Trend
Investor sentiment
growth rates and triggered downward share-price reactions in many instances, indicate that the AI rally may have reached its zenith.
• In light of the rotation observable on the equity market, investors should use the summer break (and the pleasing performance to date) to review their portfolios to correct any large stylistic (growth vs. value), size (large vs. small), sectorial, or regional imbalances. Wide diversification is called for, not least in view of a potentially turbulent election autumn in the USA.
Fixed income: Inflation-linked bonds as a hedge against a Trump victory
• The downward trend in long-term yields accelerated on fixed-income markets in July. At respective yields of around 3.8% and 2.1% at last look, 10-year US Treasury notes and German government bonds of the same tenor have pulled back considerably in the meantime from their year-to-date highs (4.7% and
2.7%, respectively). Swiss Confederation bonds are currently even trading at a year-to-date low at a yield of around 0.4%. These yield developments indicate that the markets are pricing in not just the ongoing disinflation process, but also a substantial rate-cutting cycle over the next 12 months. In the USA in particular, the significantly weakening employment market beneath the solid surface (second-quarter GDP growth of +2.8%) has probably also played a part in the yield pullback. Although a recession is not clearly discernible on the horizon at the moment, in the past the principle on the US employment market has usually been “first gradually, then suddenly.” A further deterioration could thus lead to a recession that ever fewer analysts by now have on their radar. Investment-grade bonds are a hedge against this scenario and should be a constituent part of a diversified portfolio.
• The hedge question also arises in the context of the not-improbable scenario of a Trump 2.0 presidency. If that scenario comes true, it’s possible that US Treasury bonds suddenly would no longer be a safe haven or could at least lose that function temporarily in the short run. This prospect looms particularly if the financial market senses that Trump in the White House will make good on his tax-cut pledge (without any spending offsets) and that the federal debt will spiral further out of control, increasing the risk of inflation. To hedge against this scenario, it is advisable for investors to hold part of their fixed-income exposure in inflation-linked government bonds.
Alternative assets: Crypto-President Trump(?)
• The technical reversal pattern (double top) on the Bitcoin price chart turned out to be a classic bear trap in hindsight. The drop below the support at USD 57,000 at the start of July was immediately corrected, and the price of Bitcoin swung back upward all the more quickly. The cryptocurrency also got a boost at the end of July from Donald Trump. At an election campaign rally, he promised the crypto community that he would significantly ease digital currency regulations and establish a national Bitcoin stockpile. Trump flip-flopping on his opinion from three years ago (when he said, “Bitcoin is a fraud”) apparently doesn’t matter on the campaign trail because, after all, Bitcoin investors rank among the big donors to Trump’s reelection effort. In the meantime, a bullish flag pattern is now forming on the Bitcoin price chart. A breakout above the USD 70,000 mark could cause the current crypto summer to heat up further.
• Trump also would like to roll back regulations in the energy sector, whereas policies could become less conducive for alternative energy. This means that conventional energy companies are the ones bound
to benefit the most. Although an easing of regulations is unlikely to lead to a substantial increase in US oil production (at least not in the near term), Trump nevertheless could indirectly achieve his goal of significantly lowering the price of oil. If he imposes a blanket 10% tariff on all imports, as he has threatened to do, that could weaken world economic activity and demand for oil to such an extent that the price of oil might settle down to a level 10 to 15 US dollars lower than this year’s average price per barrel.
Currencies: Swiss franc benefiting from anti-carry trade
• EUR/USD: The EUR/USD cross has stayed true to itself this summer – even though the Eurozone is only in so-so economic shape in absolute terms and has a considerable interest-rate disadvantage relative to the USA, the EUR/USD exchange rate has been oscillating sideways, not downward. That’s because the market is looking ahead to the future and sees not only an interest-rate pivot soon by the US Federal Reserve, but also a narrowing economic growth differential between the two currency areas. Nervousness about Eurozone politics (read: France) has settled down for the time being, and political uncertainty in the USA now stands more in the foreground. A continued sideways drift for the currency pair remains the most probable scenario.
• GBP/USD: In a close 5 to 4 vote, central-bank officials at the Bank of England decided to implement an initial 25-basis-point interest-rate cut to 5% at the start of August. They now are thus one step ahead of their colleagues in the USA. However, the interest-rate differential between the British pound and the US dollar looks set to stay practically steady in the near future due to a probable imminent move by the Fed to follow suit and is unlikely to be a major driver for the GBP/USD currency pair. Meanwhile, on the public finances front, the momentum is on the side of the pound right now: the new British Chancellor of the Exchequer recently announced tax hikes while budget consolidation in the USA seems illusory at present.
• EUR/CHF: In July, the Swiss franc benefited for once from developments in Asia, where the Bank of Japan resolutely continued to return its monetary policy to normal. This, in combination with a looming interest-rate cut in the USA, sparked a turbulent unwinding of the yen carry trade. The Swiss franc, too, is a popular borrowing currency. Consequently, the EUR/CHF exchange rate has recently been trending downwards and reached a new low below the 0.95 level. Another rate cut by the Swiss National Bank looks increasingly likely.
The technical reversal pattern (double top) on the Bitcoin price chart turned out to be a classic bear trap in hindsight.
The warning signals that we enumerated in last month’s “Chart in the Spotlight” (signs including investors’ low cash holdings and thin market breadth) led to an expected correction on the US equity market in recent weeks. It was accompanied by a massive rotation from large caps to small caps and from growth to value stocks, which enabled the Russell 2000 index to make up almost all of its year-to-date underperformance in the span of just a few trading sessions. The stock rotation was triggered at the start of July by a further decline in US inflation data and by a no more than mediocre US labor market report, two arguments that make an initial rate cut by the US Federal Reserve very probable in September and favor small caps that are sensitive to changes in interest rates. The extreme positioning of investors who were overinvested in large-cap and growth stocks and underinvested in small-cap and value stocks was a big reason why the rotation was so intense. It remains to be seen how far the comeback will go. However, small caps right now are at least presenting a substantial cyclical investment opportunity given the fact that they have seldom been more inexpensively valued relative to large caps than they are today. Read more about this in the “Theme in Focus” article.
Rotation | Big Small is beautiful Equity indices, indexed as of January 1, 2024
Sources: Bloomberg, Kaiser Partner Privatbank
Chart in the Spotlight
Geopolitical Heatmap
Assessments of Global Hot Spots and Market Risks
Likely
• Global Technology War
• Persian Gulf in Flames
• Devastating Cyberattacks
• Grave Terrorist Attacks
• Tensions in East Asia
• Russia-NATO Conflict
• North Korea Conflict
A Guide to Global Hot Spots and Market Risks
Financial markets come with risks, including geopolitical risks, which seem at least to have further increased in recent years, frequently dominating news headlines.
Many a pessimist thus is likely to be of the opinion that markets have become completely uninvestable by now.
But whoever stuffs his or her money under a mattress or stashes it in a safe for that reason can only lose out in the long run. That person’s wealth will inevitably lose purchasing power in any event.
However, one also cannot just ignore global hot spots. As an asset manager, we have a special duty to analytically examine the most important macroeconomic and geopolitical risks of our times, to gauge their probability of occurrence, and to infer their implications for financial markets. Fortunately, this routine exercise results not just in a concise heat map of trouble spots seen (and overlooked) by market participants, but also ultimately in the realization – more frequently than one might suspect – that a risk is improbable, is already priced in or, if it does materialize, is relevant only to rather exotic assets and niche markets.
• The Great Trump Panic
• Anti-Green-Wave Sentiment
Conventional Wisdom
Headline Risks
Overlooked Risks
Discounted Risks
European Malaise
True to the motto “political stock markets are shortlived,” investors should take headlines for what they are and shouldn’t allow the incessant chatter on the spectrum of channels to divert them from their longterm investment strategy.
User’s Manual
On our geopolitical heat map, we sort the ten most important global risks in order of their probability of occurrence and the amount of attention being paid to them by the financial markets, creating a matrix with four quadrants. Risks that already are firmly on the markets’ radar usually only cause short-term price reactions if and when they materialize. Investors should devote particular attention to the upper right quadrant of the heat map because probable but overlooked risks have the greatest potential on the whole to spring surprises and trigger market reactions. We describe the ten risks that we have identified and their latest developments in detail on the pages that follow. We additionally name the assets most affected by each hot spot.
Financial markets come with risks, including geopolitical risks, which seem at least to have further increased in recent years, frequently dominating news headlines.
•
Unlikely
In Markets’ Focus
Overlooked by Markets
The pre-election summer in the USA as been extremely turbulent.
Global Technology War Conventional Wisdom
Market Attention | High
Probability | High
Description
The USA and China in recent years have deliberately been seeking to decouple from each other, particularly in the area of highly sophisticated and militarily relevant technologies. The USA is employing a variety of tools (export controls, vetting of foreign investments) in an attempt to safeguard its lead in cutting-edge technologies (artificial intelligence, semiconductors, quantum computers). The scope of those measures is continually widening (e.g., biotechnology). Similar measures are also being contemplated in Europe. China is working on its own capabilities and is likely to achieve some technological breakthroughs on the strength of its human capital, its massive investments in research and development, and its centralized coordination. This is
The Great Trump Panic
Overlooked Risk
Market Attention | Low – Medium
Probability | Medium – High
Description
If the Democrats defend the White House in November, this likely would have no major impacts on financial markets and would probably be viewed by them as busi-ness as usual, but the picture would look different under a Trump 2.0 administration. Only Donald Trump is threatening to withdraw from NATO, to slap high tariffs on imports from Europe, Japan, and Mexico, and to militarize the USA’s southern border. Only Trump exercises presidential powers so erratically and aggressively. If he gains a significant lead in the polls during the election campaign, mounting political uncertain-ty threatens to spark a correction on the equity market. A post-election relief rally would be more the rule than the exception, particularly if Trump cuts taxes as he
Impacted Assets
• ↘ Chinese renminbi
• ↘ US investment-grade bonds
• ↘ Asia ex-Japan technology
• ↗ Infrastructure
bound to further stoke fears in the West and is likely to cause sustained tensions and to result in the development of parallel competing technologies.
Latest Developments
There is growing apprehension in the USA and Europe that China will inundate the world market with less sophisticated semiconductor chips for high-volume applications and, in doing so, will squeeze Western manufacturers out of the market. Those concerns also apply to other technological areas (including renewable energy and electric vehicles) in which China has gained a lead on the back of massive subsidies. Protectionist countermeasures by the West are becoming ever more likely.
Impacted Assets
• ↘ US Treasury bonds
• ↗ VIX index
• ↗ Bitcoin
• ↗ Gold
has said he will. However, panic could break out on the bond market if Trump additionally stimulates economic activity and further increases the federal budget deficit.
Latest Developments
The pre-election summer in the USA as been extremely turbulent. Following Joe Biden's disastrous performance in the TV duel and his subsequent withdrawal from another candidacy, as well as the attempted assassination of Donald Trump, the former president is neck and neck with his new rival Kamala Harris in the election polls. On the financial market, the “Trump trade” is most visible in Bitcoin. However, the race is still wide open and the Democrats have the momentum on their side.
Tensions in East Asia
Headline Risk
Description
The USA and China have braced themselves for a longterm competitive relationship that could become more rancorous in the decade ahead in Southeast Asia. Although the meeting between Presidents Biden and Xi in November of last year reflected serious efforts on both sides to improve stability and communication in the relations between the two countries, this thus far appears to be merely tactical maneuvering and not a structural change in the dynamics of the relationship. Taiwan remains the most important potential trouble spot, as evidenced anew by the presidential election outcome there in January 2024. A conflict over Taiwan would have serious worldwide repercussions even if a military escalation is unlikely in the near future.
Russia-NATO Conflict
Headline Risk
Description
After more than two years of fighting and in the wake of a fruitless counteroffensive by Ukraine, the war in eastern Europe may be at a turning point. A ceasefire or a diplomatic solution is unlikely at present, but pressure looks destined to mount on both sides in 2024. On one hand, Western support for Ukraine threatens to ebb, and on the other hand, Russia’s economy is soon likely to face even bigger problems than before. A political, economic, and military stalemate between the West and Russia is the most probable long-term outcome. If Russia considers itself successful in Ukraine, Moscow might contemplate attacking the Baltic countries or Poland. This appears to be a low-odds scenario as things
Impacted Assets
• ↘ Taiwanese equities
• ↘ Chinese high-yield bonds
• ↗ Defence sector stocks
• ↗ Gold
Taiwan’s semiconductor chip industry is already doing everything it can to diversify its production chain and manufacturing sites.
Latest Developments
Presidents Biden and Xi spoke on the phone in April and discussed several critical issues that overshadow relations between the USA and China (the Taiwan question, China’s support for Russia’s arms industry, unfair trade practices). Their agreement on the low-hanging fruit (including on reopening military communication channels) cannot obscure the fact that deep mistrust continues to prevail, as reflected also by the bipartisan attempt to ban TikTok in the USA.
Impacted Assets
• ↘ Russian equities
• ↘ Russian rouble
• ↗ Crude oil
• ↗ Gold
stand today because NATO continues to possess massive deterrence capability.
Latest Developments
The upcoming US elections raise uncertainty about the future of NATO – a Trump 2.0 administration would possibly mean less US backing for the alliance. To counter this risk, NATO Secretary-General Jens Stoltenberg plans to set up a 100-billion-euro five-year fund to aid Ukraine, with the costs to be spread more equitably across all NATO members. In addition, aid to Ukraine is no longer to be spearheaded by the USA in the future, but instead is to be coordinated by the alliance.
After more than two years of fighting and in the wake of a fruitless counteroffensive by Ukraine, the war in eastern Europe may be at a turning point.
Description
The attack on Israel by Hamas was the deadliest assault on the country since the Yom Kippur War in 1973 and has resulted in a humanitarian crisis. Israel’s harsh military response and corresponding backlashes from proIran factions in Lebanon, Syria, Iraq, and Yemen have recently further escalated hostilities. Militant Houthi rebels, for instance, have repeatedly attacked ships in the Red Sea, which has caused major trade disruptions and threatens to impact the world economy. The USA has implemented extensive military countermeasures in response to the attacks by the militias and to safeguard freedom of navigation in the Red Sea. Efforts by the West are currently focused on liberating Israeli hosta-
North Korea Conflict Headline Risk
Description
North Korea in recent years has continued unabated to pursue its nuclear program and to isolate itself from the West. In the meantime, it has also forsaken a peaceful reunification with South Korea as a core policy objective. In the runup to the US pres-idential election, Kim Jong Un might initiate further provocations to exert pressure on the USA. Meanwhile, North Korea’s rapprochement with China and Russia continues apace – North Korea has since become one of the most important arms suppliers to those two countries. In late 2023, North Korea successfully launched its first military satellite, further exacerbating tensions with the West. South Korea and Japan are strengthening their defenses and are deepening their relations with each
Impacted Assets
• ↗ Crude oil
• ↗ VIX index
• ↗ Swiss franc
• ↘ US high-yield bonds
ges, engineering a ceasefire, and ramping up humanitarian aid. A sustained pacification of the conflict seems illusory for now.
Latest Developments
The battle against Hamas is in its final stage, in Israel’s view. Looked at objectively, though, a conclusive victory is a long way off. Meanwhile, another front threatens to open in the north of Israel, where Hezbollah has continually stepped up its attacks lately. A war against the well-trained and heavily armed militia in Lebanon could overwhelm Israel’s army and air defenses and could definitively escalate tensions in the Middle East.
• ↗ Japanese yen
• ↘ South Korean won
• ↘ South Korean equities
• ↗ Industrial metals
other and the USA. The risk of renewed provocations and military actions by North Korea is growing, but a potential North Korea conflict remains just a “headline risk” for now.
Latest Developments
North Korea conducted a series of short-range ballistic missile tests in April that included the launch of a new intermediate-range rocket (the Hwasong-16B), which North Korea claims can carry a nuclear warhead. In spring of this year, Russia used its UN veto to dissolve the Panel of Experts that monitors compliance with sanctions against North Korea. During Vladimir Putin’s state visit to Pyongyang in June, Russia and North Korea signed a partnership treaty that includes a mutual defense pact.
The battle against Hamas is in its final stage, in Israel’s view.
Devastating Cyberattacks
Conventional Wisdom
Description
Along with the intensification of geopolitical strife, there has been a continual increase in the scope, scale, and sophistication of cyberattacks. State-sponsored hackers, particularly from Russia and China, have many times over already infiltrated vital Western infrastructures such as power grids and transportation and healthcare systems and have broken into government officials’ digital accounts, exposing critical vulnerabilities. Large-scale ransomware attacks on enterprises highlight vast vulnerability in the business world as well. Malicious cyberactivity picks up particularly in conflict zones and ahead of elections, which can cause disruptions and breakdowns and puts pressure on
Grave Terrorist Attacks
Conventional Wisdom
Description
Financial markets’ alertness to worldwide terrorism risks has increased in recent years. The conflict in the Middle East especially raises the terrorism threat not just in that specific region, but also in the USA and Europe. Western law enforcement and intelligence agencies view violent extremists and “lone wolves” as the biggest concern. Al-Qaida and ISIS are further extending their global reach, giving rise to new terrorism hot spots, for example in the Sahel, where military coups threaten to undermine Western efforts to combat terrorism. In the USA, the Biden administration has declared domestic terrorism a serious risk.
• ↗ US dollar
• ↗ Swiss franc
• ↘ Utility sector stocks
• ↗ Cybersecurity stocks
national security agencies to adopt a more proactive posture.
Latest Developments
Governments and organizations are working continuously on strengthening their cyberdefenses and cyber resilience. However, the continual evolution of cyberthreats, the difficulty of identifying cyberattackers, and swift advancements in artificial intelligence make preventing major cyberattacks a constant challenge. A defective software update from US cybersecurity firm CrowdStrike crippled air traffic and payment transaction processing in July. The market for cyberinsurance looks set to continue growing rapidly.
Impacted Assets
• ↗ German government bonds
• ↗ Swiss franc
• ↗ Japanese yen
• ↘ Airline stocks
There’s an elevated danger of a major terrorist attack in Western countries in the runup to presidential elections in 2024.
Latest Developments
On March 22, 2024, Moscow was struck by a terrorist attack that killed over 100 people. ISIS-K, the Afghanistan branch of the Islamic State militant group, claimed responsibility for the act. The attack dealt a blow to Vladimir Putin’s carefully crafted “strong man” image. Experts suspect that the Kremlin might use the attack to justify a crackdown on dissidents and to tighten its authoritarian grip on Russia.
Governments and organizations are working continuously on strengthening their cyberdefenses and cyber resilience.
The European malaise is more subjectively perceived than actually existent.
European Malaise Discounted Risk
Market Attention |
Probability
Description
The risk of a fragmentation of Europe has increased in the 2020s – the war in Ukraine, an energy crisis, inflation pressure, and an economy on the brink of a recession have put a temporary tailwind behind populist parties in some countries (e.g. Germany, the Netherlands). Nevertheless, Europe is united on core issues and objectives such as increasing its strategic autonomy and decoupling from China, supporting Ukraine, and reforming migration policies. Differences of opinion mainly concern details such as implementation and funding. Right-wing parties in France, Germany, and Italy gained votes in European elections in June, but there was no sweeping lurch to the right in Europe. However, a number of issues could strain political cohesion in Europe in
Anti-Green-Wave Sentiment Overlooked Risk
Market Attention | Low
Probability | High
Description
The war in Ukraine has pushed energy security higher up in governments’ rankings of risks. The energy shock has prompted ambitious decarbonization plans in Europe in a race against the USA to seize the leadership mantle in the field of clean energy. This “green race” could act as a catalyst for accelerating the development of low-carbon technologies. However, the progressive transition agenda clashes with many other national priorities and is irking ever wider swaths of the pubic that are angry about the high transition costs. Green parties in Europe are losing ground, reflecting voter dissatisfaction. The markets tend to be overlooking the risk of a
Impacted Assets
• ↘ Hotels & leisure stocks
• ↘ Italian government bonds
• ↗ Swiss franc
the medium term. One of them is irregular migration to the EU, which last year reached its highest level since 2016.
Latest Developments
The European malaise is more subjectively perceived than actually existent. While the core (mainly Germany) is exhibiting weak economic activity, countries on the periphery are growing much more strongly – this convergence could reinforce unity and sentiment toward the euro. There has been intermittent market turbulence, though. The snap elections in France temporarily caused credit spreads to widen. However, the election outcome showed that there are inertial forces in place against a lurch to the right.
Impacted Assets
• ↘ Industrial metals
• ↘ Renewable energy stocks
• ↗ Utilities sector stocks
• ↗ Uranium
negative swing in sentiment toward the energy transition and of delays resulting from that.
Latest Developments
The US Securities and Exchange Commission (SEC) in April announced that it has suspended the implementation of its recently enacted disclosure rules on climate-related risks and greenhouse gas emissions. Companies had already mounted legal challenges against the new regulation prior to its final adoption and publication in March. The SEC declared that it nevertheless would continue to “vigorously defend” the new climate-related disclosure requirements.
Theme in Focus
Small
caps on the sidelines, but for how much longer?
Small caps have been overshadowed by large and mega-caps for the last two-and-a-half years, but their underperformance phase may now be nearing its end. In Europe in particular, the risk-reward tradeoff is good for those investors with a medium-term perspective. However, active management is necessary in order to be able to profit from the dynamism of the hidden champions. Meanwhile, many star performers are staying away from stock exchanges these days, but investors nowadays can nonetheless participate in the performance of those privately held growth companies.
Overshadowed by the big boys
Small caps have been living in the shadows on equity markets for quite some time. The investment case for this equity category, which is based in part on the small-cap premium that can be captured over the long term and on the greater alpha opportunities that “little” stocks offer, has not persuaded investors over the last two-and-a-half years. They have preferred instead to stick their capital in the Magnificent Seven in the USA or in the European GRANOLAS. By contrast, it takes a proverbial magnifying glass to search for a good performance among the purported hidden champions in the equity universe. Strictly speaking, the weakness of small caps versus large caps since November 2021 (which marked the cyclical peak in small-cap indices) constitutes one of the widest performance discrepancies in history – the underperformance of small caps during this period exceeds 20 percentage points in the USA and even amounts to around 30 percentage points in Europe.
The weak performance, though, is only partially explained by AI fever and the motto “big is beautiful.” It also has fundamental causes. For instance, the more cyclical small caps have been affected more than large caps by the dip in economic activity in recent quarters (particularly in Europe), by the rise in interest rates, and by the intermittent overshooting of inflation. So, on the bottom line, they have also posted notably lower earnings growth. However, this reality has been more than priced in by now because the valuations of small caps have contracted by more than 30% since the start of 2022.
Cyclical investment opportunity
In fact, viewed objectively, small caps have to be considered a real (relative) bargain today. In terms of priceto-earnings multiples, small caps in Europe are just as cheap right now relative to large caps as they were during the darkest days of the 2008/2009 financial crisis. The valuation premium on European small caps observable in “normal” times on the justifying grounds of hig-
Lagging behind | Persistent performance gap between small and large Performance of small- and large-cap indices
Sources: Bloomberg, Kaiser Partner Privatbank
Big is beautiful… | …especially among US growth stocks Small vs. large on the US equity market
Sources: Bloomberg, Kaiser Partner Privatbank
her growth has since turned into a small discount over the past year. A small-cap discount has been in existence in the USA for three years already, even when the pricey Big Tech stocks are stripped out of the equation.
However, the cheapness argument is never a good reason by itself to buy on financial markets. That’s because
With a tailwind from the central bank | ECB rate cut = entry signal
Small vs. large on the European equity market (after initial ECB rate cut)
Sources: Bloomberg, Kaiser Partner Privatbank
In presidential election years, US small caps are… | …often a good choice
Small vs. large on the US equity market (in presidential election years)
Sources: Bloomberg, Kaiser Partner Privatbank
Moreover, compared to large caps, a bigger percentage of small-cap companies operate unprofitably.
there’s often a good reason why assets are inexpensively valued. A hoped-for opportunity frequently turns out to be a value trap in hindsight. A look at small caps quickly reveals a few blemishes that may explain their low valuations. To wit, small companies generally tend to be more leveraged with debt loads that are more sensitive to changes in market interest rates and have lower profit margins. Moreover, compared to large caps, a bigger percentage of small-cap companies operate unprofitably. In the past, investors could always ignore those points of criticism whenever they were offset by compensatory high growth rates. Precisely that kind of recovery in corporate earnings may now be on the verge of taking place. Just at the moment when investors have drastically dialed back their earnings expectations and are heavily underinvested, there are good chances that small caps will embark on a turnaround in the quarters ahead.
A combination of several factors makes a case for a turn for the better. Many small caps are so inexpensively valued by now that they are increasingly attracting the interest of strategic buyers (e.g. larger-sized companies or private equity managers). The currently reaccelerating M&A deal market is spurring speculation about imminent share-price upside potential at small
publicly traded companies. Another positive development is the ongoing strengthening of economic growth dynamics, particularly in Europe. This should disproportionately benefit small-cap enterprises, which typically operate with higher debt leverage than larger companies do. Last but not least, we are past the peak of restrictive monetary policy by now. A few major central banks have already implemented an initial interest-rate cut. The financing climate for smaller-sized companies soon looks set to tend to become more accommodative. In the past in the European equity space, the kickoff of a new rate-cutting cycle was a sign of an impending rotation into small caps. (Disclaimer: Only three such kickoffs have been observed over the last 25 years.)
A look at the USA also reveals encouraging data specifically showing that small caps there have outperformed by a median of around 9 percentage points since 1992 during presidential election years. However, apart from this likewise rather narrow statistic (based on just eight observation points), the immediate prospects for American small caps are a bit less favorable compared to Europe. Economic growth dynamics in the USA look set to slow somewhat while the US Federal Reserve continues to postpone an initial interest-rate cut. Moreover, a leadership change from large caps to small caps in the USA depends in large part also on how long AI mania continues. It’s impossible to time that perfectly. Mass investor psychology is unpredictable. However, some of the arguments like the ones below being invoked in favor of large caps in general and Big Tech in particular in the midst of the euphoria don’t hold up well at second glance:
• Large caps are beneficiaries of artificial intelligence: Although it is true that large companies possess more resources and capital with which to earn a profit on the artificial intelligence megatrend, in the past it has invariably been the smaller contenders that have benefited the most from tectonic technological shifts. The big players are often less adaptive and more resistant to change, and innovations usually affect only a part of their business.
• Large caps have a competitive advantage: Large companies benefit, in fact, from more than just economies of scale. Megatrends like globalization, the rise of China, the Big Tech phenomenon, and structurally falling interest rates have also made them winners over the last two decades. Looking ahead, though, the future reality for the big players looks set to become much less conducive to profitmaking. Deglobalization and reshoring could prove especially disruptive to them. Higher taxes and/or more regulation (e.g. in the technology, telecom, utilities, energy, and healthcare sectors) as a result of actions by increasingly populist governments are also likely to adversely affect large caps in particular.
• The growth of passive investing makes an outperformance by large caps a self-fulfilling prophecy: Over the past decade, large caps have benefited immensely from the rise of passively managed invest-
ment funds (ETFs). However, the price performance of the big stocks by now has become heavily dependent on that very same investment capital. During the next economic downturn, passive capital flows driven more by investor whims than by the fundamentals could cause proportionally bigger drawdowns and higher volatility among large-cap stocks.
If AI-phoria comes to an end and triggers a U-turn, that could definitely happen abruptly. The last few weeks have provided a foretaste of such a development and may already have been the starting signal for a major rotation.
The small-cap premium…
Judging by previous cycles, a possible new phase of small caps outperforming large caps would generate at least 20 to 30 percentage points of medium-term alpha potential. However, the situation beyond the medium-term time horizon looks different because the underlying conditions on the capital market have changed radically in recent years for smaller-sized companies (and their shareholders).
For decades, the premium earnable on small caps was an empirically demonstrable “law of nature.” Eugene Fama and Kenneth French looked into this in 2006.1 They discovered that the structural outperformance of small caps versus large caps is attributable to just a handful of single stocks. They experienced such dramatic share-price rises that they transformed from small caps into mid-caps and then into large caps, a phenomenon that Fama and French called “migration.” However, if this migration is stripped out and one adjusts the statistics to take account of the factor “valuation,” the outperformance by small caps turns into an underperformance. The reason is because small companies typically are more prone to go bankrupt or get bought out by other corporations. And even if they “survive,” they mostly deliver a lower performance than large companies do.
The difference thus is made by just a few highly successful companies that advance from the minor leagues of the stock market to the Champions League. Investors who bet on small caps are, in this sense, buying lottery tickets in the hope that a few of them will hit the jackpot. However, over the last 20 years there have been fewer and fewer winning tickets. The migration between stock-size classes has decreased by half since the turn of the millennium. Ever fewer small publicly traded
companies are growing big enough for a promotion and are instead staying permanently in the small-cap universe. The small-cap premium has lost a lot of its allure.
…is getting undermined
The dearth of star performers among small caps is not because there are no longer any entrepreneurs (or visionaries) these days capable of building successful, feisty companies. Quite the contrary, in fact, the number of young enterprises is perennially growing,2 and the ecosystem for growth companies is more vibrant, dynamic, and sophisticated than ever. But fewer and fewer of these small, fast-growing companies are going public. Whereas IPOs were still the norm prior to the year 2000, in nine out of ten cases these days, the exit by venture capital firms gets done by selling to a strategic buyer or to a competing company. Big Tech has contributed significantly to this trend. Since the mid-2000s, the biggest (US) technology companies have been on a virtually perpetual shopping spree and have acquired hundreds of small firms. The buyout offers from the “big guys” are just too tempting for most startups. Instead of risky and costly competition, an enormous distribution channel, massive customer growth, and huge return potential beckon. This is a major reason why some of the best startups of the last 20 years have ended up in the hands of Alphabet (Android, YouTube, Fitbit), Amazon (Twitch), Apple (Beats Music), Meta (WhatsApp, Instagram), or Microsoft (Skype, LinkedIn).
If those takeovers had never happened, many of those enterprises would have evolved into successful smallcap stocks and ultimately would have grown into large caps. By acquiring those startups, the big technology companies didn’t just eliminate competitors that threatened their monopoly power, but also siphoned off the growth that in the past would have accrued to smallcap investors after early IPOs.
For decades, the premium earnable on small caps was an empirically demonstrable “law of nature.”
A handful of star performers… | …explain the historical small-cap premium Decomposition of US stock-market performance (for period from June 1927 to June 2006)
Sources: E.F. Fama und K.R. French (2007), Kaiser Partner Privatbank
IPOs are merely a sideshow | The real action is in the private market
Number of exits from venture capital-funded companies
Sources: National Venture Capital Association, Kaiser Partner Privatbank
Too big for the small-cap index | The average tech IPO today is a large cap
Market cap of tech IPOs in relation to the Russell 2000 index’s upper market-cap limit
Sources: National Venture Capital Association, Kaiser Partner Privatbank
Founders who are able to resist the lucrative checks from tech giants also deliberately like to stay away from stock exchanges these days, and that’s not just because staying private means less compliance expenses and controls and shorter decision-making paths for companies. Unlike before, an IPO is no longer necessary even from a funding standpoint because the private capital
market is so broad and deep that growth companies can be scaled up to a massive size also this way. The biggest US company owned by venture capital firms –aerospace company SpaceX – by now is more than 40 times larger than the upper market-cap limit set by the Russell 2000 index of US small caps. If SpaceX were to go public, it currently would rank around 40th on the list of the largest publicly traded companies in the USA, ahead of multinational corporations like American Express, Pfizer, and IBM.
Many successful companies these days still go public eventually, but by the time they do, they usually are already large caps. In recent years, tech IPOs, for example, have been around 50% larger than the biggest small caps in the Russell 2000 index. In the late 1990s, they were only a fifth as large. The importance of small caps to the IPO market generally has continually diminished over the years. Whereas IPOs with issue proceeds of less than USD 100 million accounted for 27% of the total capital raised in the 1990s, their share since the year 2000 (adjusted for inflation) has shrunk to just 7%.3 These developments have significant consequences for investors in small caps. Whereas they were once able to earn massive excess returns relative to the S&P 500 index with companies like Amazon (948%) and Nvidia (557%) during their small-cap phase, profits of that kind were no longer possible with the next generation of companies like Meta, Alphabet, and Tesla. Those companies already belonged to the universe of large-cap stocks on their first day of public trading. Private financiers were the only ones that profited from their early-stage growth.
Second-rate remnants or hidden champions?
Since many of the best companies these days bypass the universe of publicly traded small caps, small-cap indices increasingly risk turning into a repository of rather subpar companies with poor fundamentals or unscalable business models. Strictly speaking, the average quality of small caps – as measured by return on equity, for example – has always been lower than that of large caps, but the quality gap has increasingly widened over the last two decades, and not due solely to the strong fundamentals of large caps. According to an analysis by Verdad Capital,4 the profitability of newly publicly traded small-cap companies has declined. Given the abundance of more attractive financing alternatives available, practically the only companies that choose to go public as a small cap are the ones that don’t have any other options. This means that small-cap indices today suffer from the problem of adverse selection. And investors in small caps run the risk in the end of holding the metaphorical trashcan of the stock market in their hands.
That risk exists for the time being for those who invest passively in small caps via ETFs. For actively managed small-cap strategies, in contrast, there are good prospects even beyond the cyclical medium-term horizon. Academic studies show that many factors and inefficiencies on the equity market are particularly pronounced in the small-cap segment, in large part because small caps do not stand in the spotlight and receive less coverage by analysts. They also show that the wide variance in the quality of companies is not necessarily problematic for experienced portfolio managers and, to a greater degree, is actually a source of significant alpha. Easily overlooked hidden champions exist particularly in niche markets like Switzerland. Kaiser Partner Privatbank has built up extensive expertise on the Swiss small- and mid-caps segment over the past decade thanks to our closeness to this market. Our Swiss Stocks Basket launched at the start of 2016 has generated sustained added value for our clients, delivering an an-
nualized return of +11.4% and a 5.5-percentage-point outperformance of the benchmark Swiss Performance Index (SPI). Clients of Kaiser Partner Privatbank now can also participate in the performance of the privately held large caps of the future. Our Private Markets Solution enables clients to gain access to privately held venture capital and growth equity firms.
1 Eugene F. Fama und Kenneth R. French, “Migration,” Financial Analysis Journal, 63-3, (48-58), 2007
2 Craig Doidge, G. Andrew Karolyi and Rene M. Stluz, “The U.S. Listing Gap,” Journal of Financial Economics, 123-3, (464-487), 2017
3 Marshall Lux und Jack Pead, “Hunting High and Low: The Decline of the Small IPO and What To Do About It,” M-RCBG Associate Working Paper Series No. 86, 2018
4 The Quality of New Entrants,” Verdad Capital, December 2023
The Back Page Asset Classes
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