Uncategorized | SWISSCHANGE Financial Services AG

17. August 202217. August 2022

Real Estate Environment

EMR August 2022

Dear Reader

ECONOMIC FRAMEWORK

The monetary authorities have recently begun to raise interest rates in unprecedented steps. The declared aim is to contain the ongoing retail price increases. The reactions by the monetary authorities can be interpreted as an indicator of tightened monetary policy. One could argue that the specific objective is to disentangle the links between the financial sector and the development of the real economy.

Why is this so? Well, they provide very valuable information about the interaction between the supply of savings and the demand for investment. Theoretically, there is broad agreement on the factors that influence interest rates, while disagreement concern the relative importance of the various instruments.

TODAY´S ENVIRONMENT

We believe that the recent and the foretold actions of the Central Bank (specifically of the Federal Reserve) to push interest rates on deposits of the banking industry higher, must be defined as a tightening indicator. The real puzzle of this tightening lies in the specific reactions of the market. We might ask whether it is reasonable to assume that further increases in interest rates will reduce the supply of money?

In the course of our many years of work in economics and finance, we have been involved in quantifying the relationship between price increases and their impact on interest rates. We have learned several lessons: one is that interest rates tend to rise when inflation rises, especially when inflation rises sharply and abruptly. Another lesson is that interest rates respond with a lag to price increases. That is not quite the case at present! The recent, marked interest rate hikes by central banks, in concert with the rise in inflation, especially due to the Covid 19 pandemic and the Russian invasion of Ukraine, are indeed quite unique. The current divergent conditions are seen as an implicit new environment, especially by lenders and borrowers. This is mainly due to the fact that the expected inflation development and the corresponding impact on interest rates and the economy have been difficult to predict and quantify.

WHICH ARE CURRENTLY THE REAL QUESTIONS FOR INVESTORS?

The first and hardly predictable question relates to the fate of the inflation rate. Do we expect that the recent and further announced interest rate hikes by central banks will significantly slow down the growth of price increases and, in due course, significantly reduce them? We doubt that this will be the case in the near term. Why is that? We continue to expect inflation to be driven by “exogenous” and almost “unpredictable” factors (war in Ukraine and, even worse, the Chinese threat to Taiwan, as well as increasing political unrest), which remain difficult to quantify.

Second, the supply of inputs (intermediates, crude oil and gas, and food) depends predominantly on very “constrained” supply chains and continues to be largely determined by barely quantifiable but increasingly unacceptable political behavior. At this stage, we doubt that the prediction of a price decline will follow a traditional cyclical scheme, as policymakers tend to follow a completely “non-economic” model.

A third argument to quantify concerns the adaptation of technological innovation in the energy sector, which, in due term would imply the “repatriation” of specific production lines.

Another difficulty we continue to face relates to the assessment of the impacts on income and on market liquidity, Will they offset each other, as it can be assumed that income will not react immediately and to the same extent as liquidity? At this stage, it is difficult to precisely quantify the proportionality of the change, also because of the war in Ukraine, especially in light of the current interest rate policy stance of central banks.

FINDINGS FOR SWISS INVESTORS

A closer look at the current environment reveals that the focus is on raising interest rates to counter inflationary pressures. The actual determinants of the current inflation are almost ignored. Assuming that the rise in inflation is mainly due to factors (such as Covid-19 and, above all, the invasion of Ukraine and China’s threat to invade Tai-wan) that put dramatic pressure on the rise in crude oil, gas and food prices above and beyond normal supply and demand trends, we should rather focus on how to solve the bottlenecks in the supply chain.

At this point in time, we believe that an “extraordinary tightening of monetary policy” could rather constrain demand without a rapid improvement of supply! However, sup-ply disruptions are expected to ease in the coming quarters, while “financing costs” may rise. We agree with Fed Chairman Powell that monetary authorities can manage demand, but not supply. Therefore, it would be worthwhile to distinguish between companies whose prices move in response to changes in demand from those that move in response to changes in supply. In this context, we argue that the most promising investment approach would be one that focuses on increasing supply as prices fall. We consider it deterministic to focus on technological improvements as well as on the adjustment of wages to the cost of living.

Examining the main components of real GDP, and focusing at this juncture to the Swiss market we find that a most intricate question mark refers to whereabouts of the mortgage market. Increasingly we read about the possibility the Swiss property market could suffer while losing some attractiveness. If the available data represent the most probable reality, that risks exist. Nevertheless, despite the recent increase in the ratio of real estate to income and the ratio of mortgage debt to GDP, the environment remains sustainable. Particularly deterministic is, in the case of Switzerland, that employment has remained sustained and as of recently it has begun to show signs of revival, concomitant with increasing immigration. Should the global economy return to some growth in the near future, it can be assumed that demand for Swiss living and working space remains high.

At this juncture, it can be assumed that we are close to the cyclical peak in real estate prices. Fact is, that there is a great demand for real estate (residential and commercial), thus, the threat of higher interest rates should not be underestimated. Land and also property remain in demand in Switzerland. Well known is that real estate also can offer protection against inflation. The big unknown remains the timing of the respective peaks of inflation and interest rates. Let´s not forget the special role of the Swiss franc.

Comments are welcome.

26. July 202226. July 2022

Inflation vs. interest rate?

EMR July 2022

Dear Reader

ECONOMIC FRAMEWORK

The current controversy is once again focused on the strategic role of interest rates and economic activity. Why, you might ask? Both variables provide a link between the financial environment and economic performance. They provide information about the interaction between the supply of savings and the demand for investment. Theoretically, there is broad agreement on the factors that influence interest rates. There is disagreement about the relative importance of the various instruments.

PRESENT SITUATION

We have no doubt that recent actions by, for example, the Federal Reserve Board to raise the fed funds rate (defined here as “i = interest rate” on banking sector deposits) should be seen as indicative of a tightening of monetary policy. How does this interplay work is the key question at this point?

A simplified demand for money (M^d) can be formulated as follows:

In other words: We speak of the “cost of holding cash” and, in particular in this context, of the cost of holding cash at the central bank. Both within the framework of economic theory and in ongoing, publicly available reporting, three deterministic effects can be derived:

Price Expectations Effect (also known as the “Fisher Effect”),
liquidity effect, and
income effect.

We would like to emphasize that the function presented above is a highly simplified demand function. Nevertheless, it helps us to assess the current situation. We do not doubt that the Fisher or price expectations effect is particularly useful in the context of recent extraordinary central bank interventions. It explains the interdependence between interest rates and expected inflation. The two recent 0.75 % increases in the key interest rate were intended to reduce commercial banks’ overnight borrowing. When the central bank raises the key interest rate, it makes borrowing more expensive for both businesses and consumers by spending more on interest payments. An important effect of higher interest rates should be that they tend to lower inflation and prevent the economy from overheating. On the other hand, higher interest rates should also affect the stock market, while the price of existing bonds should fall. Consequently, new bond issues tend to offer investors higher interest income.

The liquidity effect is widely recognized in the context of monetary policy. In other words, it refers to the benefits that can be obtained by shifting money to assets.

Contextual changes in the money supply and interest rates can balance the actual and expected money supply. In the real world, however, one is confronted with the interactions of all the above determinants.

INSIGHTS FOR INVESTORS

When we look at the current environment, we see that the focus is on raising interest rates to counter inflationary pressures. The factual determinants of current inflation go almost unnoticed. If we assume that the rise in inflation is mainly due to factors (Covid-19 and the invasion of Ukraine) that have put dramatic downward pressure on crude oil and food prices above and beyond normal supply and demand trends, we should rather focus on how supply chain bottlenecks can be resolved. At this point, we believe that “extraordinary monetary tightening” could constrain demand without rapidly improving supply! Supply disruptions are expected to ease in coming quarters, while “financing costs” could rise.

We agree with Fed Chairman Powell that monetary authorities can manage demand, but not supply. Therefore, it would be worthwhile to distinguish companies whose prices move due to changes in demand from those that move due to changes in supply. In this context, we argue that the most promising investment approach would be the one that focuses on increasing supply while prices are falling.

The expected trigger is the quantification of the change in quantities and prices. We believe it is deterministic to focus on technological improvements as well as the adjustment of wages to the cost of living.

We advise investors to quantify the “expected turnaround” in global and local supply constraints, as we expect these to continue to be key determinants of the inflation trend and hopefully reverse it.

Comments are welcome.

26. June 202226. July 2022

Focus on Switzerland

EMR June 2022

Dear Reader

ECONOMIC FRAMEWORK

Recently, the global economy has started losing momentum due to the unacceptable Russian invasion of Ukraine as well as the sharp increase in inflation and also interest rates. We take these developments, along with currency adjustments, as confirmation of our preference for investing in the Swiss market. Therefore, here we will focus on the Swiss mortgage market.

THE RECENT PAST

The chart of mortgage rates shows that there was a somewhat steep, choppy decline between 2007 and 2011/2013, followed by relatively stable, low interest rates until early 2021 and a fairly steep rise until 2022! It is striking that the 10- and 15-year interest rates have risen significantly more than the short-term interest rates.

The thorny question implicit in the graph on mortgage rates currently relates to the main drivers of the recent price increase. Following the argument made in the May 2022 EMR, we would argue that “aggregate supply disruptions” are the key determinant of the short- to medium-term outlook. Determinants of crude oil price increases include both the impact of the Covid 19 pandemic and the Russian invasion of Ukraine. However, one should also take into account the recent monetary policy interventions by central banks, the interactions of which will ensure continued volatility in the financial markets.

FRAMEWORK CONSIDERATIONS

As far as the development of inflation is concerned, we would like to point to the similarly strong increase in consumer prices in the United States and the EU, while the Swiss CPI is still lagging well behind. The U.S. CPI rose to 8.6% in May 2022, after reaching a low of 0.24% in May 2020. A similar increase can be seen in the Eurozone consumer prices, which reached 8.1% in May 2022. Swiss consumer prices are dancing on a different planet, rising to 2.94% in May 2022. These intrinsic developments have led us for some time to focus our allocation on the domestic market in order to reduce volatility and significant losses.

FINDINGS FOR INVESTORS

Assuming that the leading central banks (e.g., FED, ECB and BoE) will continue to push up interest rates, while the SNB is likely to continue to lag behind, we ask ourselves what these developments should mean for the Swiss mortgage market?

Our macroeconomic framework assumes that the rise in interest rates in Switzerland will obviously be much more moderate than in the markets of our trading partners. The decisive factor is and remains a moderate increase in the cost of accessing credit. In addition, the CHF is likely to appreciate or at least not depreciate significantly.

At this juncture we suggest clients to contact Swisschange in order to discuss the best policy for your specific portfolio. We believe that a 5 to 7 year horizon could be appropriate.

Comments are welcome.

10. March 202210. March 2022

Uncertainty

EMR March 2022

Dear Reader

Russia’s aggression in Ukraine forces us to make the following assessment. It is highly intricate and difficult to foresee any short-to-medium term outcome of the Russian invasion of the Ukraine. At this juncture we are not in the position to foresee the appropriate steps that could convince the aggressor to stop the massacre of innocent people.

At this juncture, the major question mark refers to the efficiency of the envisaged sanctions. Will they convince the aggressor that the gains from their current policy will be significantly more negative on the Russian economy than on the free world? Power politics and naked violence dominate the discussion, making comparisons to similar periods in the past highly difficult. Here are our contextual assumptions:

Higher and sustained financial markets’ volatility

What we as economists can deduce with some accuracy is that in the short-run, volatility and fear will dominate market activity. There seems to be no doubt at all that short-term inflation will continue to rise in line with rising energy costs as international supply shrinks. In the current environment, it also mandatory to keep in mind that prices of industrial goods are largely determined not only by the availability and prices of various intermediate goods, but also, and more importantly, by other supply constraints. Particular attention must also be paid – at least in the short term – to the “longevity” of wartime activities and the corresponding countermeasures in the areas of air traffic, shipping and port congestion. Undoubtedly, these events will continue to influence price developments not only on the stock market.

Economic risks

Prior to the Russian attacks on Ukraine, it could be assumed that as the COVID-19 pandemic subsided, the global economy could and would move toward more normal standards. This catch-up effect must be postponed depending on both Russia’s feared continued belligerence and the corresponding sanctions taken and contemplated by the industrialized countries. At least in the short term, they argue for lower-than-expected economic activity.

Inflation, interest rates and currencies

Fact is that Russia’s wartime activities in Ukraine may continue to cause material shortages and thus logistical difficulties, which are likely to be far more inflationary than the recent loose monetary policy of the industrialized countries. In our assessment, there is no doubt that the impact on energy prices is likely to continue, at least in the near future. It is well known that “sanctions” do not only affect exporters. Higher prices and/or restricted import volumes have and will also suffer. In other words: Imports imply – ceteris paribus – higher real GDP growth. In this context, we are less optimistic than the vast majority of analysts. Why is this, you may ask? A simple statistic, i.e., lower imports, argues for higher GDP growth. This analytical derivation is only ceteris paribus correct. It does not take into account, for example, the respective particular impact on business fixed investment, which is also likely to be negatively affected. It is clear that consumer prices will remain high or even continue to rise, at least in the short term. It should be noted that the resulting higher inflation expectations will dampen consumers‘ positive expectations, while business fixed investment may continue to suffer from supply constraints. Such an environment is generally considered a forecast impasse. In our view, economic activity could be lower than generally expected in the coming quarters, while economic growth could pick up in the second half of 2022 and beyond, provided the invasion of Ukraine is halted. In such an environment, we expect that central banks may be forced to postpone an interest rate hike so as not to hamper the medium-term economic recovery. It should be recalled that interest rate and inflation levels vary widely across countries. At this stage, they represent a deterministic “diversification risk.” The impact on currencies will need to be closely monitored in the short to medium term. The real question will be: Which country offers the best real return on investment?

The Russian invasion of Ukraine has caused great uncertainty on the capital markets, particularly with regard to the scarcity of resources. The different marketplaces have also reacted differently, as the graphic shows. As in other times of crisis, many are switching to gold stocks.

Our contextual suggestion for investors

Even if further market corrections are to be feared in the short to medium term, we advise against panic selling. We assume that the “warmongers” will come to their senses sooner rather than later. The economic and thus also the political losses on their side usually lead to a rethinking that does not seem possible at certain times.

Given the short-to-medium-term assessment difficulties, let us ask ourselves: what will the implications for investors be? If history can be taken as a valid indicator, we would deduce that there are two specific developments shaping a rewarding investment policy over the shorter- as well as the longer-term. Banking on a certain, but slow and erratic rate of growth for 2022, by somewhat higher interest rates, inflation would be expected – in the second half of 2022 – to return down to “more normal lower levels” than those registered so far in 2022 in the USA (7.4% in January and 7.8% in February). Similar, but somehow lower developments have been registered for European indices, while the Swiss inflation remained significantly lower, i.e., 1.6% in January 2022. Assuming a modest economic recovery, we bank, even if it is highly difficult to be certain and precise, on a price reduction of crude oil (which, as measured by the NYMEX crude oil quotation has reached the highs of 2014) and also of overall transportation costs.

According to our rather positive assessment of the effects of the implemented financial market interventions ¬– to the detriment of the aggressor, the investment environment is likely to remain difficult, but not completely catastrophic. Accordingly, we expect that

Equities to continue to outperform bonds and money markets. Nevertheless, on a country-by-country basis, we expect relatively high volatility on a daily and weekly basis. Why so? This ought primarily to be due to sectoral rotation, depending on short-term inflation expectations and political commentaries on interest rate changes, i.e., possible increases.
Country-wise we remain focused on our home market Switzerland, the USA and selected European markets, which focus must be set on sectoral rotation.
The initial situation, which is likely to be volatile, remains tied to politically complicated global politics. At this stage, we find it difficult to limit the conflict only to Ukraine. In this context, we are positively surprised by the historic decision of the Swiss government to freeze the assets of oligarchs.

8. February 20228. February 2022

New Energy Dilemma?

EMR Feb. 2022

Dear Reader

Most of our readers will recall the arguments put forward in the 1970‘s and 1980‘s concerning the world oil tank approaching empty. Then, as now, supply and demand were and are perceived as the reason for price increases. The developments of the 1990‘s are comparable to the current ones, but currently they are increasingly more complicated than during the previous oil crisis. The world economy faces several disruptive movers, which in a certain sense, render the current environment rather unprecedented, especially regarding its impacts on economic growth, inflation interest rates, employment and international trade. It´s a fact that many investors have turned significantly more pessimistic regarding the short to medium-term outlook. Our focus will be on equity markets, as implicitly shown in the chart of equity indexes: DJIA, SPI, DAX, FTSE, and N225.

What can be inferred from the charts? First of all, we find that the interpretation of past developments differs significantly when the focus is on percent changes on a year-over-year basis (first chart) as compared to the monthly level averages (second chart). The percent changes speak of significant volatility (see e.g. 1997 to 2003) while the chart of the monthly average levels speaks of significant long-term growth, particularly since 2009. Secondly, we find confirmation of a dramatic environmental change since the mid 1990‘s. Thirdly, the current pandemic Covid-19 situation is widely assumed to be inflationary. Fourthly, we have to take seriously into consideration that the differences to the oil-crisis are more intricate, both on the supply as well as the demand side of the economy. Our focus is not primarily on the long-term comparison as the shorter-term developments, i.e. since November 2019 into 2022.

Given that recent hard economic data (for real GDP and components) are still missing, let us now turn to the implications on the demand as well as the supply-side of price changes, since the outbreak of the Covid-19 pandemic. Analyzing closely the performance of the Swiss consumer price index (CH CPI) along the lines of the US cycles for the period since 1949, will astonish most of the readers of this EMR and this due to the fact that the most recent cyclical growth rate of Swiss inflation is absolutely the weakest!

Comparing the recent inflation ups and downs, we find that since the top of August 1991 (6.57%) and the ensuing lower top of July 2008 (3.07%) rising to 1.53% in Dec. 2021 has not been accompanied by similar swings in the Swiss 10-year Government bond yields. The chart shows that since 1998 market participants were faced with a relative long period of price stability (despite short-term swings around 1%). At this juncture we stand at cross-roads. Will demand grow in the next quarters due to past liquidity injections by Governments and Central Banks, thus fostering consumption growth, and at the same time with improving imports of much needed tech-components? We believe that we ought also to take into account the expected domestic improvements on the supply side. In the short term this approach would imply profit maximization. At this time, we are not yet ready to subscribe to such a scenario. We believe that the comparison to the previous crude-oil crisis is not expected to be repeated. Why so? Well, we expect that shortages of imports of technological intermediates ought to come soon to an end, thus implying improving local production activity. In addition, taking progress – at various levels – toward solutions of the Covid-19 pandemic would speak for an improvement of economic activity feasible without significant inflation pressures.

Contextually, it is a fact that, e.g. in 2020, the US Federal Reserve has embarked on a policy of “Av-erage Inflation Targeting” as part of its long-run monetary strategy. We take note that recent in-creases of consumer prices in the USA and Europe have been strong indeed. Thus, in this EMR we will concentrate our analysis to the Swiss developments since January 2008. Swiss 10-year Govt. Bond Yields stood at minus 0.072% on January 2008. Subsequently they fell to a bottom of minus 0.975% on August 2010, to again “rise” to minus 0.127% in December 2021. The real question at this time is: will inflation rise to the levels of the comparable levels of the previous cycle or even higher? In such an unexpected case, inflation would definitively be a stock market negative. Interpreting the below shown charts one is confronted with a differ-ent perspective, aren´t we? Now let us recall that significant inflation acceleration in the past has been a negative. Given that in December 2021 the yearly rate of Swiss inflation amounts to 1.535%; matching the previous top of mid-2010, one has to fear or assume a dramatic rise over the medium term. We have a hard time to accept and to explain these negative expectations, mostly due the reliquification measures taken in recent quarters and the slow but ongoing economic revival of international trade developments in the mak-ing. The two most tricky assumptions to be made at this time, concern the adjustment process of “Gross private domestic investment, incl. Change in private inventories” and net Exports.

At this juncture we assume that Gross private domestic investment ought to grow substantially, in line with the significant past governmental reliquification. Enterprises have learned that international trade disruptions (not just due to Covid-19) but, more importantly, by foreign governmental difficulties, require a readjustment of domestic supply of intermediate technical goods and services. The scarcity of electronic components and the lengthening of delivery times are seen as a dangerous “limiting growth”-argument; very difficult to be quantified with sizable precision. Nevertheless, the contextual developments ought to yield support to the equity market and local employment.

On the other hand, consumer spending is expected, at least short-term, to be contained as governmental financing is scaled down. The Fed Chairman gave a special hint of this on January 26, 2022, by stating that the Fed was “determined” to raise interest rates in March to combat the highest inflation in decades. He also stated that there was a risk that inflation would not return to pre-pandemic levels in the foreseeable future and that price increases could accelerate. Consequently, we assume that real GDP is not expected to rise significantly over the next few quarters. Net export, on the other hand, are expected to support real GDP activity mostly via a systematic reduction of imports of intermediate tech-supplies.

The toxic mix of increasing inflation, consistently due to rising energy costs in conjunction with bottlenecks in the global distributive system, and the expected shift in industrial production will continue to determine the growth differential and trend from country to country.

CONCLUSION FOR THE INVESTMENT POLICY

History tells us that in times of accelerating inflation, rising interest rates and rather poor economic activity the stock market performs, to say the least, below the levels or the times of relative price stability (around 2% inflation).

In order to assess future developments, one must use a combination of many factors, subjective and objective, qualitative and quantitative. The current situation is not as easy as it could be, but if one assumes a modest economic recovery, one sees slightly higher interest rates, rather strong consumer demand as well as a resumption of international trade, and important shifts in the production environment both domestically as internationally. What are our contextual expectations?

Equities stand once again to outperform bonds and money markets. The outperformance might not be as significant as it has been recently, but in any case, relatively promising. Sectoral selection will matter in terms of outperformance.
Investment in fixed income securities ought to remain selective depending on the size and duration of interest rates moving higher.
Currency adjustments must be factored in, in the international diversification approach.
An unknown, which is not considered here concerns the conflict concerning the Ukraine. Depending of the specific whereabouts it could have devastating effects on the world economy and thus also on the financial markets.

Comments are welcome.

20. January 202220. January 2022

Outlook 2022

EMR January 2022

Dear Reader

Wishing you and those you love a HAPPY NEW YEAR 2022

LET US START WITH A PUZZLE: What do the two rather tricky charts below show? Without specific information one cannot interpret the two-inverse developments. In a sense they stand for the situation we are currently facing, while writing about the outlook for the year just started.

Due to long-term data availability, as well as driven by the soaring fortunes of the US-tech giant companies dominating the stock markets, let us concentrate our attention to the US developments. Among the 100 most valuable stock market companies in the world, there are 64 from the USA alone, three more than in the previous year, according to a study by the consulting firm EY. According to the study, there are no European companies in the top ten and only two that are not based in the USA: Saudi Aramco (fourth) and the Taiwanese chip manufacturer TSMC (tenth). Apple, Microsoft and Alphabet are at the top of the list.

What are the expectations for the new year you may ask? Well, let me affirm that in my long career as an analyst, econometric model builder and user and also as common citizen, I have never been faced with such a confusing environment. In order to be set in the position to draw possible or expected conclusions, I will follow the logic of real GDP as commonly portrayed by the equation:

Y = C + I + G + (X – M)

Where:

Y stand for real GDP, C for Personal consumption expenditure, I for Gross private domestic investment, incl. Change in private inventories, G for Government consumption expenditures, and X – M for Net exports of goods and services.

There is no doubt to our mind that all the quoted contents of the equation will be impacted not solely by the Covid-19 pandemic. The principal assumption we make is that all variables stand either as a mover of supply and/or of demand. Three specific arguments are frequently reported in the media. The first and foremost made argument refers to the overall economy, which is expected to lose steam, while secondly prices and interest rates are assumed to increase, i.e. to be pushed up by Central Banks activities. However, the debt trap could force central banks to keep interest rates low in the medium to long term, which could lead to a devaluation of purchasing power that can hardly be offset by bond investments. The third argument relies on the measures to defeat the Covid-19 pandemic. Our contextual assessment is a bit different. We see that the pandemic has reduced and continues to contain the flow of vital productive inputs from low-cost producers to the industrialized world. In this context it must be assumed that the return to normalcy will take longer time than widely foretold. In order to significantly increase domestic production, the industrialize nations require significant increase of manufacturing of intermediate tech-instruments. The primary reason is seen in the “demanding” advancement of non-democratic nations as a price setter. Thus, the focus on the engine of economic activity, and thus of income and employment, ought to be set on “Gross private domestic investments”. The world has become smaller while concentrated on a restricted number of suppliers. Such a development implies a complete change in economic policy both concerning Government spending as well as Gross private domestic investment. For the time being the widespread political view is still focused on redistribution of income instead of increasing production.

Taking current available forecasts of increasing inflation and of interest rates as a starting point, let us now examine the charts of the DJIA by ranges of Inflation and of US 10y Government bond yields and inflation. Telling indeed is the historic comparison of the developments of the DJIA when inflation rises over 2-3% resp. 4-5%. The chart points to an increase of the DJIA of around the long-term average (1872 to 2021) of 5.8%! The chart on the long-run tendencies of 10Y Govt bond yields by ranges of inflation sums, over the period 1792 to 2021 to a rather astonishing similar average of 4.95%, while long-term interest rates rise significantly, both when the rate of inflation is 2-3% (average of 4.69%), topping the increase in the 4-5% inflation range (average of 6.31%).

What do the two charts imply in the current setting? The foremost important assumption refers to the movers of economic activity, i.e. real GDP. The two most tricky assumptions concern the adjustment process of “Gross private domestic investment, incl. change in private inventories” and net Exports.

Gross private domestic investment ought to grow substantially in line with the significant governmental reliquification. Enterprises have learned that international trade disruptions (not just due to Covid-19) but, more importantly, by foreign governmental difficulties, require a readjustment of domestic supply of intermediate technical goods and services. The scarcity of electronic components and the lengthening of delivery times are seen as dangerous growth-limiting arguments; very difficult to be quantified with sizable precision. Nevertheless, the contextual developments ought to yield support to the equity market and local employment.

On the other hand, consumer spending is expected, at least short-term, to be contained as governmental financing is scaled down. Consequently, we assume that real GDP is not expected to rise significantly over the next few quarters. Net export, on the other hand, are expected to support real GDP activity mostly via a systematic reduction of imports of intermediate tech-supplies.

The toxic mix of increasing inflation, consistently due to rising energy costs in conjunction with bottlenecks in the global distribution system and the expected shift in industrial production, will continue to determine the growth differential and trend from country to country.

CONCLUSION FOR THE INVESTMENT POLICY

We continue to focus on equities from both the technology and value sectors. Our relatively positive stance is supported by the following arguments: First, we do not expect central banks to raise interest rates sharply, as there is a widespread expectation that the recent spurts of inflation will subside with the recovery in international trade anticipated for the coming quarters. With a slowdown in pandemic cases, imports of selected technology goods should recover from the devastating effects of the Covid-19 measures. Employment growth is also expected to recover, although short- to medium-term expectations are modest, compared with past economic developments. Consequently, business fixed investment should be the engine of economic activity. Contrary to our assumption, available forecasts continue to assume that interest rates will rise significantly, which would limit the attractiveness of fixed-income securities. The future will show who was right and why.

The toxic mix of increasing inflation consistently due to rising energy costs, together with persisting bottlenecks in the global distribution system and the ensuing shifts in industrial production, will continue to impact the growth forecasts from country to country.

In addition, active managers should also keep an eye on currency fluctuations, even though we do not expect a dramatic change in the CHF/USD exchange rate at this point in time, as foretold by the chart below.

Comments are welcome.

20. December 202121. December 2021

Review 2021

EMR December 2021

Dear Reader

In this EMR, we take a look back at our forecasts and assumptions for 2021, and find that our preference for equities has been rewarded by an acceptable, differential rate of earnings growth. Taking the respective themes into account, we come to the following conclusions:

The focus has been on Volatility, Virus and Vaccine and respective determinism on the asset allocation.
Once again, we found that nothing is more deterministic than cyclical comparisons.
We examined the repercussions on economic activity, inflation and interest rates.
We clearly pointed out the various types of distortions, and
We found that great upheavals create major opportunities.

ASSESSMENT 1: Yearly outperformance.

The following charts and table, based on the daily closing prices of selected stock indices, show the respective annual changes. It can clearly be seen that the stock indices performed better in 2021 than in the three previous years. The disparities can be summarized as follows:

One, there are sizeable differences between the indexes on a country-by-country basis, as well as between the technological content of the US indexes. The outperformance (as we repeatedly commented in various EMR`s) of the indexes heavy-weighted in technology is astonishing indeed. These developments underline the importance of sectorial selection.

Two, “simili modo”, we might argue that 10-year bond yields confirm our assessments to underweight this investment category and to take currency expectations resp. corrections seriously into consideration. Looking back to the singly 2021 EMR´s we find confirmation of our positive assessment of equities vs. bonds and money market investments. The returns differences, excluding taxes and other costs, clearly confirm the recent attractiveness of equities over bonds, as shown in the following table and charts. The longer-term analysis of 10-year bond yields (see chart below) is telling indeed.

What does the chart tell us? Let`s remember that pessimism was widespread in 2021. Yet, we did not adopt the widespread negative assessment. The average performance of 2021 over 2020 has been significantly better than in the three years before. In the following we summarize our reporting as in the various EMR´s of 2021.

ASSESSMENT 2: The three V`s: Volatility, Virus and Vaccine.

At no time we took daily Volatility, the Virus and/or the Vaccine as trend setting. In view of the outperformance of equities versus fixed-income securities and money market instruments, we allow ourselves to solely assess the fate of the Swiss and U.S. equity markets. The following charts show the respective average monthly rates of change, revealing quite different patterns. Surprisingly for some, we did not find confirmation of the well-known statement: “The trend is your friend”. The charts simply speak of the difficulties while defining the own expectations. We deem ourselves lucky, in focusing on the right data, as implicitly visible in the differential developments of the monthly vs. the yearly rates of change.

ASSESSMENT 3: Deterministic is the cyclical comparison.

Usually, the daily closing values (of the stock indices) are shown. From the respective growth rates, one can in most cases deduce in which market one should be over- or under-invested. The developments of the SMI and the DJIA shown in the charts above are, as already mentioned, quite difficult to interpret. Nevertheless, one can deduce where the short-term trend might be headed as compared to the longer-term trend. What is easier to estimate is the time it might take for the index to return to its “normal” growth path.

ASSESSMENT 4: repercussions on economic activity, inflation and interest rates.

We all know, that this is an exercise that can go either way, i.e., as a driver of the economy or as an impediment. Depending on the context, there are a variety of possible interpretations. In other words: forecasting the future is a difficult exercise. It requires the most appropriate selection of the appropriate factors shaping the future environment. Even the knowledge of previous comparative periods is not always suitable as desired. The environment may appear to be quite similar, although important determinants remain indeterminable. Currently, these difficulties are evident in expectations, depending on the hoped-for end of the Covid 19 pandemic. Moreover, it can be argued that technological innovation, can and should provide much needed clarity. At present, many analysts remain rather skeptical about these deterministic factors of the fate of consumer attitudes. They hardly simplify entrepreneurial decision making regarding the much-needed adjustment of production lines.

ASSESSMENT 5: distortions.

TYPES OF DISTORTIONS: In the July EMR we focused on the marginal rate of transformation in production (TTP) as well as on marginal rate of substitution in consumption (TTC) and also, on the foreign terms of trade (FTT). We argued that these three factors were, are and will continue to be deterministic for some time. The transformation of production lines influences and distorts consumption goods to be exchanged in the world markets. Hardly a day goes by without a comment on one of these factors. Just think of the influence of the various Covid regulations as determinant of production and consumption. Specific repercussions are then visible in due time in the quarterly statistics of economic activity (GDP and components). At this juncture any quantification looks rather problematic and uncertain. As an expedient many analysts focus on prices, i.e. inflation as a promising determinant of future developments.

ASSESSMENT 6: great upheavals create major opportunities.

As known, in the past great upheavals did create major opportunities. As an example, we point to the growth revival following the great recession of 2007 – 2009, for Switzerland and the USA. This, in our opinion, could definitely be something to look into in the 2022 EMR`s, given vivid hopes of a U-Turn in the Pandemic, which in due time could lead to a sizeable economic recovery on a worldwide scale. We are aware of the fact that currently it is rather difficult to be optimistic, given the attitude of Central Banks, particularly of the US Federal Reserve, to start reducing the overall liquidity in order to contain feared inflation pressures. Fears of inflation are, a function of “politically induced” strong consumer`s support, and also to prevent further increases in the rate of inflation. According to Chairman Powell, the FED is no longer primarily fixated on encouraging a further recovery in the long-running labor market, but primarily on getting the potential for inflation under control. The risks of price increases have also to do with the strong demand for goods and services and also with the hope of getting the supply bottlenecks under control.

MERRY CHRISTMAS and a HAPPY NEW YEAR 2022.

Comments are welcome.

26. November 202126. November 2021

Rythm of History

EMR November 2021

Main Lines of Change

Dear Reader

Studying the literature on economic change, while focusing on the post-World War I period, is very instructive, especially as a guide to the current turbulent environment. The available forecasts reveal major economic and social imbalances. We consider them quite significant, especially in the context of current uncertain developments.

Extrapolating the graph of the U.S. Consumer Price Index to September 2021 would result in a near doubling; the index would then rise to over 800! This further increase goes hand in hand with the various shocks. The sharp increases in the inflation rate began, as shown in the graph, in the late 1960s. What are the reasons for these developments?

Deterministic Facts

The above chart portrays two very disparate developments. On the one hand we find a rather volatile but smooth increase from 1896 to the late 1960, and on the other hand a dramatic, almost linear increase into 1996. In this EMR we will concentrate our attention to the second phase, i.e., the period since 1967.

Before analyzing the developments of real GDP, we would like to show the development of the stock indices since 1970. The corresponding chart (below) shows substantial fluctuations in the annual averages. The chart is hardly exactly quantifiable, is it?

In our analysis of the economic performance, we focus primarily on the development of real GDP in Switzerland and the United States. At this point, we wonder what is the connection between the fluctuations of real GDP and the stock indices, as shown in the above graph.

The available real GDP data for the five industrialized countries clearly show that there has never been an equivalent correction since the early 1980s, with the exception of the period from 2008 to early 2010! The chart shows that the Swiss economy reacted with a “substantial” lag to the downward corrections of real GDP in the U.S., Germany and the U.K. Developments in Japan are much more pronounced for the period 2002-2010.

The diagram above indicates two very different developments. On the one hand, there was a fluctuating but steady increase from 1896 to the end of 1960, on the other hand, a dramatic, almost linear increase until 2021.

One of the main reasons for this can be derived from productivity developments. For the sake of simplicity, we again limit our analysis to productivity developments in the USA. We assume that they are also valid for Switzerland and other industrialized countries.

The level and quarterly rate of output per hour, as published by the U.S. Bureau of Economic Analysis, are much less volatile than real GDP, this measured by quarterly rates of change. Why this is so is the real question. Could it be that productivity is much more responsive to inflation – and especially to inflation expectations – than to economic activity? Long-term analysis, however, seems to suggest that productivity responds much more quickly to overall economic activity than to inflation! In recent years, productivity has adjusted strongly to sectoral changes. These developments were not so readily apparent at the macroeconomic level (real GDP). This is certainly due to the fact that companies have adjusted their production lines – and will continue to do so – much faster than reflected in macroeconomic data. New production lines require different inputs, both on a material and human basis. This has happened – and continues to happen – at both the firm and sectoral levels. In case you have a different opinion, let me draw your attention to recent developments on the stock price front. The differences between the various indices shown and the Nasdaq 100 Index speak volumes, don’t they?

The chart shows dramatic shifts between the two time periods, as well as between the various indexes and the technology-focused Nasdaq. Could it be that the Covid-19 pandemic would trigger a similar shift both between the different indices and countries?

We all know that certain sectors disappear over time while others emerge. Just think of the changes in the automotive industry in the past compared to the expectations of chip-controlled automotive production of today and especially tomorrow.

How to Benefit From Productivity Changes

Can you benefit from the expected/feared productivity changes? A somewhat difficult way to answer this very deterministic question implies that one should prefer stocks that have shown the best productivity performance in the past and have responded coherently to significant productivity changes, i.e. stocks of companies that recognize and quickly react to signs of a productivity turnaround?

If this approach does not satisfy everyone, there is another way, which is to reduce exposure to companies and industries with the worst productivity histories, either in the short term or, more importantly, in the long term. Our contextual argument is to take seriously the fact that turnarounds are sometimes quite dramatic, especially for companies or industries with high debt burdens. A dramatic productivity turnaround, such as the one we are currently experiencing, is often accompanied by dilutive financing and a high debt burden. In such a case, the substantive argument is “buy the problem solvers” or, to paraphrase a well-known slogan, “invest in the doctors, not the patients.”

Conclusions for Investors

Our conclusions should be seen as a specific consequence of an extraordinary shift toward technological innovation and away from the traditional “output per hour worked.” We should take the impact of new technologies ever more seriously.

This also means that even if inflation fluctuates by 2% (which is considered historically low), equities would continue to perform better than fixed-income securities and money market instruments.

As a result, the USD is expected to rise against the EUR, the YEN and the GBP. The fact that the CHF, EUR and JPY have recently fluctuated in quite narrow ranges against the USD must be taken into account, also because the dark clouds in the currency sky do not bode well.

Any suggestion is highly welcome.

26. October 202126. October 2021

Required Homework

EMR October 2021

Great Upheavals Create Major Investment Opportunities

Dear Reader

The investment outlook is rather bleak, driven mostly – but not solely – by lagging productivity, fears of rising inflation, and high and rising governmental indebtedness, as well “unwarranted” fears of an impending equity market correction.

What does the chart on long-term indexed equity indices suggest?

Poorest performance = NIKKEI
Mediocre performance = UKX and CAC
and
Best performance = SPI, DAX & DJIA.
Does the chart imply something about productivity and/or on something else?

Why the Focus on Productivity?

Over the years, we have learned that the best-performing companies (represented here by the respective stock index) in some sense can be quantified by the interaction of productivity, inflation growth and currency performance. Recently, however, productivity gains have been increasingly hampered by governments’ deficit spending. It is a fact that in the past those sectors of the economy that have been able to improve their productivity while providing “new” equipment (through innovation and technological progress) have experienced a significant boom and have prospered significantly. What role have currencies played is an interesting question. In this sense, we are not surprised that the SPI, the DJIA and the DAX perform so differently compared to the NIKKEI, the UKX and the CAC index. We do assume that equity markets are not an inflation hedging instrument but a play-ground for currency specialists! It can be deduced from the chart on real GDP that the problems dominating the current technological progress point to a difficult identification exercise of the companies and industries with the highest potential capabilities to solve the productivity problems, inflation expectations and currency reactions. We thus continue to focus on the innovative spirit of each company and/or sector of the economy. The focus must thus be on the power to innovate, to counterbalance the power to tax = the power to destroy.

The available real GDP data for the five industrialized nations clearly show us that there has never been a similar correction since the early 1980s, with the exception of the period from 2008 to early 2010!

The chart shows that the Swiss economic activity reacted with a “substantial” lag to the downward revisions of real GDP in the USA, Germany and the UK. The development in Japan is much more pronounced for the recession period 2007-2010.

The level and quarterly rate of output per hour, as published by the U.S. Bureau of Economic Analysis, are much less volatile than real GDP, relative to quarterly rates of change. Why this is so is the real question. Could it be that short-term productivity is much more sensitive to inflation – and, in particular, inflation expectations – than to general economic activity? Long-term analysis suggests that productivity responds much more quickly to general activity. In recent years, there has been a strong adjustment of productivity to the sectoral environment, which has not always been immediately visible in the macroeconomic data (real GDP). This is certainly due to the fact that companies have had – and will continue to have – new products and appropriate capabilities to increase productivity, both at the sectoral and company level. We all know that certain sectors fade over time while others emerge – just think of the changes in the automotive industry in the past, compared to the expectations of chip-driven automotive production.

How to Benefit From Productivity Changes

We take the liberty of asking the reader how he/she can benefit from the expected/feared productivity changes?

A rather arrogant way to start answering this very tricky question implies that one should preferentially invest in stocks that have historically shown the best productivity gains and a coherent response to significant productivity changes, i.e. stocks of companies that recognize and quickly respond to signs of a productivity turnaround?

If this approach may seem too difficult, there is another way, which is to reduce exposure to companies and industries with the worst productivity histories, either in the short term or, more importantly, in the long term. Our contextual argument is to take seriously the fact that turnarounds are sometimes quite dramatic, especially for companies or industry sectors with high debt burdens. A dramatic productivity turnaround, such as the one we are currently experiencing, is often accompanied by dilutive financing and a high debt burden. In such a case, the contextual argument is: “Buy the problem solvers” or with the corresponding slogans: “Invest in the doctors, not in the patients”.

Conclusions for Investors

Our conclusions should be seen as a specific consequence of an extraordinary shift toward technological innovation and away from the traditional “output per hour worked”. We should take the impact of new technology ever more seriously.

This also means that even if inflation were to fluctuate by 2% (which is historically low), equities would continue to perform better than fixed-income securities and money market instruments.

Any suggestion is highly welcome.

17. September 202126. November 2021

Inflation

EMR September 2021

Causes, Effects and History

A look at the following chart of the Dow Jones Industrial Average (DJIA) and the Consumer Price Index (CPI, referred to here as Pdot) raises some questions, doesn’t it?

The chart says that volatility is significantly higher for the DJIA than for INFLATION. Are there reasons for the disparities?

Why the focus on inflation?

The latest data point to a pickup in inflation. For example, inflation as measured by the Swiss national consumer price index stood at 0.7% in July 2021, while it rose by an average of 2% in the Euro Area and by 5.4% in the U.S.A., representing at this time the highest level in 13 years. In this EMR issue, we are interested in the causes of the feared/expected rise in the inflation rate. In the past, developments comparable to those of the current economic policy developments were known as “the power to tax is the power to destroy.” Surely, a valid reason to inquire into the whereabouts of inflation.

Known causes of inflation

History tells us that there are several reasons why prices rise and fall, thus implying that there are many causes of inflation. At present ii is widely assumed that prices are rising as a result of a strongly expanding money supply. In other words, it is stated that there is too much money chasing too few goods and services. In the economic literature, this approach is referred to as “Demand pull inflation”.

Demand pull inflation occurs also when supply falls while demand remains constant. A well-known example is the rise in OPEC prices in the late 1960s, early 1970s. The historic development on Crude oil price and CPI inflation are portrayed in the following chart.

The graph points to a much higher VOLATILITY in the crude oil price than in the consumer price index. The disparate developments hardly make forecasting any easier, do they?

If labor costs are arbitrarily increased, the affected producer will have to pay the price and/or suffer profit losses or even go out of business. This is certainly the case if the entrepreneur cannot improve productivity or reduce other costs. These are developments known as “Cost push inflation”.

When the government of a country – which issues its own currency – spends more than it takes in, prices will tend to rise. This approach is known as monetary debasement, which most governments have resorted to as a result of the Covid 19 pandemic. In earlier times this political refuge was also known as printing press inflation.

In recent weeks, governments have begun to focus on avoiding tax increases by taxing certain companies (see: Global minimum tax deal in our August 2021 EMR) and telling the public that their government will not raise taxes because they argue that certain companies will bear the cost. Not only economists, but also more and more people know that companies will treat taxes like other costs. If the costs cannot be passed on to consumers or other businesses, corporate profits and thus overall productivity will fall and/or there will even be wage cuts or even job losses. There is also a risk that certain companies will give up because they have difficulty raising capital. This means nothing else than Taxation decreases disposable income.

The chart of the US long-term inflation trends is telling indeed. Volatility has been highest from 1913 to the early 1950’s. The index rose dramatically, without great corrections since end 1960’s. Contextually, the question to be answered is: why the differences? Any suggestion concerning the near future? Does the chart say something about productivity?

The chart portrays the significant disparity of the trend of the CPI Index vs. its monthly rate of change. Striking indeed!

Before assessing the current situation let us examine the developments of interest rates. In the following chart we find a significant correlation between the 3-months rate and the 10-year bond yields.

The chart speaks for itself. It does not look very telling for the near-to-mid-term outlook, doesn’t it?

“Assessment through the looking glass”

Although the focus in this EMR is on inflation, we would argue that the outlook for productivity is the most crucial determinant for overall economic activity, interest rates, inflation and foreign trade. We argue that expanding and contracting credit demand has a much larger impact on short- and long-term interest rates than anything else.

We will therefore try to present a possible outcome in order to be able to define a promising investment strategy. The focus of our consideration is on the “power to tax”, which could end up as the “power to destroy”. In a capitalist environment, companies should not be excessively taxed to discourage the employment level of highly productive units that end up paying the price for policy missteps.

Pervasive socio-economic change

There is no doubt that we are faced with a new set of arguments primarily due to pervasive socio-economic change, a tendency to socialism and the implications of Covid-19. Economies in the developed world are driven in the short term by the multiple responses to the Covid-19 pandemic, while in the medium-to-long term they remain a function of technological advantage. It must be reckoned that the commonly used definition of productivity is output per man hour. Currently it is progressively determined by energy productivity and even more so by capital productivity.

The widespread, politically motivated assumption is that certain business owners should absorb these higher labor costs by cutting profits. However, since management and investors are usually not enthusiastic about this alternative, they will either try to raise prices to compensate for the increased costs or reduce employment, which will contribute to lower income growth. Neither option seems to make much sense at a time of “competitive disruption”, i.e. declining imports from low-wage countries. Nor does switching to cheaper substitutes seem to be a viable alternative. This seems to indicate that the fear of cost-driving inflation exists but is not as sustainable as generally expected. The switch to cheaper substitutes does not seem a feasible alternative either. What this seems to suggest is that fears of cost-push inflation exists but somehow not as sustained as widely feared or even expected.

In addition, based on the considerations outlined above, we believe that the decisive factor is and will remain the return to local production relationships! The struggle between the USA, Europe and China is obvious. Dependence on a producer with a ‘slightly’ different attitude than we are used to do business can no longer be accepted. Currently the outlook is also driven by the impact of Covid-19. It is a fact that labor productivity in the USA increased rapidly during the pandemic compared with the previous decade. However, it is unlikely that this rapid pace will continue. Similar to the Great Recession, the main reasons for the strong productivity growth now are cyclical effects that are likely to dissipate as the economy continues to recover. For example, as the number of workers has fallen, capital per worker has increased, raising “labor productivity” , i.e. including energy productivity and capital productivity. How the pandemic itself will impact productivity remains to be seen.

Our approach to economic growth makes it clear that the extraordinary recent rise in productivity is primarily due to cyclical effects that are unlikely to last and could even reverse. While there is much speculation about how the pandemic itself will affect productivity, it is too early to reliably assess how strong these effects will be in the long run.

The growth accounting shows that the main causes of the recent increase in productivity are cyclical and unlikely to last. In particular, the decline in employment has boosted capital deepening; the post-Great Recession experience suggests that this temporary boost is likely to reverse. Moreover, because the employment decline was more pronounced among workers with less education and experience, the average job quality of those who kept their jobs rose. This effect has already begun to reverse and may reverse further as less skilled workers return to work.

Conclusions for investors

The chart of the selected exchange rates on a monthly rate since 1971 does not yet points to an imminent change. Does the spending spree of the new US Administration tell us something, that we don`t know yet?

Our conclusions, are to be seen as a specific consequence of an extraordinary shift towards technological innovation away from traditional “output per man-hour”.

It also implies that even if inflation would narrowly fluctuate around 2%, historically seen, equities would continue to outperform fixed income securities and money market instruments.

Consequently, the USD is expected to rise vs. EUR, YEN, and GBP.

Keeping in mind that versus the USD, the CHF, the EUR and the JPY have fluctuated withing rather narrow bands, at this juncture we see no impending dangerous clouds in the currency sky.

Any suggestion is highly welcome.