PARTNERS ' VIEW SEPTMEBER 2016

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1 PARTNERS ' VIEW SEPTMEBER 2016 CURRENCIES AND INTEREST RATES Bond investments at a loss Turkey - a new high-risk country. Swiss Franc bond investments: negative for years to come. Stimuli after Brexit. After downgrading Turkey s sovereign debt to BB (junk status), the rating agency, Standard & Poor s, followed with classifying the country as high-risk. The Turkish president has labelled the move as politically motivated: With all due respect, clearly, this decision has to do with political events in Turkey. COSTLY SWITZERLAND GOVERNMENT BONDS In the meantime, we have become well aware that the interest rates are at their historic lows. Especially brutal is this fact for investors holding bonds from prior issue that are facing a top-up. For that matter Germany has increased its issue of the February year bond with an interest rate of 2.5 percent, at a price of percent with an additional billion. The 575 million top-up for an annual rate of 25 million euros implies a return on the remaining 28 years of 0.45 percent. Even more extreme is the case of the Swiss government bonds. In 1998 the Swiss Confederation issued a 50-year bond at 4 percent interest, which meanwhile is being quoted at 236 percent. Should someone invest today 236'000 Swiss francs in this bond, he would receive 100,000 Swiss francs of nominal worth at maturity in In the meantime the 128,000 francs interest paid out constitute significantly less than the bond price loss of CHF 136'000. In other words, the thirty two years to maturity would bring a negative return. On top of that, one may ask, what will the 100,000 francs buy in the year Quite a losing business, isn t it? WEAK POUND Bank of England has responded to the negative consequences of Brexit with a variety of stimuli to counter the impending economic slowdown. For one, the Bank has cut the interest rates by half from the current 0.5 percent to 0.25 percent - the lowest level for over 300 years! For another, it has been expanding directly the money supply through bond purchases in the worth of nearly 60 billion. The reaction of the markets has been following the usual pattern: The bond and equity markets have been friendly, while the British pound has crashed again (see chart). Thus, the Bank of England has been reinforcing the one measure that the European Central Bank, ECB, has also chosen as its blue-print solution. The implementation shows, however, that the ECB has to deal with problems of grander magnitude. The corporate bonds purchased by ECB have a negative return and this already at the time of buying. In other words, the central bank actually pays an interest to invest in bonds. - Written by Ralph Weidenmann 1

2 >> Who says A does not have to say B. He can also recognize that A was wrong. Berthold Brecht 2

3 POLITICS Growing divergence in Europe Third election round in Spain. Angela Merkel under pressure over Turkey. Impunity for deficit sinners. As we have already foretold in the June issue, Spain is most likely to face yet the third voting round. Neither the December 2015 general elections, nor the second round in June 2016 brought about an agreement between political parties on forming a government. CONSEQUENTIAL The failed coup attempt in Turkey has had rather drastic consequences. Domestically President Erdogan goes about cleansing relentlessly with a tough hand, while Turkeys disregard of human rights has gained a new momentum with the declaration of the state of emergency; the demands for reintroducing the death penalty being only one aspect of how the alleged coupplotters will be dealt with in the future. On the foreign policy agenda the controversial EU-Turkish refugee agreement struck in March 2016 warrants our mention. Visa-free travel for all Turks seems, under the circumstances, an illusion. In spite of the EU vital interest in a solution to the Syrian refugee issue, for Angela Merkel it is time to reconsider her prior position, particularly in light of ever stronger opposition faced domestically - notably from the Red-Red-Green coalition. Even though the recent terrorist attacks in Germany (Ansbach, Würzburg) may have nothing to do with Turkey, the very fact that the assassins had Islamist background would make the future unrestricted entry for Turks difficult to justify to the frightened German population. Perhaps also Merkel s welcome-culture towards the Syrian refugees has failed because of a handful of isolated cases. Should the end justify the means and the objective at hand be to combat the terrorist threat, the means chosen may well imply a substantially more restrictive refugee policy. However difficult to comprehend on humanitarian grounds they may be, politically there will be hardly another way. Politicians main objective is to be re-elected and, to this end, their primarily concern is the mood of their constituency, and after the attacks that mood has been as bad as ever. UNPUNISHED Formal disciplinary procedures initiated by the Eurofinance ministers against Portugal and Spain for their years-long violation of the Maastricht debt limits will be swept under the carpet with impunity. However comprehensible the motives may seem - both countries have record-high unemployment - this decision is tantamount to a surrender of the compliance with the convergence criteria, and it was made in spite of the seemingly clear concept, that in a community of states with a single currency it is imperative that certain rules must be strictly adhered to. 3

4 STRESSFUL The stress test of the European banks brought rather sobering results. The report published end of July shows how much capital is left to cushion banks against losses in an adverse economic scenario. That the oldest bank in the world, Monte dei Paschi di Sienna will be at the bottom of the list was well known in advance. In its case for the first time a state support solution was successfully evaded. Such support anyway would have been possible only with the involvement of private creditors (bond holders) politically in Italy a solution unlikely to be executed. The so-called bail-in (i.e. the waiver by private investors) was first tested in practice in Cyprus, and to this day is considered a Pandora's Box. If debt reduction of the beleaguered banks with the help of the private sector were to be made socially acceptable, sooner or later, the financially weak debtor countries (Spain, Portugal, Italy, etc.) would follow suit dipping into this honey pot. - Written by Ralph Weidenmann Ralph Weidenmann, Partner ralph.weidenmann@swisspartners.com 4

5 FINANCIAL MARKETS AND BUSINESS The day after tomorrow Despite the gnashing and the wailing after the surprise UK referendum result the world continues to turn as we predicted. Our decision to decisively increase equity exposure in the eye of the storm seems to have been well timed, as markets posted a spectacular recovery, while the doomsayers were once again proven wrong. European markets made most headway but still have a large catching up to do compared to their US peers. At this point in time European markets as measured by the Eurostoxx 50 index are still down -4.4% for the year, whilst US equities as measured by the S&P500 are up 8% over the same period. 5

6 The gap of underperformance by European equities versus their US counterparts is closing; nevertheless, we expect much more progress before year s end. With European equities trading on a price -earnings ratio of 14x this year s earnings versus 18.5x for US equities, the valuation gap just looks too wide. A compelling argument on valuation grounds can also be made when looking at the relevant risk free rate (the 10-year sovereign bonds yield). European equities yield 4% versus the 10-year German Bund yielding -0.04%, whilst US equities yield 2.11% versus the 10-year Treasuries yielding 1.58%. VERY HAPPY TO BE LONELY We realise that we are in a very small minority against the consensus by being overweight in European versus the US equities, however, we see signs of encouragement. European consumer confidence and spending has held up well post BREXIT and there are also signs of the UK car market resiliency a market important for the EU carmakers. 6

7 Eurozone growth has also held up well despite the many dire post BREXIT predictions. Furthermore, with the recent discouraging GDP figures from the USA the GDP growth differential has narrowed substantially. Looking at the latest Bank of America Merrill Lynch surveys it seems that recent cash holdings by investors have been reduced substantially (they were at record highs post BREXIT) with a strong bias towards an overweight in US equities. These are the same investors who escaped into cash in the February market drawdown but were bullish after the recovery. - Written by Peter Ahluwalia Peter Ahluwalia, Partner Chief Investment Officer peter.ahluwalia@swisspartners.com 7

8 NEWS THE ART OF PARTNERSHIP Invitation to the public concert in the Hall of Zurich s Main Station As a thank-you to the citizens of Zurich, who, with a great majority, have voted for the renovation of the Tonhalle the Zurich s concert hall the Tonhalle- Orchester Zürich will give a public concert on September 3, 2016, from 1:00 pm untill 2:30 pm in the Hall of the Main Station. Prominent personalities will be conducting parts of the piece of music. We are very pleased to support the Tonhalle-Orchester Zürich on this event and cordially invite you to take part in this unique experience. 8