Since we last wrote our report a few important eras ended. As you have probably heard by now, Queen Elizabeth II passed away in early September after 70 years on the throne.
In Switzerland, our world-class tennis player, Roger Federer, retired at age 41. Amongst many other accomplishments, Roger was ranked world No. 1 by the Association of Tennis Professionals for 310 weeks, including a record 237 consecutive weeks, and finished as the year-end No. 1 five times. He was not only an exceptional athlete but was also a beloved ambassador to our country.
Lastly, after more than seven years the era of negative interest rates in Switzerland ended when the Swiss national bank announced on September 22 that they raise interest rates by 0.75% up to 0.5%.
With interest rate hikes around the world, the markets intensified their downward movement after a quick bear market rally over the summer. However, not only interest rates had a huge impact on the markets, the war on Ukraine, the dispute between China and Taiwan as well as the energy crisis had its impact. The latter is the main topic of this report; however before we get into that, let’s start with a general market overview.
Obviously, this year has been challenging for investors. Stock market indices lost more than 20% this year. The Nasdaq 100 is even down over 30%.
After inflation started to pick up last year due to supply chain issues, the war in Ukraine started threatening western stability even more. Long story short, we slid from one crisis into another, and then another. Investors, governments, and central banks seem to have erased the concept of economic cycles from their memory. They desperately try to dispute and fight an economic contraction, which is a normal, sometimes even healthy, short-term development. We are convinced that big economies such as the U.S. and the European Union (EU) are in a recession already despite them trying to change the definition in an effort to make the situation look less dire. Nonetheless, it is important to not let fear take over our decision-making abilities and long-term investment strategy. Times of crisis, no matter how painful they may be, also always offer opportunities.
Europe the good, the bad, and the ugly
In the last decade, the EU made one crucial error. They put everything on one card when it came to their energy supply. On average, almost 40% of the EUs imported natural gas came from Russia. In 2020, the Russian part of Germany’s imported natural gas aggregated to approximately 65%. This year, with Russia’s attack on Ukraine and the shutdown of Nord Stream 1, there is only little natural gas coming from Russia. While members of the EU are able to do damage control in the short term, there is no question that they need a better solution in the long term. It looks likely that the EU will make it through this winter without big disruptions and even find a solution to refill their storage during summer. However, this will come with a big price tag. This becomes even clearer, seeing German chancellor Olaf Scholz flying to the Arabic Emirates to discuss the delivery of liquefied gas. However, Germany is not the only one shopping for energy. Joe Biden, Emmanuel Macron, and Boris Johnson already had the pleasure of meeting with Arabic royals in the previous months.
Nevertheless, the total storage level in Germany as of September 26 is 91.02%. The average level from previous years is 86.6%. In case there will be another mild winter, the chance of getting through it without any energy shortages becomes even more likely. Taking this into consideration and the fact that countries like the Netherlands or Norway can deliver natural gas too, there is a good chance that Germany and the EU do not end up running out of power.
Having said that, companies became active too, and put into place contingency plans. These preparation costs will not be borne by the companies but rather by the consumers, which will push inflation higher. This will cause the European central bank to keep interest rates rising, which will put additional pressure on the Euro and the credit ratings of European government bonds. Consequently, we continue to be underweighted in our investment in the Eurozone.
How is Switzerland holding up?
As we keep saying, Switzerland is an island of independence in Europe, not being part of the EU or NATO. This means that while we do have some dependency on our neighbors we are much less dependent as one might assume. Switzerland has an energy mix where we are able to cover a significant portion through domestic production. Switzerland with its mountains, lakes, and rivers is able to produce a reasonable part of its consumption through hydroelectric power and other alternative sources. We export electricity if we produce more than we need but import electricity if we do not have enough capacity. According to the Swiss Federal Office of Energy, about 55% of the electricity is consumed by manufacturing and the service industry. Since these companies are well aware of the situation, they started to prepare by putting into place contingency plans as well.
As seen in the graphic, Switzerland needs fossil fuels too, which we do not have domestically. While Switzerland used to consume Russian gas in the past, it is encouraging to see that only 10.9% of the energy consumption is through gas. While we will be able to lower this dependency even further, next to Russia (43%), we import natural gas from Norway (22%), the EU (19%), and Algeria (3%).
The most important reason why we are convinced that Switzerland will get through this energy crisis better than most other western countries is the close relationship between the government officials and the private industry. Due to the “militia” political system, where politicians usually work in the private industry and administrate their political duties part-time makes sure that the government is aware of the economy’s challenges and can react properly. Furthermore, this does not mean that companies rely totally on the government's efforts to solve the energy crisis or the other way around but it allows each party to navigate his or her efforts towards an overall solution.
China and the World's Chip Manufacturer Taiwan
While Europe is dealing with a scarcity of energy, China is potentially facing its own housing bubble. The Chinese government seems to be planning to find a way to prevent a real estate meltdown by throwing billions of dollars at property markets. Whether this will work depends on their credibility. Direct government funding of the distressed real estate market could increase the demand for commodities, which would benefit commodity companies and countries that are rich in commodities like Australia or Canada. Furthermore, China still follows an unsustainable zero-Covid policy. This prolongs the problem of supply chain issues.
The biggest worry coming out of China however is still the tension with Taiwan. Since the visit of US House Speaker Nancy Pelosi, the tensions between the two governments have intensified. President Joe Biden was very clear in communicating several times the U.S. government’s support for Taiwan in the event of an “unprecedented attack” by China. While we are reluctant on whether Xi Jinping would decide on an attack in the near future, the Chinese military’s drills around Taiwan bear the risk of an erroneous attack, which would result in an escalation. China acts as an important supplier of many different goods and components and Taiwan bears more than 90% of the manufacturing capacity for the world’s most advanced semiconductors. Therefore, keeping an eye on China and Taiwan is important to us when building a long-term portfolio.
Speaking of Escalation… Russia’s still at war
The most recent decision of a partial mobilization in Russia intensified our feeling that the war is going to last a bit longer. On the other side, seeing the lack of support from Xi Jinping as well as the Turkish president, and Indian Prime Minister might be a turning point. Nevertheless, President Putin stated that he would not shy away from “using all the means at their disposal”, adding, “This is not a bluff.” This includes his arsenal of nuclear weapons. In the case of the use of a nuclear weapon, the whole war would take on a totally different dimension. This would put more pressure on the world’s economy and lead to an immediate selloff in the markets.
Bonds and Currencies
Due to rising interest rates bonds crashed similarly to equities this year. The main question to answer is what the expectations are regarding inflation. If one believes that inflation will come down within the next 12 – 18 months, a bond investment with a yield to maturity of 3% or more might make sense after all. Taking into consideration the currently unprecedented strong USD, there might be opportunities showing up again. If the bond is denominated in another currency that will appreciate against the USD once things clear up, it might be a good time to be brave and make an investment. However, higher interest rates do also mean higher costs for companies to take on new debt or refinance their existing debt.
We believe that it is worth having a look at bonds from companies that offer a stable balance sheet and cash flow. Additionally, currencies like the Australian dollar, the Canadian dollar, and in particular, the Swiss franc is preferred. Additionally, some emerging market currencies such as the Mexican peso also show some potential from our perspective. Having a look at emerging market currencies, one might be surprised by how well many of them hold up against the USD.
What on Earth is going on with Gold?
Looking at the gold price these days is frustrating. The fact that gold is “crashing” is highly suspicious to us. Assessing the current geopolitical environment and keeping in mind that real interest rates are still negative, there is no valid reason why gold would be so low. However, whether we like it or not, this is the case. The question lies in what to expect out of the gold price in the future. While central banks most probably will maintain their hawkish course, chances are that gold will stay at the current levels for longer. Once the recession in the U.S. and the E.U. becomes unbearable and central banks deviate from their restrictive monetary policy, we expect gold and silver to get back towards USD 2,000 an ounce and USD 25 an ounce, respectively. In the meantime, there are scenarios that would spur precious metals prices leaving central banks out. As we could observe back in February when Russia invaded Ukraine, gold is still a hedge in geopolitical escalating environments. Taking into consideration the current geopolitical environment that is the main reason why we hold on to precious metals, gold in particular.
The thing with markets, in general, is that investors tend to develop herd behavior. This means that once investors start to lose confidence in the markets, they sell everything including well-functioning companies. We do see that currently, where the vast majority of equities have lost a considerable amount this year. In previous newsletters, we already mentioned that this will happen and that it will lead to opportunities. The good thing is, that quality companies, which have excessively grown in value during the last two years, have come down to more reasonable levels. In the meantime, these companies trade at fair or even attractive levels. This represents an opportunity to take a stack. Doing so needs some courage since, taking the investment in a time of fear bears the risk that the share price falls even lower after the purchase. However, the perspective should be to use an environment of fear and panic to position the portfolio in a way, which will benefit you once these bumpy times are over. When making the assessment to invest, we look at the different economies and evaluate how they are positioned and how capable they are to weather the storm. We believe that in Europe, Switzerland is the place to be. Otherwise, we believe that countries far away from any hotspots might use the current environment to position themselves in a way that will benefit them in the long term since they do not have to deal with the challenges like the European Union and the United States who are absorbed with high inflation and the war in Ukraine. Let me end this newsletter with the following quote made by Carlos Slim Helu:
Courage taught me no matter how bad a crisis gets... any sound investment will eventually pay off.