The Swiss View: Cash is King
While this year had a good start so far, with a hick-up in February, the signs are still contradictory. Central banks moved on with their contractionary monetary policy while governments pushed further for their expansionary fiscal policies. Simultaneously, investors seem to have lost their faith in the central banks, expecting especially the Fed to lower interest rates later this year. The focus lies fully on headline inflation which is significantly below its peak from June 2022 for the U.S. and October 2022 for the European Union, respectively. However, it is surprising how little focus is given to core inflation, which does not show any easing. Especially in the U.S., core inflation has moved between 5.4% and 6.6% since December 2021, while in the European Union, it is still accelerating.
As you can see in the graph, Switzerland’s headline inflation and core inflation overshoot the targeted inflation level of a maximum of two percent but by very little. Therefore, inflation is less of an issue than in other developed countries, which we can also see in our strong currency.
Nevertheless, investors have come to the conclusion that they have been spoiled when it comes to economic growth in the last decade or so. I.e., it seems to be unlikely that we will experience the same growth rate in the future as in the past. Accordingly, a recession sooner or later will hit the economy, which is one of the reasons, some investors and economists believe that central banks are going to lower interest rates again.
There is one trigger that could at least lead the U.S. into a recession soon. While the U.S. government is not particularly known for its financial discipline, another adjustment of the current debt ceiling has to be conducted. The fact that President Joe Biden and Republican representative Kevin McCarthy have not reached a solution yet, adds nervousness to the markets. We expect a last-minute arrangement. Due to the existing stress in the system, no one wants to be responsible for causing a recession that might be more hurtful than necessary. Therefore, an outcome similar to 2011 is not our base scenario.
Stay invested to face a slowdown in the economic growth
Expecting a slowdown in economic growth will most likely lead to a reduction in corporate gains. So far, companies have been able to pass on price increases in raw materials to their clients. Additionally, managers try to keep their profit margins by laying off employees and transforming their production to more efficiency.
Not everyone will be successful in this environment and will be able to keep the profit margin at a high level. However, there will be firms that find ways to become more price efficient or increase their product or service’s quality to a level that increases the consumers' willingness to pay higher prices. Long story short, “Cash is King!”. Accordingly, it is crucial to look out for companies that generate a cash flow that enables them to run their business, invest for the future, and if the time is ripe to acquire one or the other company to either grow their market share or use synergies. One attribute to look out for, when checking for the capability to run a business efficiently is to check their track record on paying dividends.
However, that is not the only perspective where Cash is King. On the investing side, keeping some cash on hand is essential to weather the time ahead. Since investors cannot know the future, there is always a certain tradeoff between being fully invested and holding some cash as dry powder. As mentioned in previous publications, chances are that volatility will stay increased. Especially our assumption of interest rates staying higher for longer has the potential to move markets. Once investors realize that they have been too optimistic in this regard, a sell-off is a likely result. Should such a scenario become reality that would be the beginning of the end of the bear market and therefore represent an opportunity to increase the exposure to equities again.
Nevertheless, do not underestimate the current environment. There are opportunities out there, where an investment can be done without a bad conscience.
Debt? Yes, but…
As was the case with equity markets last year already, fixed income lost too. Not only investors experienced that, banks struggle with this “safe” asset class as well. Not high yield, speculative bonds have been the reason for SVB to go bankrupt, but U.S. treasury debt, which was not worth what they valued it on their balance sheet. This kind of defined safety towards government debt seems quite arrogant to us. I like to compare it with a scenario of engineers building a huge cruise ship claiming that it is impossible for the ship to sink. Wait… there was such a story. I was not alive back then, but I think to remember that ship’s name was Titanic. The fast increase of interest rates by central banks can be compared to the iceberg that came close quickly and there was too little time to adjust the course of the ship (in the current scenario, the bank).
Nevertheless, investors are starting to move back into bonds again, to lock-in the current yields. If you expect interest rates to stay at current levels or even decrease within the next 12 months, buying fixed income investments is a good idea. We do agree that fixed income should not be cold-shouldered anymore. The risk of central banks overtaxing the system has become a serious threat, and therefore, we anticipate more reservations in further hiking interest rates.
But… we cannot stress enough to examine the quality of the bond issuer. Here, once again, Cash is King! The cash-flow must be generated to at least meet the interest payments on time and if the debt should be repaid to do so.
De-Dollarization! Yes, but not today…
People have been talking about the end of the U.S. dollar for a long time already. However, getting rid of a global reserve currency is not as easy as one might anticipate. Nevertheless, that does not mean it will not happen. According to the International Monetary Fund, at the end of Q4 2022, the Shares of the U.S. dollars measures as a percentage of all allocated reserves was 58.36% (see here). Back in 1995 this figure was 58.96% and the high was in 2001, when the share was 72.70%. While the increase was within a short period of time (about six years), the decrease turned into a trend over the last 22 years. Additionally, given the efforts of the BRICS countries and the sanctions against Russia in particular, it does not seem that this trend will reverse anytime soon.
Talking about the BRICS countries’ effort to come up with an alternative reserve currency to the U.S. dollar, the term “de-dollarization” resounds throughout the land. The goal is to come up with an alternative currency the BRICS countries can use for international trade. While this gives reason to be concerned about the hegemony of the United States of America and its currency, many questions remain unanswered. Furthermore, assuming that this alternative currency will come into reality the question remains how much the U.S. dollar in its value will suffer as a direct consequence. Having said that, we do believe that the days of the U.S. dollar’s status are counted and that in the long-run the U.S. dollar will continue to lose relevance and value. However, how fast or slow this transformation will take place is up in the stars. For us, it is important to be aware of this development and take active measures to protect your family’s wealth, preventing you from losing purchasing power.
In the meantime, the U.S. dollar will fluctuate and, by doing so, allows you to move into other currencies of economies that are stable, having sustainable levels of debt, reasonable inflation levels, and political stability.
…well, but what about today?
While the U.S. dollar was strong last year, we have seen a weakening of the U.S. dollar this year so far. When forecasting the behavior of forex exchange rates, one has to differentiate between short- and long-term expectations. While in the long-term we do believe that the U.S. dollar will lose value, we also believe that at the current stage, the U.S. dollar is oversold. The countermovement will be triggered by increasing insecurity at the markets. This will lead to a sell-off at the markets and investors moving back into the U.S. dollar in the short-run.
In the longer perspective, we see the U.S. dollar continuing its downturn. As mentioned above, we expect Biden and McCarthy to agree on a higher debt-ceiling. Such an agreement will ease the current stress in the market. This development will bring more trust back into the U.S. currency in the short-term since the U.S. will pay interest on its debt. However, the main challenge the U.S. will have, is that their economy will not grow in lockstep with their debt. While a country is generally capable of managing such an environment in the short-term, in the longer-term this will lead to higher interest rates and a lack of trust into the government and the currency.
Precious metals shine… don’t get blended
Precious metals have had a great start to the year. Due to the ongoing insecurity around the world, gold and silver in particular increased in value. While we expect that precious metals will stay strong for longer, the tremendous rally they experienced calls for an in-between correction. We would consider such a correction as an opportunity to build up a position if you have not done so. However, keep in mind the importance of a sustainable and healthy asset allocation of your portfolio. Having said that, we believe that a strategic overweight in precious metals and precious metals related investments can serve as a hedge in certain circumstances as we are experiencing. However, in the longer-term precious metals have proven to require a certain patience.
To be clear, especially as Swiss based investors with our conservative approach, we believe that precious metals are almost always justified to represent a certain part of your portfolio. However, the question lies in the chosen exposure. In times of peace and sustainable global economic growth, we believe that the opportunity costs of missing out on other investments should be taken into consideration.