Review and outlook First Quarter 2023
At a glance – Important developments in the first quarter 2023
Economy and inflation
Monetary and fiscal policy
Politics und geopolitics
Stock markets experienced a rollercoaster ride in the first quarter. Torn between hopes for a quick end to aggressive interest rate hikes and inflation and economic data that contradicted this, triggered strong price fluctuations on several occasions. Equities showed a positive development in the first quarter, albeit with strong fluctuations and varying results (chart 1).
Reports of mostly solid corporate earnings developments for 2022 and slightly better than expected corporate results for 2023 provided good fundamental valuation support to equity markets.
Doubts about the stability of the banking sector, emanating from problems at some medium-sized US banks and Switzerland's Credit Suisse, triggered turbulence in the second half of March (chart 2).
The loss of confidence triggered shifts in bank deposits and could only be stopped by coordinated interventions of governments, central banks and banking supervisors. Comparisons to the "Great Financial Crisis" of 2008 seem inappropriate. In addition to the other causes and the different initial situation, the fact that central banks were able to raise key interest rates again to combat inflation despite the extremely tense situation without further shaking the financial markets also speaks against this.
Growth stocks clearly outperformed value stocks. The Russell 1000 Growth Index rose by 20.4 %, while the Russell 1000 Value Index, which is made up of value stocks, rose by only 0.4 % in the first quarter. Thus, value stocks probably reflect the current economic situation better.
Unsettled market conditions will persist until it is easier to see how higher prices and interest rates will affect consumer and corporate behaviour. If companies continue to protect their profit margins by raising prices, a recession is unlikely to affect equity market performance.
Bond markets and interest rates
Bonds continued their recovery after last year's heavy losses, albeit again with strong fluctuations. In the first quarter, bonds recorded positive results in all credit rating segments (chart 3).
It was particularly helpful that bond portfolios have become noticeably more resilient to further increases in market interest rates due to the significantly higher yields. Yields on USD corporate bonds of good debtor quality (investment grade) are now above 5%; those on Euro corporate bonds are at 4%. Just 12 months ago, these yields were 2% and just above zero, respectively. With yields at their highest level for more than 10 years, investments in bonds are interesting for a period of 1 to 2 years. For long-term investments, however, it should be borne in mind that the "return after expected inflation" still makes real wealth preservation unlikely.
With the exception of China and Japan, the major central banks continued their policy of raising interest rates in the first quarter. The declared goal remains to reduce inflation rates, which are clearly too high. As a result, economic development is expected to slow down considerably. There is still no reliable expectation on the financial markets as to how far the interest rate hikes will go. In view of the economic data situation, this uncertainty factor will remain and produce new fluctuations in value (chart 4).
Subordinated bonds of banks were under considerable pressure after the rescue measures for Credit Suisse. This resulted in price declines that in the vast majority of cases were clearly too high. At the end of March, the start of a broad recovery movement could already be observed - confidence slowly returned.
Bonds make sense again for portfolio design, even if "buy-and-hold strategies" are not tempting given the prospect of negative real returns. On the positive side, bonds, as an important form of investment for diversified portfolios, are once again yielding appreciable returns and thus enable more stable performance of the entire portfolio in the future.
"Stores of value" such as physical gold or cryptocurrencies, which are independent of the classic world of shares or bonds, were particularly in demand during the crisis of confidence in the banking sector. They benefited from strong demand due to the generally high level of uncertainty. The gold price reached its highest level in more than a year at just under USD 2,000 at the end of March.
Commodities, which play a key role in the energy transition, are now part of geostrategic considerations and their development is therefore often generously subsidised. In the portfolios designed by BPM, we already invested in this investment theme with a view to the future some time ago. The price development in this segment has been disappointing recently. However, regardless of short-term negative price influences, we see a considerable structural demand overhang here due to the upcoming transformations in areas such as mobility, energy generation, energy transmission and storage.
In addition to the improved availability, lower demand (mild weather, use of other energy sources) also led to an easing of energy prices (chart 6).
Industrial raw materials showed a mixed price trend in the first quarter. The modest economic outlook is having a negative impact. Hopes are now resting on additional demand from China after the end of the burdensome zero-covid policy and the reduction of the still relatively high inventories there. On the other hand, the lack of economic stimulus for commodity demand from the USA or Europe this year is probably already reflected in current prices.
Gold, as well as broadly diversified cryptocurrencies with a sensibly limited share, help to stabilise mixed portfolios during particular market stress. Commodities as an asset class have already proven to be an effective asset protection in earlier times when economic growth was low and prices rose sharply.
What will happen next
Nervousness and stronger market fluctuations are still to be expected. Interest rate development is currently the decisive factor for short-term financial market development. Stable labour markets and the ability of companies to raise prices speak for a continued robust economy, but also inflation development. Doubts about the stability of the banking sector should not become a permanent issue. Liquidity remains scarce and in high demand - this is how the central banks want it.
Expectations and investment ideas in our portfolios
Our main scenario assumes a cautiously positive development of the financial markets on the basis of a stable, albeit not strongly growing, global economy in the coming months. The rise in interest rates should slow further before probably coming to a halt in the second half of the year in the USA and somewhat later in the eurozone.
Although there are arguments for reducing equity weightings in portfolios (e.g. tense geopolitical situation, threat of social unrest, restrictive monetary policy, tight liquidity), it seems too early for us to do so. European equity markets in particular still have room for further gains, measured by the valuation level (price/earnings ratio approx. 13x) and earnings estimates for 2023 (consensus estimate + 16%).
Bonds are now benefiting from the sharp rise in current interest rates, but are subject to a residual risk of further increases in yields and, in the event of a recession, also to rising credit risk and / or higher inflation expectations.
We expect particularly positive earnings contributions from investment ideas such as emerging market bonds (investment grade), corporate bonds (investment grade) with short to medium maturities, equities of precious metal and commodity mine operators, gold (physical) and alternative investments such as volatility premium strategies or reinsurance premiums ("cat bonds").
A broad diversification of opportunity and risk factors in the portfolio is important to us. We also explicitly take into account less likely risk scenarios such as a prolonged economic phase without growth and with high inflation. Commodity investments, physical precious metals, but also cryptocurrencies to an extent appropriate to the individual risk appetite act as "fire insurance" for the portfolio in this environment.
Interesting questions we were asked…
Value or Growth?
The question of whether it is better to buy shares that are considered to be value stocks in the face of rising inflation, rising interest rates and a rather weak economic situation or whether it is better to bet on shares whose business model promises strong growth in the future is currently the subject of controversial discussion, even among experienced investors. Definitions and understanding often differ. Connections are also made from time to time that do not necessarily make sense. For example: "Value" is suitable for conservative investors - dynamic investors prefer "Growth". Unfortunately, it is not that simple!
Companies that have high book values on their balance sheets and regularly pay dividends are not necessarily "value". In the same way, dividend-free but high-growth companies are not always "growth". Regardless of the already rather arbitrary criteria, we believe that a business model that does not bring investors any (real!) growth in the long term does not belong in the portfolio - regardless of which camp you assign it to.
The reason why "Value" came into focus after the years-long soaring of "Growth" is the sharp rise in interest rates since the beginning of 2022 and the resulting higher discounting of future cash flows in the investment valuation. These should be significantly higher for "Growth" (one expects high profits in the future) and thus trigger a stronger negative reaction of the share price to rising interest rates (chart 7). Growth shares achieved significantly stronger price gains than value shares during the low-interest-rate phase in 2019/2020. With the sharp rise in interest rates from the end of 2021, this advantage was initially reversed and then led to a sideways movement.
In the long run, however, the real "return engine" of growth lies in the development of new products or services and the resulting exponentially growing profits in case of success. We implement this idea in the portfolios we design, among others, in various future topics (e.g. "Internet next generation", future mobility, clean technology or BioHealth).
We like equity investments with a moderate dividend yield and a lot of qualitative growth. It is not for nothing that successful dividend funds have always focused on dividend growth.
For pure dividend strategies, we only see sense in strategies clearly focused on regular income generation.
The old Warren Buffett quote still applies: "Price is what you pay. Value is what you get."
Our primary objective is to ensure that our clients achieve real compensation for the depreciation of money over the agreed investment horizon. For us, therefore, in addition to the actual "craftsmanship" of the fund managers, things like creativity, consistency in action and far-sighted anticipation are decisive in the selection of investment forms. In our experience, this is the only way to achieve an attractive risk-adjusted performance.
Founding member and Managing Director of BPM - Berlin Portfolio Management GmbH, Berlin.
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