Your questions, our answers

In our latest issue of Clear and Simple, our Portfolio Managers discuss the impact of both the coronavirus and this year’s U.S. presidential election on the markets and what preparations are being made in the portfolios of the Ethna Funds. They then cover the development of interest rates this year and whether 2020 will be a growth or value stock year. Finally, they discuss our approach to the Ethna-AKTIV’s equity quota in 2020.

In your opinion, what impact will the coronavirus have on the global financial markets? What measures have you already taken, and what do you plan to do, to prepare the Ethna Funds’ portfolios for various scenarios?

Although the virus and the associated illnesses and fatalities are primarily human tragedies, it is still necessary to assess their impact on both the global economy and the capital markets. However, despite the panic-mongering we have seen in the media of late, it is important to note that the scale of the outbreak is nowhere near that of the normal influenza epidemics that we experience every year. This is not to say that the effect is negligible. In particular, as the precautions taken do have an impact on global supply chains and, of course, on demand. However, these are all temporary effects, which, once the virus has been contained, should return to their normal levels. Although the demand shortfall will not necessarily be offset, the corresponding losses will ultimately only be a one-off effect. We are therefore convinced that the economic impact will be limited and will not cause any longer-term damage.

Following the brief period of uncertainty at the end of January, the global capital markets are obviously assuming a similar scenario. However, this does not mean that we do not need to prepare ourselves for an alternative and possibly more serious scenario. The fact that our direct exposure to the most affected Asian region is minimal clearly makes this task easier. As, in the event of an escalation, the effects will also be felt beyond Chinese securities, the inherent diversification in our portfolios is an important initial protective mechanism. Should the situation deteriorate, our next step would be to successively reduce the affected risk assets, in particular equities. However, until this happens, we are avoiding panic-mongering and are trusting in our flexibility and our active management approach.

What impact do you believe this year’s U.S. presidential election will have on the markets? How would you prepare your portfolios for the following scenarios – Trump’s re-election or a change in administration?

We certainly expect it to be an exciting and polarizing election. From a capital market perspective, the Trump era was very successful. All of the U.S. indices are at record levels, there is full employment, and the economy is booming. The markets currently assume that President Trump will be re-elected. As was the case in 2016, should he be returned to office, more cyclical sectors such as banks and the construction industry are likely to benefit. President Trump will continue support the defence and infrastructure sectors through significant investments in a range of projects. However, a continued protectionist stance in economic policy, particularly towards China, could hurt the technology sector, as most of their production is in that country. Trump is also likely to maintain pressure on the Fed, in the hopes of further interest rate cuts. Should President Trump be re-elected, we would need to consider these aspects in the Ethna-DYNAMISCH portfolio, and would likely overweight the respective cyclically sensitive sectors. In the Ethna-AKTIV, we would return to a relatively high equity exposure, while in the Ethna-DEFENSIV, we would plan on keeping our high-yield bond position at around the 10% mark.

At this stage, it is not clear which of the current Democratic candidates will stand against President Trump, although all are currently trying to score points with left-wing election programmes. It is also important to note that, in light of the fact that the candidates range from the more left-wing Bernie Sanders to the more centrist Pete Buttigieg, until one is confirmed in July, we will not know exactly what we can expect in terms of policy. However, should a Democratic candidate win the election, we are likely to see a nervous reaction from markets. In particular, the sectors that are benefitting from Trump’s polices could start to falter. Industrial securities and banks are likely to be among the losers, while defensive sectors such as non-cyclical consumption will benefit. In the Ethna-DYNAMISCH, we would overweight or underweight the aforementioned sectors, depending on the election outcome, while in the Ethna-AKTIV, we would decrease our equity allocation. An increased likelihood of Bernie Sanders becoming the next US president would lead us to reduce our spread duration in the Ethna-DEFENSIV, as well as decrease our allocation in corporate bonds with a weaker ratings or that belong to sectors that could be impacted by Sanders’ programmes, such as industrials and banks.

In 2019, interest rates fell significantly and both the Ethna-AKTIV and the Ethna-DEFENSIV were able to benefit from this. What is your view on the development of interest rates in 2020?

Our central scenario for 2020 envisages a fairly stable interest rate environment, with inflation expectations well established in both the eurozone and the US. Current ECB and Fed forward guidance not only points to stable key central bank interest rates but also to quantitative easing (i.e. central bank balance sheet expansion), which in turn should support rates in the eurozone and the US. However, it is not only the Fed and the ECB that are following an accommodative monetary policy; global central banks remain supportive and are in the middle of a lowering cycle. Due to this, both the Ethna-AKTIV and the Ethna-DEFENSIV will maintain their duration of between 5 and 6 in order to profit from this benign interest rate environment.

Nevertheless, a positive growth surprise in the US could lead to rising inflation expectations there, which would move the longer end of the rates curve higher. In such a scenario, it would be appropriate to significantly reduce the portfolio duration. In the Ethna-AKTIV and the Ethna-DEFENSIV, we are able to actively steer duration in order not only to shield the portfolios from this type of yield-shift shock but also to profit in such a scenario.

What is your view on the valuation of growth stocks? Do you think 2020 will be a growth or a value year, and how will you position the portfolio of the Ethna-DYNAMISCH accordingly?

The relative performance of these two main styles of equity investment has followed a globally consistent trend for more than a decade now, with growth stocks outperforming their value counterparts by far. This trend also continued into the first weeks of 2020. Due to the persistent divergence in performance, the representatives of both investor camps have become so divided that the discussion about the underlying reasons for this development is unfortunately losing its objectivity. It goes without saying that there are good arguments for both sides. But there are also risks.

Value investors cite the sometimes extremely low valuations. A prime example is the German automotive industry, which, with P/E ratios in the single-digit range, has been at the lower end of equity valuations for years. The valuation argument is steadily gaining in importance, as overall market valuations have successively climbed in the wake of low interest rates. Growth investors, on the other hand, like to point to the disruptive business models of today's growth stars, who are often - like the U.S. electric car pioneer Tesla, for example - direct competitors of companies with depressed valuations. However, the current valuation of the expected future sales and profits is increasingly receding into the background. The problem is that both camps are right - however, this does not automatically make either the allegedly inexpensive or the supposedly high-growth stocks good investments.

As long as both extremes of the valuation range are associated with increased risks, prudent investors should take the middle road. The middle should not be confused with mediocrity, but stands for high-quality companies with structural growth drivers and solid balance sheets, which are also fairly valued. It is exactly these companies that we have focused on in the Ethna-DYNAMISCH.

In the last couple of months, you have successively increased the equity quota to an above-average level in the Ethna-AKTIV. What is your approach for 2020?

After a very good year for equities in 2019, hopes for 2020 are subdued in many places. We only partially agree with this scepticism. In our view, it is important to look at equity valuations not only in absolute terms, but also relative to the available alternatives. The current low interest rate level has made the most obvious alternative, corporate bonds, so much more expensive that even the current share valuations offer further upside potential. It also important to note that many of the obstacles of the past two years have been removed or are no longer in focus. In this regard, it is worth mentioning the U.S. – China trade dispute and the tiresome Brexit issue. If we take into account that all the major central banks are currently providing additional support through their balance sheet expansions and that we have an election year in the U.S., we can currently expect more of a tailwind than a headwind for equities. Accordingly, the Ethna-AKTIV’s equity ratio is currently relatively high, but we will continue to manage this flexibly. This means that, in particular in the last few months before the election, we expect equity markets to move sideways, during which it may also be advisable to have less equity exposure. When it is clear who will be America’s new president, a new decision can be made on the fund’s equity exposure.