Recession worries
Global recession worries are haunting markets. Ethenea’s portfolio managers discuss the current environment and detail how the funds are currently positioned.
Last month worries concerning a global recession gained significant ground. The U.S. reported the second consecutive quarter of economic contraction, which is the established definition of recession. In contrast, the eurozone economy is in positive territory, despite widespread predictions of doom and gloom, with the traditional holiday countries in the south performing particularly well.
A strong decline in long-term yields is also widely considered as an indicator of recession and, as an example, 10-year Bund yields sank from 1.75% to 0.85% in June. “We too were surprised by the speed with which yields declined, while inflation in Europe and the U.S. climbed to new record highs,” says Volker Schmidt, Senior Portfolio Manager at Ethenea.
The ECB joined in the worldwide cycle of interest rate hikes with a higher than expected increase in its key rates of 50 basis points on 21 July. “This is a step in the right direction, which gives the ECB some leeway for further rate hikes and could at the same time prevent the risk of market fragmentation. However, the situation remains particularly challenging for the ECB, which is juggling the risks of stagflation, recession and political tensions within the eurozone,” says Andrea Siviero, Investment Strategist at Ethenea.
A weak euro is not benefitting exporters
The sharp depreciation of the euro recently is damaging the inflation outlook and European consumers. The divergence of regional monetary policy measures is one of the main reasons for euro weakness, according to Andrea Siviero: “Decisive ECB action could provide a boost to the euro and protect the eurozone from a further acceleration of inflation.”
Contrary to what one might think, a weak euro versus the US dollar is currently not benefitting European exporters and is neither advantageous for the EU in general. Philip Bold, Portfolio Manager at Ethenea: “Exports of goods and services to non-eurozone countries generally account for a substantial proportion of GDP (around 20% in 2021). However, only a fraction of this (around 15%) goes to the U.S. A comparison to a broader trade-weighted basket of currencies is therefore more telling for an assessment of EUR competitiveness. The EER-421 exchange rate published by the ECB is an appropriate reference for this. It takes into account the weight of trade with the 42 most important trading partners of the EU. Against this basket of currencies, the EUR has fallen by only around 4% since the start of the war in Ukraine until reaching parity with the USD. The international competitive advantage gained by the EUR is therefore significantly lower than the change in the EUR/USD exchange rate suggests.”
Furthermore, EUR weakness versus the USD brings a significant disadvantage, Philip Bold continues: “Energy and commodities are generally quoted in USD. The dual burden of higher energy and commodity prices and the appreciation of the USD is likely to more than offset the slight competitive advantage from general EUR weakness. EUR weakness versus the USD is not therefore cause for celebration, even among strong European exporters.”
Which recession to be expected ?
Investors are confident that central banks will get inflation under control quickly. “This is clear, for example, from inflation expectations reflected in the prices of inflation-linked 10-year sovereign bonds,” says Volker Schmidt. “Long-term expectations for average inflation over the next ten years currently stand at a little over 2%, for both Germany and the U.S. Most economists also expect inflation to drop significantly in 2023. If the global economy really does then slide into recession, central banks may indeed think about renewed interest rate cuts as early as 2023. The U.S. Federal Reserve sees the long-term neutral level of interest rates at 2.5% – this is likely to be exceeded by September 2022, thus paving the way for future interest rate cuts.”
What type of recession should we expect? Unemployment is low and there is a severe shortage of skilled and unskilled labour. Volker Schmidt: “On the other hand, the big tech groups are announcing hiring freezes or are already making layoffs. A slowdown in economic growth is also likely here and there is even the possibility of a technical recession in Europe – defined as two consecutive quarters without economic growth. But could we also see a hard landing with unemployment rates rising significantly? We doubt this.”
Prudent positioning
Against this backdrop, the portfolio management of Ethenea’s Ethna-DEFENSIV remains prudent: “Our strongest conviction regards currencies,” says Volker Schmidt. “We have therefore raised the U.S. dollar allocation to 25% and remain invested in the Swiss franc and Norwegian krone. We are only slightly exposed to interest rate risk. The average duration of the bond portfolio is extremely low at 3.1. This in conjunction with the high-quality of our holdings – our average rating is around AA – reduces the threat of rising risk premiums for our corporate bonds. We have further reduced interest rate risk by hedging interest rates via futures.”
“Given the rampant inflation prevailing, we believe that Bund and Treasury yields of 1% and 2.75%, respectively, make no sense,” adds Senior Portfolio Manager Michael Blümke, who manages Ethenea’s flagship multi-asset fund Ethna-AKTIV.
On the equity side, Michael Blümke does not subscribe to the theory that we have already seen the bottom. With interest levels raising, equities have also lost their status as the only available risk asset, argues Christian Schmitt, who oversees Ethenea’s Ethna-DYNAMISCH fund. “In addition, the earnings prospects of companies – with the exception of the energy sector – are weakening in real economic terms. The stress factors of this reporting season – cost inflation, weaker consumer demand, U.S. dollar strength – are likely to continue into the second half of the year. Current corporate prospects are accordingly modest.”
Price movements in equity markets in the first half of the year have already priced in a lot and valuation levels (depending on the ratio used) are generally back in the mid-range. “Yet we continue to anticipate a difficult and volatile environment this summer,” says Christian Schmitt. “This is due to the top-down drivers which are, in a word, negative. We therefore remain prudent and have recently – during market strength at the beginning of July – counter-cyclically reduced our equity allocation using hedging instruments, from around 40% to 30% in the Ethna-DYNAMISCH. Meanwhile, we continue to run a high cash allocation (roughly 65% including cash equivalents and equity hedgdes) to anchor stability in a negative market environment.”
1 https://www.ecb.europa.eu/mopo/eaec/eer/html/index.en.html
