Monthly Report 09/2023

The SNB greatly underestimated the upswing in inflation in 2022. In January 2023, inflation was +3.3% compared to the same month of the previous year. But the impressive decline was likewise unexpected. The inflation rate has more than halved within a very short time. In August 2023, inflation in Switzerland was +1.6% compared to the same month of the previous year. Core inflation even fell to +1.5%. This is evident from the latest figures from the Federal Statistical Office (FSO).

We have always been somewhat more optimistic than the SNB when it comes to inflation trends. This is mainly due to the fact that we have assessed the development of rental prices differently. The FSO incorporates the results of its rent index into the inflation rate on a quarterly basis in the months of February, May, August, and November. As a result, the effects of the SNB’s key interest rate increases, which have a large influence on the reference rate for rents, are factored into the index at a delay. We expect the next boost from November 2023 onwards, which could be even larger if the SNB tightens the reins again when it reviews its monetary policy on 21 September.

Due to the increased reference mortgage rate for leases in June 2023, moderate rent increases are expected. The extent to which and how quickly the adjustments to existing leases will affect the results of the rental price index can be assessed in the quarters from November 2023 onwards. These effects are not yet visible in August 2023. In addition to the adjustments due to the increased reference interest rate (1.5%), which could even be accelerated by the SNB decision in September, a large number of other factors also influence the rental price development captured in the rental price index (such as new constructions, renovations, or tenant changeover).

The interesting thing is that although we compare inflation values across borders, we overlook the fact that the corresponding variables are measured very differently. When looking at US inflation as a trendsetter, it is important to know that “housing” is factored into the inflation calculation with a weighting of around 35% and that this factor is technically linked to the Fed’s key interest rate. If the Fed stops raising key interest rates for a year, inflation will stay out of this range. If housing costs were calculated and weighted the same way today as they are in the eurozone, inflation would already be below the Fed’s target – which would be accompanied by faster key interest rate cuts, more stable real estate markets, more robust regional banks, more stable economic prospects, and rising equity prices.

In the bond markets, volatility has dropped back down now that the cycle of key interest rate hikes is nearly over. In Switzerland, inflation is at 1.6% and core inflation (1.5%) remains on the decline. The only institution that could directly fuel inflation is the Swiss National Bank (SNB) – provided that it raises the key interest rate by a further 25 basis points to 2.0% on 21 September. However, this is by no means necessary, and therefore the probability of such an increase is currently only 28%.

In the USA, the peak of the cycle has been reached. The implicit market expectations no longer assume there will be further interest rate hikes. Instead, a total of around five interest rate cuts of 0.25% each are expected by January 2025 and eight cuts by the end of 2025. The Fed’s Open Market Committee itself has determined that the key interest rate will settle at between 3% and 3.5% in the longer term. Consequently, this will result in a reduction margin of 2.0% in the coming eight quarters.

Accordingly, US Treasury bonds are attractive, as the largest bond segment in the world at just under $32,000 billion. The longer-term bonds are popular in particular, because they offer potential price gains in addition to interest payments. This also applies to longer term corporate bonds with a high credit rating. However, there are not so many of them in the $11,000 billion high-grade corporate bond market. Top-rated companies such as Microsoft (AAA) are rare, but yield a higher return than US Treasuries with a slightly lower AA+ rating.

Because European countries are much less indebted than the USA, the market for government bonds is “only” around €12’000 billion. At €2’400 billion, the market for the approximately 3’500 high grade corporate bonds also comprises only a fraction of the equivalent dollar market. This volume does not even correspond to Apple’s market capitalization and also explains the relatively low liquidity of individual bonds compared to the trade for an Apple share.

This is even more true in the even smaller areas of high-yield bonds in dollars and euros. These are comparatively niche markets with extremely attractive semi-liquid bonds from numerous companies that are household names (e. g., Elektrolux, Marks & Spencer, Hurtigruten). In this segment, interest rate risks play a subordinate role. What matters are the credit risks, which require selective and scrupulous diversification. For example, with Scandinavian corporate bonds, which have variable interest rates more often average, which was an advantage in the phase of interest rate increases.

The ZIF and COF differ even more than before, and the overlaps are minimal. We believe that corporate bonds with a high credit rating and a long duration are particularly attractive in dollars. After all, US corporate bond yields have risen to a 16-year high. Recently, data from a weakening economy reinforced the expectation that the period of rising interest rates and yields (and thus falling prices) was over. The real return (nominal redemption yield minus the expected inflation rate) is higher than it has been in decades.

That is why, for example, a bond from Microsoft was included in the ZIF, which will yield 4.8% p.a. over the next 27 years. This is attractive, plain and simple, even after the cost of currency hedging. Similar transactions in the best debtor categories were made in the ZIF with Deutsche Bahn (with Germany as the guarantor) and companies with strong cash flows, such as Nvidia, Starbucks, McDonald’s, and the Zürcher Kantonalbank. In general, the remaining terms are now higher and the credit ratings better.

The COF focuses on credit risk premiums. The typical residual maturity of a bond in the COF is three to four years. However, the interest rate risks are much lower because the portfolio contains a number of corporate bonds whose coupons adjust to the money market interest rate on a quarterly basis. These are known as “floaters”. In addition, a number of very good debtors are represented in the COF, but each with subordinated bonds. These usually still have a high-grade rating. Bonds from UBS, Swiss Re, Zurich Insurance, Allianz, Julius Baer, Volkswagen, and Telefonica, for example, are among the positions that we consider to be an opportunity and were therefore newly added or increased in August.

There is a special complexity premium for investors in subordinated bonds issued by financial institutions. These markets are inefficient and barely react to fundamental changes. As can be seen from the graph using the example of a subordinated bond from the Luzerner Kantonalbank, which has a BBB rating, increases in the interest rate led to declining prices. On top of this came the shock of how subordinated bonds were handled in the collapse of Credit Suisse in March 2023. The bond has not recovered from this to date, although the Luzerner Kantonalbank carried out a capital increase of around CHF 500 million in the first half of 2023, substantially strengthening its own equity situation.

A prosperous economy is a growing economy, so the need for space likewise increases. The main drivers of housing demand, for example, are household income and demographics, with immigration to Switzerland standing out in particular. In Switzerland as a whole, there is currently a shortfall of around 10,000 additional apartments needed to ensure steady real rents. More complex building permit procedures, endless appeals, and legal hurdles slow down the rapid implementation of construction projects, especially in large cities. “The delays are increasing,” researchers Marco Salvi and Patrick Schnell recently noted.

However, in the last two years, construction investment has also declined by 10% in real terms due to the unfavorable confluence of various factors. In many places, a significant economic slowdown was predicted. In addition, the construction price index shot up significantly post-pandemic. According to the Federal Statistical Office, anyone building a single-family or multi-family house in the Greater Zurich area would have to contend with 14.8% and 15.2% higher costs respectively in the spring of 2023 than in October 2020. The increase was even higher in northeastern Switzerland and slightly lower in the Central Plateau.

But even if construction prices stop rising so rapidly, there is now another challenge facing real estate investors. The borrowing costs in October 2020 were around 1% and are now 2.5% annually, which means that anyone carrying out construction today will have to contend with much higher financing costs.

While new rents have risen in recent years, the adjustment of existing rents is tied to inflation and interest rates, which has led to a difference between new and existing rents. The existing rents are often cheap, especially in big cities. This particularly affects “mobile” households, i.e., those where a disproportionate number of new tenants are young, divorced, and / or immigrants. Although ageing increases the pool of inexpensive apartments by 13’400 apartments per year by making apartments cheaper over the course of their life cycle, this is not enough to meet the demand by far.

There is not enough construction being done. This is also due to restrictive mortgage lending. The affordability requirements were significantly tightened due to macro- and micro-prudential market supervision around ten years ago and have led to a declining ownership ratio in Switzerland.

The strain on infrastructure is more equitable. There is no systematic disadvantage in this area. In Switzerland, the public infrastructure (air traffic and railway infrastructure, schools, multi-story car parks, roads, and local transport companies, etc.) enjoys an excellent reputation – not least thanks to the Federal Office of Transport, which plans 20 to 30 years in advance (the “Perspektive Bahn 2050” strategy).

The half-yearly reports and investor conferences have often confirmed the trend that our scrupulously selected securities are currently in sound shape and have at times been able to achieve strong total returns over the course of the year to date. In addition, the most important technology support lines have taken effect in the critical mood phases in recent weeks. Thanks to these international market leaders, our portfolios have shown robust development so far this year:

Google (+55%): The Group is generating a free cash flow that is more than twice that of Amazon or Meta (Facebook) and has outstanding prospects.

Apple (+45%): With $167 billion in cash, the world’s most valuable company is well supplied with liquid assets and has a great deal of room for maneuver to acquire attractive young companies and integrate them into its own community. Apple also generates approximately $124 billion in gross profit from its operating business annually, which equates to more than $300 million per day. Apple has distributed $788 billion to shareholders through share buyback programs over the past decade. Apple’s market capitalization is twice that of the SMI as a whole.

Microsoft (+38%): Behind Apple and ahead of Google, Microsoft’s EBITDA generation is around $100 billion annually and it currently has an annual turnover of $212 billion. It is in a kind of competition for the title of the GOAT (“greatest of all time”) alongside Google and Apple. In any case, these three companies have an AAA rating, i.e., their creditworthiness is rated higher than that of the USA.

KKR (+37%): The top specialist in alternative investments benefits from the fact that economic conditions worldwide are brightening and a global recession has become a more remote possibility.

Various European titles were also able to achieve impressive performances.

Saint Gobain (+37%): Sika’s competitor is exhibiting excellent development (+14%), in particular thanks to its specialization in the renovation business and industrial lightweight construction. The title will be included in the Euro Stoxx 50 Index on 18 September – a valuable distinction for a modestly valued company.

SAP (+36%): There are different positioning options in the IT industry: hardware or software, IT services, semiconductors, or the equipment business. SAP has occupied a lucrative market segment focusing on enterprise management software and remains the undisputed world market leader. In the short term, the valuation seems fair to us; we consider it attractive in the longer term and for patient investors. SAP is one of the market leaders in the field of artificial intelligence. The new global head of SAP set up the corresponding division at Microsoft and ran it for a long time.

DHL Group (+28%): Kühne+Nagel’s German competitor is showing impressive development (+30%) and has increased its guidance for the year 2023 overall. The valuation is still significantly cheaper than that of K+N and the dividend yield is well above 4% with interesting prospects.

Axa (+13%): The world’s largest insurer has so far clearly outperformed its competitor Zurich Insurance (-1%) with its total return. The result in the first half of the year (+€4.1 billion) clearly showed it is on track to achieve the guidance for the current year (+€7.5 billion). The high solvency ratio (+20% to 235%) also raises hopes of profit consolidation through a share buyback program under the new IFRS 17 accounting guidelines.

The global laboratory equipment supplier ThermoFisherScientific (+1%), which performed better than Roche Diagnostika (Roche -7%), has experienced a slump in the share price so far this year. By contrast, the Indian basket of shares (+8%) performed well above average, rising significantly faster than its benchmark MSCI Emerging Markets (+5%). Its prospects remain intact, as the Indian subcontinent is experiencing excellent structural momentum.

Alternative investments are a field of investment opportunities that do not fit into the traditional vessels (equity, bonds, and real estate). These investments are not homogeneous and do not have uniform risk/return patterns.

One category is commodities. Strong global economic growth tends to contribute to increased commodity prices. But the steepness of the supply and demand curves varies greatly in the different individual markets, which in some places enables a cartel-like situation (e. g., in the crude oil segment due to supply shortages). Crude oil prices have risen by almost 4% this year as a result of corresponding cutbacks. In other markets, there is much more speculation (e. g., in the case of liquefied gas). Numerous speculators bought gas to sell it at higher prices in a cold winter or spring. That plan backfired. Gas prices are now 35% to 60% lower than at the beginning of the year.

A second category is subordinated insurance bonds. The insurance industry is well capitalized. On average, the solvency ratio is 217% – with only 100% required to survive a 1-in-200-year loss event. New capital is generated every year, thus increasing the company’s financial flexibility. Axa, for example, had increased its solvency ratio from 217% to 241% through its operations in 2022, which subsequently led to a generous dividend distribution. Even if a stress event were to occur, an insurance company would quickly be able to use tried-and-tested bundles of measures (e. g., more selective underwriting, closure of unprofitable business units, etc.) as part of the annual renewal of insurance companies.

Insurers are not banks and operate according to a more conservative business model. There is no empirical evidence for an “insurance run”. Intensive regulatory oversight prevents strategic adventures. This makes the industry and structural premiums, which can be earned over several years, all the more attractive to us.