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Market Commentary

1st quarter 2020

Reading time 15 minutes
  • Covid-19 highlights the fragility of financial markets in a globalized economy
  • Central banks supply the markets with liquidity, but with the oil crisis the danger of insolvencies increases
  • Governments decide on extraordinary fiscal measures, but act unprepared and usually too late for the pandemic

The first quarter and especially March 2020 will go down in the history books. The western, democratic industrialized countries followed the events surrounding Covid-19 in China and other Asian countries for months. From the supposedly safe distance, there seemed to be no cause for concern. The West even mocked the martial measures of some countries. The inevitable spread of the virus caught the world completely on the wrong foot. At the end of February, the financial markets were the first to react to the dramatic implications of the pandemic with great vehemence. This was at a time when valuations were at all-time highs and double-digit growth in corporate earnings was expected for 2020/21. The US even reported a sharp increase in new jobs and a falling unemployment to historically low levels in February. The new, gloomy outlook dragged the financial markets into a downward spiral unlike any other. After many governments first played down the danger, the turnaround soon followed in the form of an economic and social emergency stop: "Shutdown"! In panic, total uncertainty and disorientation, the stock markets lost a third of their value within a few days.

Central banks - quick and effective

Already in Q4 2019, the Fed and the ECB were forced to inject liquidity. In the first two weeks of March, the liquidity situation deteriorated dramatically once again, increasing the speed and severity of the market correction to a degree last seen during the Great Depression of 1929. The central banks reacted promptly. The US Fed cut interest rates to zero, and both the European, British and American central banks launched new "quantitative easing" programs (i.e. securities purchases) worth around 6.5 trillion USD. For comparison, the QE programs to overcome the financial crisis of 2008 totaled 16 trillion USD over ten years.

Governments weak in pandemic control, but always ready with "helicopter money"

The economic standstill has forced governments to put together packages of measures to support businesses and private households - including direct payments. The USA, for example, provided 2 trillion USD. This amount is equivalent to around 10% of 2019 GDP! In other countries, the amount of money spoken ranges from 3-7% of GDP. In these dramatic times the long-standing, critically regarded issue of "helicopter money" is not even being questioned - it is currently the only available solution. The consequence of this: Not only will the balance sheets of the central banks grow strongly, but also the deficits and with them the debts of the affected countries. A "Japanification" of the Western economy is drawing ever closer. But this is certainly not the right time to rack your brains over this.

After the rain comes the sun - but no rainbow yet

By mid-March, the stock markets suffered an average loss of around 30%. Intervention by central banks and governments first slowed down the correction and then sparked a strong stock market rebound. Our equity funds were able to cushion the losses in the first half of the month significantly. This first phase saw a rotation from cyclical to defensive stocks. In the subsequent upswing, however, cyclical stocks and growth stocks - especially technology stocks - were again in strong demand. As expected, our strategies were unable to keep pace with the respective benchmark indices in this second phase and thus relinquished part of their outperformance.

On the interest rate front, too, there were lively ups and downs: in the first week of March, interest rates fell and our bond funds were able to post gains. In the following week the opposite happened - interest rates suddenly rose again. In phases of increased risk, high-quality government and corporate bonds are generally in high demand. But this time it was different. The general rise in interest rates meant that the positive returns of our government bond funds gave way to a black zero. The global rise in interest rates in mid-March can be explained by several factors:

  1. Asset outflows combined with sharply falling prices and a lack of liquidity caused fund managers to reduce the asset class that was still liquid at all - namely government bonds.
  2. So-called "risk parity" funds massively reduced their leverage, selling both equities and bonds on a large scale.
  3. The massive reduction of portfolio risks led to the massive closure of derivative positions and thus to a sale of the guarantees deposited in the form of government bonds.

Our CHF bond fund even slipped into the red. Interest rates on Swiss government bonds rose significantly, especially at the longer end of the yield curve. The negative return of the CHF bond fund had nothing to do with an increased risk of the bonds or with increased inflation expectations (it would rather be the opposite). Even though CHF bonds with high credit ratings have not yet been able to achieve a positive return, unlike in other crises, they still remain the safest asset class available.

Solvency and bankruptcy crisis is the elephant in the room

A recession is practically inevitable, some even talk about a depression. The fact is that even the monetary and fiscal package of measures has not been able to stop the great uncertainty and blind flight on the financial markets. If we look a few months into the future, the lack of income and cash flows could lead to a major insolvency crisis. A decade of low or even negative interest rates has also led to a sharp rise in global corporate debt - both in absolute terms and in relation to GDP. The largest increase in debt was in the "BBB" segment. The "BBB" rating is only one notch above what is commonly referred to as junk. The danger of a downgrade is acute. Far-reaching downgrades would exacerbate the already critical liquidity situation of corporate bonds and push up credit spreads.

If the circumstances were not already critical enough, Russia and Saudi Arabia are now also engaged in a dispute over oil production. It looks like this is the last straw that broke the camel's back. Since the beginning of the year, the price of oil has plummeted by almost 70% and at times was trading below USD 20 per barrel. This price level dramatically increases the probability of bankruptcies in the energy sector and has led to generally higher risk premiums in all sectors. The greatest risk at present is therefore an insolvency crisis, followed by bankruptcies. This would mean that a large part of the economy would depend on emergency government support.

Effective vs. cosmetic diversification

A decade of unorthodox monetary policy and suppressed volatility has led investors to take greater investment risks than their risk profile would allow. They ventured into asset classes that were beyond their "natural territories". In order to escape the negative interest rates and maximize returns, increasingly complex and illiquid products piled up in the portfolio, and their latent risks are now materializing.

Our investment approach has always focused on liquidity, effective diversification and risk optimization. The OLZ bond funds were able to fulfill their function as an airbag in March and still proved to be the safest alternative in times of crisis - even though the rise in interest rates slowed the CHF bond fund down somewhat. You will not find any structured products in our portfolios that turn out to be Trojan horses in hectic market phases. We do not invest in high-yield or emerging market bonds, which are now as volatile as equities. We also avoid supposedly diversifying asset classes such as private equity or infrastructure.

We are facing a historically unique phase. Such a synchronous and global cut in the economy and society is unparalleled. The financial markets have already priced in many of the uncertainties and risks, governments have become active and will pull out all the stops in the near future to find a way out of this unprecedented situation and back to normality. A rebound (like at the end of March) within the next few months cannot be ruled out. As is well known, both the crisis and the recovery come without notice. However, we are convinced that OLZ portfolios correspond to the respective risk profiles of our customers and are constructed according to the best diversification principles. Combined with strict risk management, this forms a good basis for facing the coming challenges. And at some point we will be happy to shake hands again.

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