Please note that this will be the last weekly review, until January 6.
I take this opportunity to wish you and your families a lovely holiday season , health and prosperity !
After the horrible 2022, it has been a good two-year period for invested portfolios. US main indices have rallied so far by more than 20%, for each of the last two years and the German DAX index reached the 20k level for the first time ever. It has not been a similarly explosive year for defensive portfolios, but are still having very respectable returns. Defensive segments of the markets (for example large cap Swiss stocks, Consumer Staples, Food & Beverages, Healthcare etc. ) have been abandoned and underperformed massively in 2024. But as financial assets' prices eventually revert to the mean, their fortunes might be different next year. The Fixed Income market has also produced above-average returns across all segments, with corporate spreads close to the record lows, especially in the US. Last but not least, Gold has registered its own record high and everyone is looking to buy Bitcoin (except for us).
All these developments beg the question: what happens next ? What is a realistic return for portfolios across the risk profiles, from current levels of all asset classes? There are two ways to answer this question. The first is based on fundamentals and historical patterns. If we follow this road, then bonds in EUR terms will not be easy to generate more than 2-3% of total returns and equities could generate 4-6% in EUR terms, at best. In that sense, it would be realistic to expect low to mid-single digit returns for EUR balanced portfolios, at the benchmark level. The rationale is simple and based on simple mathematics: Rich valuations in the US have already discounted the S&P500's 15% earnings growth currently expected for next year, a quite significant forecasted increase. Multiples (P/E) should therefore stop expanding, which means the equity gains will have to be much smaller than the EPS increase, to revert to better valuations.
The second way of looking at 2025 is to assume that the market will have a late 1990s moment, when the S&P500 rallied more than 20% for four consecutive years, before eventually crashing. A crash that was suffered by investors for three long years and then led to a significant underperformance of US equities, which lasted almost until the end of that decade. In that party-time scenario you can forget everything we mentioned in the above paragraph and the 2025 potential return for portfolios is of course... "the sky is the limit" . Bubbles will be created, dragging more and more people into them and asset prices higher and higher, until a 2000 or 2008 type of crash will bring everyone back to reality eventually in 2026 or shortly after. If we had to chose, we would opt for the low return 2025 , that would bring valuations back to better levels, index returns will revert to the long-term mean and life can continue afterwards with much less drama and volatility.
A few surprises can catch investors off-guard next year. Looking at Mr. Trump's first year of presidency (2017), we find that the USD sold-off significantly despite the initial after-election rally, with the EURUSD moving from 1.05, which is by coincidence today's levels, all the way to 1.25. We also note that in 2017, Chinese equities were the best performer among major regions. Both these potential surprises are currently so out of consensus, that if someone claims that they could happen again, will either lose his/her job in finance or be ridiculed. In Europe, Healthcare was among the top performers back in 2017, a sector which is now continuously being sold, by investors wishing to ride higher-risk higher return sectors. But the most realistic and harmful surprise will be if the FED reverses course and starts raising interest rates in the first quarter, to combat a rising inflation which will be the result of a growth re-acceleration, a further equity rally and consumers spending their capital gains to enjoy goods and services. Lastly, what if companies realize that the hundreds of billions that they are spending on building AI infrastructure will have very small actual monetization return for them in 2025 or 2026 and decide to cut back ? Our fiduciary obligation for clients' money is to consider all these potental outcomes, even if they are not the base scenario and be prepared for them.
The ECB cut the depo rate by 25bps to 3.0%, as expected. Mrs. Lagarde said that the decision was unanimous, although the option of a 50bps cut had been raised during the discussion in the Governing Council. They also reiterated their intention to maintain a data-dependent, meeting-by-meeting approach, explicitly refusing to commit to a future rate path. Accordingly, Mrs. Lagarde also refused to provide rate guidance for the next meeting on 30th of January, when the market already has priced in another 25bp rate cut. Slightly on the hawkish side, the ECB dropped the reference of "maintaining policy rates sufficiently restrictive for as long as necessary", implying that they believe that the current rate of 3% is close to what they consider as the neutral rate. They are probably in for a big surprise, as EUR rates will eventually have to be cut south of 2% as early as the second quarter of next year.
The Swiss National Bank surprised the markets, yet again, with a 50bp rate cut, to 0.5%. The central bank's message is that it wishes to fight the CHF's strength, which found itself at record highs against the EUR. The strength of the currency is indeed pulling down inflation, but Switzerland does not really have an inflation problem at about 1%, as of recent data. The SNB could cut interest rates into negative territory again to tackle the currency strength, but that has all sorts of unintended consequences. Therefore, it's more likely the SNB would cut rates again, by 25bp to 0.25%, but at that point it could change direction and engage in currency-market intervention to deal with the strength of the franc. If necessary it could cut to zero and then intervene more forcefully in the FX market.
Chair Martin Schlegel's final comment at his press conference was critical: the SNB does not like negative rates, but the possibility couldn't be excluded in the future.
US October inflation rose to 2.6%, as expected. The 0.3% monthly change brought the 6-month average to 0.2% and if this rate can be maintained on average for the next months, then inflation can drop close to 2% by end of March, according to our calculations. Things are not so rosy with respect to the Core inflation , which includes items such as rents, insurance premium, medicare and other services, which impact the people's daily lives. Core inflation remained at a rather high rate of 3.3%. Performing the same mathematical calculations we find that core CPI will be hard to drop below 2.8% in the next three months, at the current pace.
Bonds had a rough week. The sticky core inflation as well as the realization that the FED will pause cutting rates in January, after most probably cutting by 25bp this Wednesday, lead to a mini sell-off in both USD and EUR bonds. The US 10-year reached again the 4.40% level, up almost 25bp for the week, and the German equivalent approached 2.30%, also up about 25bp. It is no surprise that US equities lost their momentum, as higher yields are not friends with the equity market. Having recommended to avoid buying bonds in the previous two weeks, we now see again interesting buying levels, especially in EUR.
Equities also lost ground in most regions, last week. The S&P500 lost 0.6% and the "Trump-beneficiary" Small caps index (Russell 2000) dropped almost 3%. Nasdaq managed to move higher by 0.3% as mega caps were bid aggressively, despite the weakness in semiconductor names. Europe was rather flat, with most indices finishing +0.1% or -0.1%, with the exception of Swiss SMI which lost 0.7%, as the SNB's decisions confused everybody.
Chart of the Week : The historical 3-year return of the S&P500 from current valuation levels is un-inspiring.
Each dot in the above chart, created by Apollo Management, shows the 3-year returns of the S&P500 at various valuation levels (on the x-axis). We have highlighted in yellow where we are now, in terms of P/E valuations. It is obvious that based on history, the next 3-year returns are usually 0-5%, with a couple of exceptions with 10% returns. But unfortunately the majority of the dots (actual returns) are negative when we start at current levels. As we move further higher in valuations all cases had provided negative returns (all dots below the 0% return line). Which means if P/Es expand further next year, then we will get to the situation described in paragraph 3. This is very normal, as we all know that the average annual return of the S&P500 is 8-10%, and when we have two or more consecutive years of 20%+ returns, the reversion to the above average means that subsequent returns will be much lower, until the next leg of higher than average returns. Some will argue that "this time is different". This is a hope, of course. We are just stating real facts and data, here.
Disclaimer
• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.
• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.
• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.
• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.
• Sources: Chart of the Week : Apollo Management
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