Economic forecast SNB shock: lessons for investors

Great challanges for Swiss Economy.

by Stephan Lehmann-Maldonado 20 Oct 2015

What was good about 2014?

(Smiles) I was invited to address an audience of some 800 people at an event in Biel. That almost made me feel like a rock star! As Chief Economist, I'm especially pleased that we got our investment recommendations right – and that our Research department received an award for issuing the most accurate economic forecasts in the past few years.

2015 got off to an altogether more difficult start. The SNB ditched the EUR-CHF floor and you had to revise your economic forecasts significantly downward ...

The SNB's scrapping of the exchange rate floor came as a complete surprise to everyone, including us. Any sudden appreciation of the franc like this will obviously cause damage to the Swiss economy. We had to scale back our growth expectations for 2015 from 1.8% to 0.5%, which means we will probably just narrowly avoid a recession.

In your look at the year ahead, you had actually already warned of even greater movements.

Yes. The title of our “Year Ahead” publication that appeared in December is: The diverging world. Although the American economy is in good shape, Europe is lagging behind and the emerging markets are treading water. The US Federal Reserve is aiming to slowly tighten the reins, while the Europeans and Japanese continue to loosen them. Huge disparities are emerging in terms of economic policy, which may lead to surprises on the markets. 2012 and 2013 were fantastic years for equities, 2014 was already somewhat more volatile – and 2015 will be more so again. Which means the stock markets will actually be getting back to normal volatility.

What do you advise investors to do in this environment?

We recommend slightly overweighting high-risk investments, i.e. equities. And we prefer US equities. After the European Central Bank announced its bond-buying program at the end of January and began flooding the market with euros, we also started overweighting European equities in our portfolios. We have underweighted equities from emerging markets. In fixed income securities, we are sticking with corporate bonds and will continue to avoid government bonds, where Swiss franc investors now have to shell out even more money. That's why it actually makes sense to add hedge funds to your portfolio. There are tried-and-tested solutions available that generate stable and attractive returns combined with low fluctuations compared with bonds.

But equities are no longer valued favorably.

It's true that equities are trading somewhat above their long-term average values. But there is no alternative to this asset class. Focusing on equity markets with a good outlook is what matters. Corporate earnings are currently growing by 8 percent in the USA – so there's no reason to assume the stock market will collapse.

What global economic challenges can we expect to face in 2015?

The oil slump is changing the structure of the economy. There are winners and losers. Oil producers are among the losers, while consumers in the Western industrialized countries are on the winning side. Their purchasing power is increasing and that is boosting consumption. The European debt crisis remains a risk. For example, doubts arise in relation to Greece's budget figures. What's more, Europe is inching close to deflation.

What alternatives are there to the euro?

Once Mario Draghi, the President of the European Central Bank (ECB), opened the liquidity floodgates on January 22, the euro came under even more pressure. The previous dramatic surge in the franc following the SNB's out-of-the-blue announcement clearly illustrated yet again that investors should only take on currency risks if they are aware of the considerable risk involved.

Growth has slowed in the emerging markets. How should investors treat emerging market bonds?

I see emerging market bonds in local currencies as risky. Especially for countries that are failing to serve up reforms. These include Brazil and Russia, which is involved in warlike conflicts. I would tend to ditch these securities. Bonds in US dollars and Swiss francs are less risky. And bonds from countries enacting reforms are more attractive, too. India and Mexico are worth mentioning in this respect.

You have been recommending high yield bonds for some time now. Is that still the case?

We have been recommending high yield bonds for the past four years. Anyone who has added these to their portfolio since will have benefited from a sizeable spread. Although I would no longer additionally invest in these instruments on such a large scale, they still have certain points in their favor: the US economy is gathering pace, so we shouldn't expect many corporate bankruptcies. Any uncertainty stems from the fact that part of the American high yield bond market is reliant on the oil price.

When do you expect to see inflation?

It's amazing: the central banks have pumped huge amounts of money into the economy, yet there is still no sign of inflation. Just the opposite – in many places, deflation is a threat owing to falling prices. Inflation can only come about if and when the labor market dries up and salaries rise. We are still far removed from that scenario in Europe and Switzerland. Inflation rates are likely to rise first in the USA and the UK. US unemployment figures have fallen significantly and the Fed is already thinking about raising interest rates. But even there, it will be another year or two before inflation emerges as the current oil price decline is pushing the cost of living down.

So investors don't need to worry about maintaining their purchasing power?

In the medium to long-term it makes sense to protect yourself against inflation. That means changing the way you think: instead of parking money in a savings account, investors should buy sound equities with significant dividend yields. Equities may be subject to fluctuations, but they ultimately represent a real value. We can learn a lesson from the United Kingdom, where inflation stood at three to four percent a year. Because savings accounts no longer provide any return, you effectively end up with a loss – after just a few years you are down 10 percent.

How do you view Switzerland's prospects if the Eurozone fails to return to the growth path?

The Eurozone is by far Switzerland's most important trading partner. Despite the recession in Europe and the strong franc, the Swiss economy has performed really well over the past five years. Why? Because our economy has been driven by far too cheap money and by immigration. These factors alone led to basic growth of one to one-and-a-half percent. However, the sudden appreciation of the franc following the abandonment of the EUR-CHF floor will now put a considerable damper on the Swiss economy.

Can the ECB strengthen the European economy by pumping even more liquidity into the market?

The ECB has announced a full-blown bond-buying program through which it will also buy up government bonds and release more than 1.1 trillion euros into the markets by September 2016. However, it is doubtful as to what extent this will stimulate the economy. An even weaker euro will certainly help export companies. But as to whether the many SMEs that are focused on the domestic market will really set off a new investment cycle: that requires more than just cheap money. Structural reforms, such as labor market deregulation, are also badly needed. And France and Italy are struggling with these aspects. 

So how will Europe develop in 2015?

We expect to see growth speed up slightly as a whole. All that cheap money is likely to have a certain effect, after all. The equity markets will continue to climb, the euro will weaken. All of which will help, but it's hardly likely to be the liberating blow that puts an end to the debt crisis.

For some time now, the EU and USA have been in negotiations over a free trade agreement (TTIP). What effect will this have on Switzerland?

For a small country like Switzerland, there is a danger of its being worn down by the large trading blocks if there's a trade agreement between them. From Switzerland's viewpoint, a global opening up of trade under the auspices of the World Trade Organization (WTO) would be better. In any case, Switzerland now has to try and conclude free trade agreements with many of the large nations - as it managed to do with China.

Coming back to the Swiss National Bank: what can it still do to weaken the franc?

It can scarcely introduce a minimum exchange rate again. That instrument has burned itself out, is no longer credible. The SNB will try and use ad hoc interventions to weaken the franc if it becomes too strong. On top of which it can also tighten the screw a bit more, not only by taking interest rates further into negative territory but also by lowering the current exemption threshold of twenty times the minimum reserve requirement so that even more banks would be affected by negative interest.

What lessons can investors learn from the SNB's decision and from the subsequent massive slump in Swiss equities and in the euro and US dollar?

It has been shown that, contrary to widespread belief, too much of a “home bias”, i.e. practically holding only Swiss (equity) securities, can indeed be problematic. While the Swiss equity market lost almost 18% in the two days following the announcement of the SNB's decision to abandon the exchange rate floor, the global equity market actually picked up slightly. We have repeatedly drawn attention to our recommendation that even those investors who live in supposedly safe Switzerland put together a globally well-diversified portfolio. In a nutshell: global diversification was an absolute key priority and will remain so in future.

And what could have been done by investors with foreign exposures to prevent a fall in currency values?

CHF investors should make absolutely sure to hedge any foreign investments they hold against currency risk. This is done consistently in the investment solutions offered to clients who delegate their asset management to us. Foreign investments were therefore protected against a strong slump in foreign currencies even in the days following the SNB's decision. Given the very low interest rate differentials that prevail worldwide, currency hedging can be performed at a relatively reasonable cost. So whoever was invested in a globally well-diversified portfolio in which the investments in foreign markets are hedged against currency devaluations, is bound to have fared better than someone with a strong concentration risk in Swiss equities or an investor with no protection against currency risks. These considerations once again underline how important it is to build an investment portfolio that follows a clearly structured investment strategy and to implement the defined strategy with lots of discipline.

What is your personal investment tip for 2015?

Invest in a diversified portfolio with sound equities and high dividend yields!

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