investment insights

    Testing Swiss resilience

    Testing Swiss resilience
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Key takeaways

    • The Swiss economy is forecast to rebound slightly next year from 2019’s slowdown
    • Any improvement in international trade, plus bottoming-out manufacturing activity, should support the euro-dollar and weaken the franc as a haven currency
    • SMI equities are not particularly expensive against historic premia, dividend yields remain attractive
    • Swiss real estate looks sound and central commercial and residential markets should deliver positive rents
    • Portfolio construction with a global strategy remains key for Swiss investors

    Faced with the threats of recession, deflation and a challenging global trade outlook, the resilience of Switzerland’s export-oriented economy continues to be tested. In this environment, five years after first cutting interest rates into negative territory, we expect the Swiss National Bank to carry its accommodative monetary policy into next year and beyond.

    The Swiss economy has slowed dramatically. Gross domestic product growth expanded 2.5% in 2018 and is expected to have slowed to 1% in 2019. Next year, the economy may rebound slightly with headline growth of as much as 1.5%, including a 0.5% boost from sporting events, leaving underlying growth at 1.0%, according to our forecasts. Indeed, with inflation expected to rise only 0.1% in 2020 as domestic demand, wage growth and household spending continue to slow, it seems likely that the SNB may cut interest rates even further into negative territory later in the year.

    Switzerland remains highly dependent on international trade. 2020 should bring some relief once the US and China move ahead with their promises of a truce in their trade dispute. Any eventual improvement in global trade may particularly affect Switzerland through its biggest markets; Germany and the US (see chart 1). Germany, which accounted for more than one-sixth of Swiss exports by value in 2018, has suffered from the US/China trade tensions, as well as from Trump administration threats to impose tariffs on its carmakers.

    Faced with the threats of recession, deflation and a challenging global trade outlook, the resilience of Switzerland’s export-oriented economy continues to be tested.

    Chemical and pharmaceutical goods accounted for 45% of all exports in 2018, making it the country’s largest goods export sector. Machinery and electronics made up 14% of exports, and Swiss watch shipments in 2018 accounted for 21.2 billion francs of exports, or 9.1% of all exports by value.

    Taken as a whole, the European Union remains Switzerland’s largest market, accounting for 52% of exports and 70% of imports last year. Negotiations between Switzerland and the EU to conclude a single market access agreement consolidating more than 120 bilateral agreements stalled this year.

    The talks, now almost five years old, are stumbling over a series of disagreements. These include how to manage wage protection and social assistance, as well as mechanisms for resolving disputes between EU and Swiss laws in future. With Swiss voters set to decide on an immigration initiative in May 2020, there are few expectations for progress in the meantime.

    The franc does not look expensive

    Franc strength

    On the currency side, the franc’s safe-haven status means that developments in the global economy, rather than purely Swiss factors, are likely to drive the franc. The first factor is clearly the expected stabilisation in the US/China trade relationship. Any modest improvement in trade growth, coupled with the bottoming out of manufacturing activity seen recently, should support the euro-dollar and weaken the franc as a haven currency. Our forecast for the end of 2020 is that EURCHF will trade at 1.12, with upside risks. Historically, upside in EURUSD has coincided with upside in EURCHF.

    For now, however, the widely held view is that the franc is overvalued. SNB Chairman Thomas Jordan, for example, said last week that the currency “remains highly valued, and the situation on the foreign exchange market is still fragile.” However, in the context of Switzerland’s current account surplus of more than 10% of GDP, the currency does not look expensive.

    Any modest improvement in trade growth, coupled with the bottoming out of manufacturing activity seen recently, should support the euro-dollar and weaken the franc as a haven currency.

    On the downside, we believe that any decline would be limited to the 1.08 or 1.07 levels, since the SNB has shown itself prepared to intervene significantly at these levels (see chart 2).

    SNB assets and fixed income

    Thanks to those interventions to cap the franc’s rise, the SNB has built a balance sheet that hit a record 861 billion Swiss francs in October 2019. That represents an unusually large investment portfolio for a central bank of the size of Switzerland’s, the equivalent of one-sixth of the European Central Bank’s balance sheet and 122% of Switzerland’s GDP.

    Some of these assets include fossil fuel investments, which the SNB may have to sell as part of changes to the bank’s mandate. Swiss legislators are preparing to add climate change to the SNB’s list of policy targets, along with its traditional monetary objectives of price stability and economic stimulus. The SNB is resisting that change, arguing that it is already prevented from investing in environmentally harmful assets. “It is not part of the SNB’s mandate to promote or disadvantage certain companies or sectors,” said board member Thomas Moser recently. “The aim is to avoid such conflicts of interest at all costs.”

    In fixed income, the Swiss yield curve has flattened and normalised, following the US yield curve recently. Still, most Swiss sovereign debt now offers negative yields along with much of the corporate bond market. To put it mildly, that severely limits the attractiveness of Swiss fixed income for international investors.

    In addition to the structural illiquidity of the Swiss bond market, each year the flow of issues slows, choked by negative absolute returns. If Switzerland’s economy shows signs of improvement in 2020, we would expect to see the yield curve steepen, with yields rising around 40 basis points on the 10-year note, in other words from -0.6% to -0.2%.

    Value in Swiss stocks

    Turning to equities, total return including dividends in both the mid and small cap Swiss Performance Index EXTRA and larger Swiss Market Index was exceptional at 29% year to date. Returns in 2020 will almost certainly be more modest. Nevertheless, we continue to see value in the Swiss equity market, as well as in dividend yields.

    The obvious question then is whether Swiss stocks are expensive. While the SMI’s forward price-to-earnings ratio is 16 times, compared with the Euro Stoxx 50’s 14.2 times, that is not particularly expensive compared with the historic premium of 20%. The SPIEX’s forward PE is at the high end of its historical premium compared with European peers, at 21 times.

    However, the SMI and SPIEX are expected to generate average dividend yields of 3% and 2.3% respectively in 2020, providing clearly attractive investments in this negative interest rate environment. Our preference, in the circumstances, is to build balanced portfolios exposed to both large caps and selective, high quality mid and small cap names.

    …we expect commercial and central residential real estate to deliver positive rental growth

    Locating real estate yield

    In this environment of limited yield opportunities, it is logical for investors to turn to real assets, in particular Swiss real estate. Overall, the Swiss residential and commercial property markets are sound. However, the peripheral residential markets look oversupplied. This oversupply is set to continue as institutional investors keep placing capital and develop new properties in markets that are already recording rising vacancy rates.

    As a result, we expect commercial and central residential markets to deliver positive rental growth while peripheral residential markets register zero-to-negative rental growth.

    This should generate a price increase of 1% at most in the property market as a whole. Given the active management of Swiss real estate fund managers, we expect a 1% increase in Net Asset Values in 2020 for listed portfolios. We also expect to see investors earn dividend yields of around 2.5% in 2020. That is of course appealing compared with sovereign bond yields, and supports the real estate asset class generally.

    The main risk to this outlook comes from Swiss listed real estate fund valuations where premiums are close to the record levels seen in August 2017. After supportive inflows over December, these high premiums mean that we would not be surprised to see some profit taking in the asset class, leading to volatility in 2020.

    Although it is difficult to predict capital market activity in the real estate sector, we do not anticipate many Initial Public Offerings next year. We should see demand for any additional supply, as long as spreads between rental yield and interest rates remain attractive.

    Robust portfolio construction still key

    For Swiss-based investors, the past few years have underlined the value and the importance of a global investment strategy. Looking forward, the formula of a well-diversified portfolio including exposure to real assets, along with adequate protections to weather the challenges of high asset valuations and geopolitical volatility, remains the best policy.

    Finally, as our thoughts turn to the festive season, we would like to wish you all a healthy, happy and prosperous 2020.

    Wichtige Hinweise.

    Die vorliegende Marketingmitteilung wurde von der Bank Lombard Odier & Co AG oder einer Geschäftseinheit der Gruppe (nachstehend “Lombard Odier”) herausgegeben. Sie ist weder für die Abgabe, Veröffentlichung oder Verwendung in Rechtsordnungen bestimmt, in denen eine solche Abgabe, Veröffentlichung oder Verwendung rechtswidrig wäre, noch richtet sie sich an Personen oder Rechtsstrukturen, an die eine entsprechende Abgabe rechtswidrig wäre.

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