Switzerland remains one of the most anomalously and counterintuitively performing shares markets worldwide. Even though the composite year-to-date return of the most liquid stocks on the Zurich, Basel and Geneva exchanges – as measured by the Swiss Market Index – has varied considerably in the aftermath of the Swiss National Bank’s sudden decision on January 15 to abandon the nearly three-year-old Swiss franc (CHF) floor (or currency peg) of CHF1.20 that it had been defending against the euro (EUR), a gain of 9.2 percent in US dollar (USD) terms (3.6 and 18.4 percent when denominated in CHF and EUR, respectively) is remarkable in light of the competitiveness foregone as a result of the CHF’s 12.4 percent appreciation on a trade-weighted, spot-market basis in the past four months.
Furthermore, Swiss Confederation bonds have eclipsed American and British sovereign debt in performance regardless of currency denomination and now rank strongest globally across the entire maturity spectrum due to persistent refuge demand arising from Russian subversion in Eastern Europe and mounting uncertainty over Greece’s future in the European Monetary Union (EMU). Earlier in the year, Swiss government issuance had been vying neck-and-neck with US and UK sovereign bonds, but – since then – has overtaken both safe haven alternatives. In either USD, CHF, GBP, JPY or EUR terms, Swiss sovereign debt thus far this year has scored impressive single- to double-digit gains of increasing magnitude the longer to redemption.
Reflecting vigorous investor confidence in the domestic equity and fixed income markets, the CHF has been the second sturdiest currency against any of its reserve counterparts since the beginning of the year, having appreciated 6.7, 7.0, 15.0 and 9.5 percent versus the USD, Japanese yen (JPY), EUR and British pound (GBP), respectively, during the last four months in spite of record low interest rates that the central bank – the Swiss National Bank (SNB) – has implemented for the purpose of weakening the currency and restoring a measure of export competitiveness. In fact, the monetary authorities have had to follow their fellow Western European central banks in adopting a parallel policy of reducing its key lending three-month CHF LIBOR lending rate into negative territory in order to discourage refuge demand for Swiss unit.
Even so, a buoyant CHF has had an adverse, double-edged effect on the Swiss economy. On the one hand, the soaring franc has had a detrimental impact on foreign trade. By increasing the cost of goods and services sold abroad, CHF strength has effectively reduced the competitiveness of its world-class corporations vis-à-vis their rivals in Germany, Japan, the US, Great Britain and elsewhere, evident in a narrowing of the current account surplus as a share of nominal gross domestic product (GDP).
On the other hand, a vigorous Swiss currency is steering the trend in the country’s cost of living in a potentially perilous direction. Having flirted with deflation in the past six years, Switzerland has witnessed a dramatic worsening of its price patterns since November of last year. Deflation is speeding toward single-digit rates at the headline level and the living costs excluding food and energy transitioned from a zero to negative pace of advance in March. Like the Eurozone, the consensus outlook for inflation in Switzerland looks gloomy this year and next.
Monetary policy will proceed to counteract the economically disadvantageous influences of a strong franc and persistent deflation with its entire armory of defensive weapons. Nevertheless, the SNB’s arsenal is limited in its power to deter foreign safe-haven investment in its debt and equity markets. Until Athens comes to terms with Brussels on reforming its economy and fulfilling the obligations of its austerity program and Moscow halts its territorial violations in Ukraine and the Baltic nations, refuge demand for Swiss assets will proceed apace, preventing the SNB from restoring conventionality to its monetary policy anytime soon.
A disciplined fiscal policy will accompany a generously accommodative credit policy through 2015. Notable for its long-standing history of budgetary prudence, Bern’s reputation for maintaining strict control of federal spending should preserve the country’s much cherished triple-A credit rating for the foreseeable future. A balanced budget is projected in each of the next three years unless, of course, the economy takes a decided turn for the worse requiring the multi-party government to undertake countercyclical fiscal measures to pump prime domestic demand.
Inauspicious export and fiscal effects aside, domestic deflationary pressures are forecast to depress macroeconomic growth through 2016. Median forecasts, compiled by Bloomberg, foresee real GDP expanding fractionally this year before accelerating to a 1.2 percent rate of growth next year. Negative living costs will hold down personal consumption as will a modestly higher jobless rate. Capital spending, despite extremely low lending rates, should remain flat, and with government spending on hold and overseas exports trending lower, the economy is unlikely to experience much upside momentum in 2014 and 2015.
Although Swiss shares remain compositely undervalued on a relative value basis compared with their benchmark (S&P Europe 350 index), their premium in absolute terms to nearly all their competitors in Western Europe – together with dormant economic prospects amid hastening deflation – discourages Global Markets Intelligence (GMI) from assessing anything more than a market-weight for the SMI. The 17.9x one-year, positive-adjusted price earnings multiple (p/e) compares unfavorably to that of German, French, Italian and British stocks, but is cheaper than Dutch and Danish shares, which trade at a discount to the SMI.
We reaffirm our market-neutral emphasis of Swiss equities aggregately on account of the mixed picture depicted by valuations in addition to the anemic outlook for domestic demand and the anticipated persistence of declining living costs for the duration of 2014 and perhaps the first half of next year. Investors should stay selective and avoid companies that derive an undue proportion of their earnings from exports abroad and concentrate instead on firms with either balanced or prodigious domestic sources of revenue.