Principles of structural and cyclical analysis of economies and interest rate levels
Focusing on facts and not on “stories”:
A constant effort to detect and understand relevant key factors and avoid information overload, headlines and “noise”.
Discipline, structure and know-how in the collection and monitoring of relevant economic data:
A constant effort to achieve consistency and comparability over time, economic areas and markets in order to comprehend new realities.
The fundamentals (quality) must always be compared with market valuations (price):
Development of economically meaningful, relevant evaluation benchmarks based on fundamental analysis. This is the only way to give a well-founded opinion on “fair”, “expensive” or “cheap” market prices, both in absolute and relative terms.
Careful and continuous search for opportunities:
Continuous, systematic, disciplined and extensive screening of markets for discrepancies and gaps between fundamentals and valuations, in order to detect and take advantage of opportunities as fully and quickly as possible.
Fundamentals: structural analysis
The analysis of the relevant macroeconomic data of countries is intended to determine their vulnerability at an early stage and ultimately to identify strengths, weaknesses or even countries at risk. This identification process is a central component of our macroeconomic country analysis. In fact, this process can be crucial not only to avoid weaknesses and countries at risk at an early stage, but also to know which countries have the potential to recover and which have not, and to know when. The analysis of countries with a potential for recovery and similarly the avoidance of weaknesses and countries at risk may indeed contribute to the generation of added value.
The structural analysis of the fundamentals includes the following dimensions and factors, which must not be considered individually but as a whole (e.g. a liquidity problem can become more or less threatening depending on a country’s solvency or debt level):
Economic structure and power
GDP per capita
Income distribution - Gini coefficient
Economic diversification - the more diversified an economy, the more stable it is
Growth potential - long-term, structural growth
Growth volatility - characteristics/potential escalation of growth cycles
Competitivity - unit labour costs
Monetary flexibility
Exchange rate - fixed or flexible
Inflation potential - long-term, structural inflation
Inflation volatility - effects/potential escalation of inflation cycles
Fiscal flexibility
National debt - in % of GDP
Maturity profile of public debt
Budget deficit - in % of GDP
Sustainability - interest expenditure in % of government revenue
Government revenue - in % of GDP, average tax rate
Debt dynamics - interest rate level minus nominal growth
Private debt - in % of GDP
Foreign trade flexibility
Current account balance - in % of GDP, deficit financing (including foreign exchange reserves and FDI)
External debt - short/long term, in % of GDP, of foreign exchange reserves, of exports
Domestic savings rate - domestic financing capacity
Contingent liabilities, in particular, banking sector risks
Banking sector volume - total assets in % of GDP
Leverage - equity/assets
External debt - in % of GDP
House prices - central security in the banking sector
Political situation
The analysis of these factors is performed continuously, using the same set of factors for all countries as a starting point. This enables us to achieve a high degree of homogeneity in terms of the analysis of countries and thus meaningful comparisons, both over time and between countries. Thus, the analysis can focus on the early detection of trends and of inflection points.
Of course, the value of any fundamental analysis relies on the team’s ability to identify the relevant factors, to raise them homogeneously and to identify trends, critical levels and inversion points in a country’s vulnerability. Accordingly, our team has invested considerable time in understanding and detecting relevant factors in the past, and this will remain a key task in the future.
Fundamentals: cyclical analysis
In addition to the structural vulnerability of a country, the domestic and global economic cycle is an important driver of absolute and relative interest rates and country risk. Understanding where an economic area is within the economic cycle and in which direction it is moving (boom, slowdown, recession, upswing) makes it possible to generate added value from movements in interest rates and risk premiums.
The cyclical analysis of fundamentals involves the following dimensions and factors, and requires that both domestic and global factors be taken into account. In fact, a country’s economic cycle is influenced to a greater or lesser extent by both domestic and global factors, and the understanding of this interaction is essential:
Identification of the phase within the economic cycle (boom, slowdown, recession, upswing)
Leading/coincidence indices
Purchasing managers’ indices (PMI)
Surprise indices - market expectations versus reality
Aggregation and diffusion indices
Credit growth and momentum - 1st and 2nd derivation of private debt
Evaluating the strength of the cycle
As with the structural analysis, the analysis of these cyclical factors is continuous, with the same set of factors being raised for all countries as a starting point. This allows us to achieve a high degree of homogeneity in terms of the analysis of cycles and thus meaningful comparisons, both over time and between countries. Once again, the analysis can focus on the early detection of trends and inversion points in cycles, and thus, on the anticipation of movements in interest rates and risk premiums. Last but not least, this proprietary, homogeneous cyclical analysis enables us to simplify the enormous data flood and complexity in a structured and relevant manner.
Valuation
The structural and cyclical analysis of the fundamentals must be related to the valuation, i.e. the market rates. Only this relationship can lead to investment decisions and active interest rate strategies. We basically distinguish between absolute and relative valuation and the corresponding active interest rate strategies. In both cases, it is crucial that meaningful, relevant valuation anchors based on fundamental analysis are found. These valuation anchors or models allow us to make an informed decision as to whether market prices are “fairly” valued, or whether discrepancies or “gaps” exist relative to the fundamentals, and whether market price valuations are “expensive” or “cheap”, both in absolute and relative terms. In this process it is important that a permanent, systematic, disciplined and extensive screening of the markets occurs, in order to be able to spot such discrepancies or “gaps” between fundamentals and valuations, and to identify and exploit any opportunities as extensively and as early as possible.
The following valuation anchors or models are applied systematically and homogeneously:
Structural interest rate evaluation
Based on our analysis of the fundamentals, we determine a “fair” structural equilibrium interest rate level for a given country, consisting of the long-term real growth potential and the long-term inflation potential, i.e. a “fair” long-term nominal interest rate level. This “fair” equilibrium interest rate level is compared to the current interest rate level in the market and allows us to evaluate whether the interest rates are “fair”, “cheap”, or “expensive”. In this context, the interest rate level of the market must also express a long-term interest rate level, which is why the implied forward interest rates in the interest rate curve are used for comparison purposes.
The implementation of this structural interest rate evaluation enables not only the evaluation of nominal interest rates, but at the same time the separate evaluation of real interest rates and inflation expectations and thus the separate evaluation of inflation-protected bonds and break-even inflation rates (where applicable). Long-term real growth potential represents the valuation anchor for real interest rates traded in the market and long-term inflation potential represents the valuation anchor for break-even inflation rates traded in the market. As a result, it can be assessed whether real interest rates and inflation expectations can be considered “fair”, “cheap” or “expensive”.
Cyclical interest rate evaluation
The cyclical analysis of fundamentals, i.e. where a country is in the economic cycle and in which direction it is moving, is compared with the market interest rate and its movements, thus allowing to identify any discrepancies or “gaps”. In particular, the comparison of market expectations and surprises regarding fundamentals on the one hand and interest rates on the other represents an important anchor for cyclical interest rate evaluation. Discrepancies or “gaps” between the economic cycle and the market interest rates can again be identified and exploited. Understanding how the respective central banks will react is another essential element of the cyclical interest rate evaluation – although it remains very challenging to identify a relevant valuation anchor in this case.
Interest rate curve evaluation
Cyclical and structural evaluation of the interest rates is also part of the interest rate curve evaluation:
Interest rate curves, i.e. the incrementation and the numerous ratios within the curve, often perform directionally to the interest rate cycle and interest rate movements. This cyclical directionality must be identified and considered by means of the historical analysis of interest rate cycles. The comparison of the interest rate curve and levels allows to identify and exploit discrepancies and “gaps”.
The structural evaluation of the interest rates compared with the entire interest rate curve provides insights into the speed at which individual sections of the interest rate curve are priced by the market and how far from or how close to the equilibrium level the price is, thus allowing insights into their relative attractiveness.
In another step, the fact that carry and roll-down returns are important drivers for successful interest rate curve strategies is taken into account, in addition to the described directionality. This income component is systematically and continuously calculated and, based on its relative attractiveness, included within the interest rate curve and the interest rate curve positioning.
Country risk evaluation
The evaluation of country risks is obviously based on the comparison of the described structural analysis of the fundamentals (and thus the vulnerability of a given country) on the one hand, and the risk premium for a given country on the other hand.
In addition, the described structural evaluation of the interest rates is also applied to countries fraught with risk and the “fair” long-term nominal interest rate level is compared to the implied forward interest rates (including the separate evaluation of real interest rates and inflation expectations described above).
In order to manage the country risk, the structural evaluation of the interest rates is completed by the country’s explicit risk premium. In this process the long-term real growth potential of a country is modelled in a risk-adjusted manner by adding the respective risk premium of the country (CDS market spread) to a real “global” or “regional” long-term growth potential. This results in an explicitly risk-adjusted and “fair” real and nominal interest rate level, which in turn can be compared with the implied forward interest rates.
Currency evaluation
The structural evaluation of currencies is performed systematically on the basis of common methods, such as PPP (Purchasing Power Parity) and REER (Real Effective Exchange Rate), which are supplemented by proprietary analyses (e.g. Z-scores, analysis and evolution of terms of trade). In addition, currency pairs are evaluated in accordance with cyclical factors and searched for discrepancies or “gaps”, in particular differences in growth momentum (relative surprise indices), in inflation momentum (relative surprise indices) and in carry return (interest rate differentials).
Instrument evaluation
Finally, the relative evaluation of the individual instruments available for optimal portfolio construction, i.e. cash investments versus derivatives, investments in different currencies on a currency-hedged basis, individual bonds, etc., is performed.
All valuation anchors and models can be applied for both absolute and relative evaluation, and for the corresponding generation of interest rate and country strategies. An example: cyclical interest rate evaluation can lead to a long duration in EUR interest rates in absolute terms if EUR interest rates shift away from the cyclical momentum in the eurozone. The cyclical interest rate evaluation can lead to a long duration in EUR interest rates in relative terms and a short duration in CHF interest rates if the EUR-CHF interest rate differential shifts away from the difference in the cyclical momentum in the eurozone and Switzerland.