investment viewpoints
Swiss bright spots amid global uncertainty
Geopolitical uncertainty is the key driver of the outlook at present, fomenting a global economic slowdown as the US-China trade dispute takes its toll. We expect a worsening of global data to drive monetary policy accommodation in both the US and Eurozone, given low inflation generally. Even so, some areas of Switzerland are signalling bright spots in the domestic economy.
Amid the global deterioration in growth, central bank easing remains our baseline scenario for the US Federal Reserve and European Central Bank (ECB). In the Eurozone, the ECB has ratcheted up stimulus talk, and we expect the ECB to provide further accommodation, eventually re-starting its quantitative easing (QE) programme with a focus on corporate bonds.
Swiss economic data, meanwhile, have emulated the dip in the neighbouring Eurozone. After rising slightly in the spring, the KOF leading indicator was lower again in June and is markedly softer than December 2017 peaks. The weakness in German manufacturing has likewise been seen in Switzerland, as Swiss PMI fell further in June and undershot forecasts. While Swiss March GDP figures surprised to the upside, considerable time has passed, and thus we expect September GDP to mirror sluggish global growth.
Against this backdrop, there is also cause for optimism, however. We highlight the robust Swiss labour market and positive economic surprises. Put simply, the labour market in Switzerland looks strong as the June unemployment rate (seasonally adjusted) retreated to multi-year lows. Secondly, Swiss economic surprise indicators seem to have turned a corner, with figures surprising less to the downside.
Inflation, the SNB and the franc
Turning to inflation, imported vs domestic inflation remains a key issue in Switzerland. The strength of the Swiss franc has dampened imported inflation, leaving only domestic drivers for inflation. This means the inflation outlook appears rather subdued unless some sort of external shock (for instance oil prices) were to drive inflation higher. For the time being, we see inflation remaining muted as long as the Swiss franc remains firm and uncertainty reigns globally.
At its June meeting, the Swiss National Bank (SNB) maintained its expansionary monetary policy and said it will remain active in foreign exchange markets as necessary because the franc is still highly valued. The SNB moved its June conditional inflation forecasts slightly higher than March forecasts, but highlighted that the longer-term inflation outlook is virtually unchanged. While stressing positive labour markets domestically, the bank also warned of potential downside risks to Swiss GDP growth from a sharp slowdown internationally.
We expect the SNB to keep rates steady here, while closely tracking the Eurozone and global developments, as well as the Swiss franc. If the Swiss labour market continues to be buoyant, it could eventually feed through to inflation. That, however, is not happening at the moment. Instead, domestic developments appear more at risk of being dragged down by the uncertain global environment.
We believe the SNB will be steered by other central banks, and look to maintain the Swiss interest rate differential to other countries’ policy rates in order to stem potential currency strength.
We expect the SNB to keep rates steady here, while closely tracking the Eurozone and global developments, as well as the Swiss franc.
A key risk to the Swiss outlook would be a concert of deep global policy accommodation that leads to currency side effects. A race to the bottom in global cuts would strengthen the Swiss franc and force the SNB’s hand. It might react by reducing rates or stepping up currency interventions. The SNB would likely be challenged responding to an ECB QE programme, which could soften yields materially.
Only time will tell how global developments pan out and influence the Swiss economy. The current geopolitical uncertainty could prove to be just a temporary shock, or the decline could become more entrenched and warrant a larger dose of stimulus.
At this juncture, we broadly expect the Swiss economy to continue on its current trajectory, with potentially a small pick-up in activity, and a benign inflation outlook. Global developments, meanwhile, will depend on the trade war, not to mention the Fed and ECB responses, all of which appear to be hovering in an unstable equilibrium at present.
The current environment reinforces the outlook for low rates and investors searching for yield. We see compelling arguments for corporate bonds denominated in CHF with shorter-dated exposure. A dedicated and disciplined approach is best suited to exploit the return potential available in Swiss credit, in our view.
SARON, in with the new
Amid benchmark rate reforms and the expected retirement of LIBOR1, the SNB has introduced a new policy rate called the Swiss average rate overnight, or SARON2. From now on, the SNB will use SARON for its target range rather than LIBOR. The central bank reasoned that SARON is the most representative short-term money market rate today and is establishing itself as the reference rate for financial products.
Because the SNB targets inflation with a three-year horizon, it needs a rate that will be in existence over that future timespan. The UK’s Financial Conduct Authority cannot ensure that LIBOR will exist as a reference rate after 2021 as the market transitions to alternative risk-free rates.
The move to SARON particularly affects interest rate swaps where the floating rate leg is linked to LIBOR but increasingly migrating to SARON. The interbank market remains largely based on LIBOR, and CHF swap traders estimate that only about 10% of CHF swaps are traded against SARON at present. Demand, however, is increasing continuously.
Looking ahead, we see areas of resilience in the Swiss economy but risks emanating from the uncertain geopolitical outlook. Amid a muted inflation outlook, we expect the SNB to track global central banks and support the outlook for CHF-denominated corporate bonds. The SNB’s hallmark on SARON as its policy rate is a manifestation of broader trends in risk-free rates.
sources.
1 A ubiquitous, unsecured rate, LIBOR stands for London interbank offered rate. The FCA set out the future beyond LIBOR back in 2017. Earlier this year it updated the state of play in the transition to risk-free rates.
2 SARON is a secured overnight rate based on the most liquid segment of the Swiss franc money market.
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