Making our way back to a more familiar way of life
EARLY in the pandemic, and pre-lockdown, Kleinwort Hambros suggested a potential best case, ‘V’-shaped scenario where fears are overblown, and the pathogen is quickly contained, and ‘economies and equity markets rebound sharply’. We also noted a potential worst case, where the epidemic becomes a serious pandemic, and global economies enter recession and we enter a bear market for risk assets. With the benefit of hindsight, the worst-case scenario is what ensued. What many didn’t foresee was the shocking bounce back in risk assets, if not economies.
With the benefit of hindsight it is easy to see how pundits and forecasters were wrong-footed during such a volatile time. Lockdowns were imposed to control transmission of the virus, but there was little clarity on how long they would last. Governments and central banks unleashed unthinkable levels of fiscal spending and monetary stimulus to help stabilise economies and provide liquidity to financial markets. This was followed by much better news on the viral front: lockdowns are slowly being eased in China, Europe and North America; and therapeutics and a vaccine are being actively developed.
As we creep back to a more familiar way of life, we believe it is more important than ever to remain moored to Kleinwort Hambros’s time-tested investment process. Our process is built for the long-term and designed exactly to help guide us in times such as these. This is how the four pillars of the process appear at present:
. Economic Regime: In aggregate, the global economy will suffer its deepest recession since World War II in 2020 according to the World Bank’s latest forecast (8 June), with global output set to contract by 5.2%. Per capita income will fall in the largest proportion of countries globally since 1870. While they are opening, advanced economies are still projected to shrink by 7% this year. Growth may well rebound strongly in 2021, but this will depend on no major second wave of infections leading to renewed lockdowns, among other things. In perfect conditions, a rebound may begin as soon as the third quarter. We will be guided partly by if our in-house Leading Economic Macro Indicator (LEMI) turns from a ‘regime’ of recession into one of recovery. Should it do so, we will consider it favourable to risk-taking. We are not there yet.
. Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging on absolute terms. The US equity market, equal to nearly 60% of the global total, is currently trading at a forward price-to-earnings multiple of 22.6x, the highest since 2002. That is expensive. However, with rates near zero, there is a good case for a higher than usual tolerance to valuations, particularly for large-cap companies that appear to be immune to the business cycle (‘secular growth’). When compared to cash or government bonds, equities still have a clear advantage in terms of long-term expected returns. While equities are expensive, the situation is nuanced and far from clear-cut.
. Momentum: The recent surge in equity markets is a case in point of why momentum is a critical factor in our asset allocation process. We view momentum on a slow moving, month-end basis. There is good reason for this, as it helps avoid whipsaw in oscillating markets and for us to take advantage of trends that have sufficient strength. On that basis, as of the end of May, the global equity market was close to, but not above, the ten-month moving average metric that we favour. Should momentum on the global equity level tip into positive momentum on a sustained basis, we will view it positively from a risk-taking standpoint.
. Sentiment: Sentiment for risk assets has oscillated wildly over the last few months. Given the strength of the rally over the last two months, there may well be some over-optimism. Of the indicators we follow, some, such as the S&P 500 net speculative positions imply more bullishness. Others, such as the ten-year US treasury net speculative positions, imply more bearishness. Overall, we are in neutral territory.
Taking all of that into account, we remain cautiously positioned in our risk allocations. A month can be a long time in markets, and risks – from the pandemic or elsewhere – may strike with staggering market reactions.
. For more information please visit https://www.kleinworthambros.com/en/markets-and-insights/markets/strategy/.
