Kleinwort Hambros: Is it over?

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If ever there was a data point that confounded the collective investment community, it was the May figure for the US non-farm payrolls. Released in the first week of June, it was supposed to confirm the expectations of another dramatic loss in jobs across the world’s largest economy – 7.5 million job losses to be exact. The figure came out as 2.5 million – that is 2.5 million jobs added. Such a massive miss by forecasters and pundits will forever live in infamy.

In its June Monthly House Views, Kleinwort Hambros writes:

To be fair, the current economic and market environment is rife with non-sequiturs. On one hand, the 2.5 million jobs added in the US – the world’s largest and single most important economy – is the highest on record. On the other, the US is experiencing the highest unemployment rate since the Great Depression (marginally lower than the prior month).

On one hand, global equity markets have just suffered the fastest and most intense fall into a bear market in history, with the MSCI AC World index suffering falling 32.6% from 19 February to 23 March. On the other, they have rocketed back into one of the fastest post-WWII bull markets of all-time, with the global equity index up 38.5% between 23 March and 8 June. On one hand, US corporate earnings are expected to be down over 20% in 2020 in aggregate. On the other, segments of the markets – particularly large, growth-oriented technology companies – have either benefitted from the pandemic (e.g. Netflix, Amazon) or are considered resilient to it (e.g. Apple, Microsoft). We could go on and on, but the point it clear.

It is easy to see how pundits and forecasters can be wrongfooted in an environment with glaring contradictions. With the benefit of hindsight, let’s focus on what we do know. First, the huge losses in March were due to a viral pandemic that was out of control. The subsequent lockdowns that were imposed brought a measure of control on the viral transmission, but there was little clarity on how long they would last. Second, governments and central banks unleashed hitherto unthinkable levels of fiscal spending and monetary stimulus to help stabilise economies and provide liquidity to financial markets. The latter, where governments have essentially backstopped wages and cashflows for now, ended up being “enough” to underpin a powerful fillip in markets. Moreover, there is much better news on the viral front: lockdowns are slowly being eased in China, Europe and North America; there is development on both therapeutics (i.e. Remdesivir) and a vaccine (i.e. a number of trials are have progressed to wide-scale human testing); and we are far better prepared for a second-wave, should it come.

These are important and powerful factors, and we take them into account. Nonetheless, it is more important than ever to remain moored by our time-tested investment process, and not be carried away by the emotions (“Fear Of Missing Out”) of any given day or month, particularly in a period of such uncertainty. Our process is built for the long-term and designed exactly to help guide us in times such as these where passionate cases can eloquently be made for increasing or decreasing risk. 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, amongst other things. In perfect conditions, a rebound may begin as soon as the third quarter. We will be guided partly by if our inhouse 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”). Moreover, when compared to cash or government bonds, equities still have a clear advantage in terms of long-term expected returns. Therefore, 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. Markets don’t have to follow expectations, or even logic, and trends themselves can prove to be self-fulfilling. However, 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. When peeking beneath the hood, there is reasonable divergence between regions and sectors. 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. At present, it is well off the lows seen in March, far from the pure, unadulterated pessimism that usually marks a bottom, and where we get more excited about risk-taking. 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.

Bottom Line
Taking all the above into account, the Kleinwort Hambros Investment Committee has chosen, for now, to remain cautiously positioned in its risk allocations. Markets remain volatile (e.g. VIX near 30, well above its long-term average) and thus more unpredictable than usual; a significant drawdown is more than possible. We will continue to assess markets and be mindful of any changes in the economic regime, valuations, momentum and sentiment. Some (or all) of these factors may well signal a move towards increasing risk allocations soon. For example, the economic regime may decisively move towards recovery, forward earnings for large swathes of the equity market may be revised upwards (bringing valuations down) or momentum may begin a sustained uptrend. The opposite is also true. As this year has shown, a month can be a long time in markets, and risks – from the pandemic or elsewhere – may strike with staggering market reactions. We remain vigilant and will act in line with our process.

For more information please contact Sam Hartles, Private Banker - sam.hartles@kleinworthambros.com


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