A month is a long time in markets

Our best case was “V”-shaped where fears are overblown and economies and equity markets rebound sharply.

Our worst case identified a serious pandemic with global economies entering recession and a bear market for risk assets (equities).

Needless to say, it was the worst case that ensued and with the benefit of hindsight it is perhaps not surprising given such volatile times. Sweeping lockdowns were imposed globally and unthinkable levels of fiscal spending and monetary stimulus implemented - at the time there was little clarity on how long all these measures would last.

At present, we are able to look to the not so distant future of a more familiar way of life. This is how the four pillars of Kleinwort Hambros’s investment process looks now:

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 cent; per capita income will fall in the largest proportion of countries globally since 1870. Advanced economies are projected to shrink by 7 per cent 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.

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 per cent of the global total, is currently trading at a forward price-to-earnings multiple of 22.6x (i.e. the multiple of the trading price of US Equities over 12 month forward earnings) 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.

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 for risk assets has oscillated wildly over the last few months. 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.

Markets remain volatile and more unpredictable than usual, and as such Kleinwort Hambros remains cautiously positioned in its risk allocations. 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.