Investment Flash update
As with others across society, the Kleinwort Hambros Investment Committee (KHIC) is at a heightened state of vigilance. The Committee is processing information in real-time in what is undoubtedly an unprecedented health crisis in our modern history, and one which has potentially wide-ranging ramifications for the economy and financial markets.
Similar to others making decisions in this environment, we are operating with imperfect information. We list some of the obvious uncertainties. One, we don’t know how long the Coronavirus will last or how it will be impacted by warmer weather; if it slows, we do not know now if it will reoccur in the Autumn. Two, there are economic sudden stops occurring all across the globe, but we don’t know how long they will last. There is the appearance of stabilisation – perhaps even a recovery – in China, a country at the vanguard of the crisis and its initial epicentre. However, we don’t know if this is a temporary respite; there are also good reasons to question if China is a valid proxy for the path other economies are likely to experience. What is not in doubt is that the length of the current economic sudden stops will prove a critical variable: if it is weeks or even a few months, recoveries can be expected to be quick; if the stop lasts longer, there will likely be permanent economic damage. Three, we do not know how financial markets will react to the factors that no one can predict in the first place.
Nonetheless, it is exactly at times such as these – when uncertainty and imperfect information are the order of the day – we must rely on the investment principles which underpin our investment process. Those principles are to get the big decisions right (i.e. the broad weight of risk assets versus safety assets in portfolios); to take risk only when it is likely to be well rewarded (i.e. when valuations for risk assets are attractive); and to avoid large losses (i.e. as they are harder to recover from than shallower losses).
At present, this is how we view the world through the lens of our investment process which considers the economic regime plus valuation, momentum, and sentiment signals from markets:
- Economic regime: We are likely entering a global economic recession if we are not in one already. The synchronised sudden stops across much of the globe is a paradigm shift from the growth/slowdown regime we have been oscillating in for years. Monetary and fiscal policymakers across major economies have already shifted policy in anticipation of a recession, not waiting on the data to confirm what is widely expected. We know an economic contraction is a poor state for risk assets.
- Valuations: Valuations for global equities are difficult to assess given enormous volatility in both the numerator (i.e. rapidly moving prices) and the denominator (i.e. uncertain earnings), but they are not cheap. The US equity market – the world’s biggest– is trading at 13.5x forward earnings. In 2011, at the time of the Eurozone debt crisis, it fell to just under 11x; in 2008, it fell below 10x. Crisis periods can see valuations fall significantly further than where they are.
- Momentum:The momentum case is clear and unambiguous, with global equity markets across all regions trading well below their ten-month moving averages, respectively.
- Sentiment: This is the one part of our process which arguably would suggest staying invested, and perhaps even increasing, risk assets. However, sentiment has increasingly deteriorated over the last few weeks and can continue to do so.
We present some additional considerations:
- Drawdown: The current drawdown (peak-to-trough loss) in global equity markets at the end of trading on 17 March is about 30%. This is in line with the average drawdown in global equities over history. However, markets obviously can and do suffer larger drawdowns than the average. For example, in 2000 and 2008, drawdowns were about 50%. We have no idea how big this current drawdown will be. If it is about average, the worst may well be behind us, but there is precedent for equity markets to fall significantly further.
- Volatility:Markets are incredibly volatile at present. The volatility index – or VIX as it is commonly known – hit an all-time high in recent days. Moreover, since the beginning of 2015 to the end of 2019, the MSCI AC World index moved by more than 3% in any direction just twice (i.e. 24/8/2015 and 24/6/2016); in 2020 it has done so nine times, all since 27 February. These are uncommon and unusual gyrations.
Putting all the above in context of our investment philosophy is useful. At present, we continue to find it sensible to reduce the proportion of our risk assets in favour of our safety assets. Risk assets are not adequately compensating investors at these valuations. Finally, with the economic regime likely entering a recession, momentum clearly negative, markets highly volatile and a greater drawdown than already experienced more than possible, we believe reducing risk can help mitigate a big potential loss.
Therefore, as we stated in our most recent KHIC Note, we believe it prudent to decrease the level of risk in most strategies. Only in hindsight will we know when the current market volatility and drawdown will come to an end. It may well be the worst is already over and our risk reduction was unduly prudent. We will always prefer to err on the side of caution to protect portfolios and mitigate big losses, particularly after the gains of recent years.