Mounting Risks Call for Neutrality

The Neutral

Sonic Youth, 2006

What’s Next?

Agitated macro data

We see several reasons to adopt a certain neutrality in the dynamic allocation of our portfolios. Until recently, the macro picture was a strong driver of our positive conviction for growth assets but now we are seeing some shadows in the picture here and there.

To be clear, an analysis of our macroeconomic indicators – be it our Nowcasters or our Newscasters – clearly shows that the recovery in the vast majority of economic zones is not in doubt. Yet, with the volatility that we have seen in recent times in economic figures, our indicators show unusual volatility levels. At the beginning of December, Chinese consumption figures experienced a singular decline, plunging our Chinese growth Nowcaster below the recessionary threshold. However, this situation resolved itself a few days later and our indicator returned to positive on 1 February.

Then it was the turn of the US to show volatility. To put it into perspective, US indicators plunged to unprecedented lows in March 2020 as containment took hold. When it ended, these same indicators rebounded in proportion to their fall. Since January 15, 2021, a spectrum of indicators have begun to show signs of erosion. For example, the ISM manufacturing index’s “new orders” component reached highs in early January (67.5) not seen since the recovery of 2003. Such levels are generally unsustainable in the medium term, and it has since begun to normalise rapidly, falling back to 61.1 early last week. The same is true for retail sales, consumer confidence indices, overall employment figures, and surveys of wages and investment expectations.

All of this is not necessarily worrying at this stage. These various figures have seen pronounced upward movements, reflecting the intensity of the recovery in the US, just as the Chinese consumption figures reflected the intensity of the country’s recovery. Europe is only slightly affected by this phenomenon: the intensity of the fiscal stimulus was lower and this can be seen today in the speed at which its figures are increasing. Overall, it seems difficult at this stage to see this decline as a signal beyond the noise of variations. This is all the more the case since our Newscaster indicators remain indicative of good economic conditions in China, Europe and the US. For the moment, our systematic indicators show that we are not on the verge of a recession.

Consistent exuberance

Perhaps what concerns us more is market sentiment. It was positive in December but became exuberant in January. Two figures provide some perspective on this idea of exuberance. The S&P 500 index is more than 400 points above its 200, 100 and 50-day moving averages, and it’s not the only one. All of the world’s major equity indices are also above their 200-day moving average and 98% are above their 50-day moving average. US equities are up an average of 3.26% over 50 days, European equities are up 1.99% and Asian equities are up 3.23%: the upward movement is broad, deep and affects all global equity markets. The second figure is an intra-index figure. Within the S&P 500, 85% of its constituent stocks are above their 200-day moving average. The last two months in equity markets have been truly exceptional, both in the magnitude and consistency of the upward movement. It seems clear to us that the sense of euphoria that currently drives investors is exaggerated and that current valuations are a significant risk. Moreover, our Market Stress Nowcaster is showing rapid variations, reflecting the volatility that markets could potentially experience at the slightest catalyst, be it health, economic or a communication error by a central bank. The market is currently being driven by anticipations and promises. Let’s hope that the former are justified and the latter are met.

Ambitious valuations

The main consequence of this investor craze for equities is elevated price levels. The S&P 500’s PE ratio is now 25 but this overall figure hides strong disparities between sectors: Consumer Discretionary has a PE of 36, the Energy sector has a PE of 32 while Financials are at 13. However, it has become very difficult to interpret these figures for two reasons: the level of rates and the extent of variations in company results.

An important part of last year’s market recovery was due to the sensitivity of many equities to interest rates. This is a well-known channel of monetary policy that has been exploited for several decades. Estimates vary but the 1% drop in rates in 2020 explains between 10 and 20% of the recovery from the end of March. Rates remain low to date, maintaining the valuation of shares at high levels. Our equity valuation metrics, which subtract rates from earnings yields, are therefore in neutral territory as the rate effect counterbalances the rise in prices.

The second element is the magnitude of the earnings variations. S&P 500 company earnings declined 13.7% in 2020 and are expected to rise by 23.5% in 2021. In the case of the Stoxx Europe 600, the decline to date stands at 18.6%, with an increase of 32% expected by analysts in 2021. So how can we judge high share prices in February 2021 using PE ratios? Using “trailing” or “forward-looking” data gives very different figures, creating another source of confusion when assessing the prospects of equities today.

Time for neutrality

Thus, we find ourselves today in a situation where, on one hand, the image conveyed by the economic figures reflects a degree of uncertainty that the markets still seem to be totally ignoring. On the other, these same investors have propelled equities to high levels without considering fair valuations. At this stage, we believe that a neutral dynamic positioning makes sense from a tactical perspective. We have therefore considerably reduced the biases of our dynamic allocation: we are now neutral on growth assets globally, and only exposed to energy and commodity currencies as far as our active inflation bias is concerned.

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