HSBC Private Bank’s Sels notes caution in latest quarterly investment outlook

The balance of risk has tipped towards a recession in developed markets, but it is by no means clear that this will happen. Thus, it may be too early to call the end of the sell-off in global markets, according to HSBC Private Bank’s latest quarterly investment outlook. Willem Sels, UK head of Investment Strategy comments.

The combination of a global economic slowdown and political uncertainty in the world’s largest economic blocs has given a knock to investor sentiment over the past few months. This has left prices of many “risk assets” at lower levels than earlier this year. In some cases much lower. Perceived safe haven assets such as US Treasuries, German Bunds and gold have been the beneficiaries.

Is it time for investors to move back into equities and commodities at these lower prices? A prerequisite for a recovery in these assets is a recovery in economic growth. Unfortunately, we do not see any material recovery in growth over the next three months in any major economy – indeed the risk of a new recession developing is still there. It is therefore too early to call the bottom of this sell-off, but careful watching of leading economic indicators should give us an early warning of any change to this outlook.

There are some silver linings: inflationary pressures are generally coming down across the world economy and with slow growth these should continue to fall. Monetary policy remains helpful and the interest rate cycle in the emerging markets seems to have peaked and started to move down. Quantitative easing has become even more popular with Switzerland joining the “easers” by pegging its currency to the euro.

So, in our view, investor patience will continue to be rewarded by the opportunity to “buy low” in the future. In the meantime, proper diversification and a focus on high quality assets should serve investors well.

Portfolio Considerations

Long-term value vs short- to-medium term challenges

We believe the long-term growth potential in the developed world is falling, and short-term cyclical momentum is fading. Indeed, even before economic data weakened over the summer, investment spending and hiring had been weaker than expected, potentially acting as a brake on growth in the coming years. Consumer and government deleveraging may be a problem for the next 5-10 years, and aging populations may keep the average economic growth rate down for decades.

The recent market sell-off now seems to be moving quickly towards pricing in both the weak short-term and the longer-term news at once. US equity markets have already taken a much more negative view of future earnings growth than analysts have. If we assume that P/E multiples should reflect lower long-term growth, we may assume that they should probably be closer to 12x than their historical average of 15x. If we further assume that US earnings were to drop by 15% as they have historically done on average during milder recessions, this would imply a fair value for the S&P 500 index of 1140, around the current level. This may suggest that both a mild recession and a weak long-term growth outlook are already priced in. Similarly, flattened yield curves suggest that bond markets, too, are already pricing in lower economic growth for longer, and a reduced probability for a quick rebound in economic activity.

However, it would be dangerous to conclude from this analysis that this is a buying opportunity for equities and that bonds are a sell. For a start, there is much debate about where ‘fair value’ is. During past recessions, earnings have often collapsed by much more than the 15% – sometimes up to 50%. One can look at different scenarios for earnings revisions and equilibrium P/E rates to arrive at an estimate of where fair value for the S&P 500 index should be. Markets rarely stabilise around fair value but tend to overshoot. To include a margin of error, equity markets may want to price in a much lower earnings number than their current best guess is.

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