Investors have got away without a recession for far too long and soon there will be a price to pay, according to Charlotte Yonge, assistant fund manager of the Personal Assets Trust.
The longer someone gets away with something, the less likely they are to think they will get caught, but the outlook is too “murky” to keep on closing your eyes and hoping for the best.
Yonge was fairly adamant in saying that, despite what the market might be telling itself, a recession is coming, probably by the end of next year.
“The number of times that a soft landing is referenced in company management earnings calls is very high right now. Unfortunately, that was also the case just prior to the financial crisis and to the recession of the early Noughties,” she said.
“That, paired with our analysis of the fundamentals, makes us fairly convinced that now is not the time to be aggressive. Covid and inflation have been amazing components of the hot growth we’ve seen in 2023 and central banks had to respond with the fastest rate-hiking cycle in decades”.
The new scenario emerging from this is no possibility of a ‘Goldilocks’ scenario and implications for valuations, earnings and growth.
On valuations, the forward price-to-earnings multiple on the S&P 500 today is in line with that of 2019, when we were 10 years into a bull market.
“These aren’t cheap valuations, they are actually above the historical average and should be lower. You have to go back as far as 2002 to see a valuation that high,” she said.
“The same goes for earnings. In a mild recession, earnings tend to fall 20%. Today in the US, they're forecast to grow high-single digits for the next couple of years. That's quite far away from falling 20%. These are quite high-expectation earnings and aren’t factoring in a recession.”
The manager has also started to see signs of distress, citing a paper by Federal Reserve economists who found that 37% of non-financial US firms were in financial distress this summer.
But there is another piece of the puzzle worrying the manager: historically, all hiking cycles have caused a recession. So the question remaining is: When will it kick in?
“In 1989, it was 16 months after the final rate hike that a recession happened. In 2000, it was 10 months, actually happening in 2001. In the financial crisis, the last rate hike happened in 2006, so 18 months until the recession,” she said.
“Based on these recent precedents, you could say maybe, if we’ve had our last rate hike, a recession will happen at the end of next year.”
There is therefore “a lot of scope for disappointment” from now on, prompting the Personal Assets Trust, which is designed to protect capital first and to grow it second, to keep its equity valuations very close to its lowest point on record.
“With valuations and earnings beyond their margin of safety, the fund is only keeping a 25% equity exposure, only marginally above the level kept during the previous recession,” the manager said.
“Historically, we’ve been as high as 70%, so we do take risks when we believe we are getting paid for it. Today’s levels are reflecting our caution around earnings and valuations.”
The trust has a 40% allocation to bonds, and just over 10% in gold, an “excellent hedge against monetary stability and market volatility to the downside”, and finally, just under 30% in liquidity in the form of short-dated bonds.
“We locked in on almost all of those bonds that yield very near to 5%, giving us the opportunity to have cash to redeploy,” Yonge said.
“We don't want to have liquidity of 30% in three years’ time and fully expect to get back into equities when we’ll get more realistic valuations and earnings numbers. On that regard, our modus operandi is to lean in on the way down, so we will likely be buying into weakness. And that's what feels quite painful at first, but we will only start when we see that margin of safety.
“Times have really changed, and we think that the mass distortions of the past 14 years, with the ability to borrow with rates near zero and valuations reaching through the roof, are going to change. The next decade is going to be much more challenging for investors,” she concluded.