The adage “sell in May and go away” may become prove correct this year – here is why!
Pro risk-oriented investors still hope for an economic soft landing and a rapid start to a new interest cycle “cut” which in turn could justify today’s equity valuations. On the other side, bearish investors believe that valuations are much too high as recession risks are not out of scope for now.
Recent economic data suggest that a higher probability ratio needs to be attributed to the recession scenario. Here is what we expect for the next three to six months:
- Growth: For our key market orientation (the US market), the inflation-adjusted Q1 GDP was at 1.1% while forecasts were around 2% while the core inflation rate, measured by means of the personal-consumption expenditures (PCE) index, remained close to 5%, i.e., at 4.9% – clearly, we note that there is significant downward trend – on the contrary, the latter is up by 0.5% when compared to the previous quarter. Given this, we do not expect the FED to start anytime soon a new interest cycle – rather, we would expect the FED to maintain rates higher for longer, which in turn will impact negatively the cost of capital for corporations and ultimately profitability.
- Earnings: As expressed in our yesterday’s publication, we believe that earnings per unit are far too high given the present economic conditions. While earnings for now appear to be “ok” with a 5% YoY variation, a closer look at the earnings quality though gives us a different return. In fact, the earnings quality ratio is as bad as in 2008 and the financial engineering to make them look good is more than ever questioned by the larger investment community. Our conclusion: higher WACC is taking the grip on earnings!
- Leverage: US corporation alike the US Government are heavily leveraged and this is a drag on equity markets. With interest rates now at a sustainable level, many investors may be tempted to switch back much of their allocation into more prudent fixed income vehicles. While the US Government is expected to honor its debt until further notice, the same is not applied by the corporate world. We would expect that the bankruptcy ratio is to increase substantially over the next 2 years which in turn will destabilize markets while at the same time government borrowing will drag from the financial system close to 1 trillion by the end of this year. Conclusion: Leveraged capital is normally allocated to equity instruments – with the overall terms becoming less attractive, equity markets miss some of its traditional support.
Our present equity allocation:
Equity: Consumer technology and consumer discretionary are strongly linked to the well-being of the consumers. As of now, the average consumer does start feeling the heat of the prolonged high rate of inflation. Until such has passed, we advise investors to look at defensive sectors such as consumer staples, energy, and utilities. In particular, we like the idea of investing in companies related to the energy transition. There are a good number of companies in the utilities and energy sector that quality for this – consult our list here
Fixed Income: We continue to like the idea of European Credit. Companies in Europe have a much lower delinquency ratio, while offering investors higher average returns (when compared to US corporations). Our present preference goes for iTraxx Euro S35 06/26 offering a YTM of over 9% p.a.