Stocks rose last week despite weak economic data which indicate the global economy may already be in a recession. “Excluding pandemic lockdown months, output is falling at a rate not seen since 2009,” says S&P.
The surprising resilience of the market may be due to the bad data being expected. Investors are currently the most pessimistic about the economy since 2008 and have positioned defensively accordingly.
Fund managers are holding the most cash since 2001, and within equities, they are overweight defensive sectors, such as Healthcare ($XLV) and Staples ($XLP), and underweight riskier sectors, such as Consumer Discretionary ($XLY).
These levels of pessimism have historically led to rallies. The catalyst this time has been speculation about lower inflation readings, and a possible “Fed pivot” coming later this year.
Our portfolio held a lot of cash last week, but after the latest investor positioning data was released, we decided our pessimistic view had become too consensus. We don’t want to be doing the same thing as everybody else.
Thus, we decided to buy back into Bank shares, whose valuations have fallen to February 2016, July 2016 and December 2018 levels. These occasions coincided with economic slowdown fears and were all followed by strong rallies.
The current economic situation is far worse than 2016 or 2018, so holding banks is far from a slam dunk, and the position is more tactical than strategic in nature. If bad news hits about Nord Stream 1, for example, we would not be surprised to see banks drop 30% in a few days, and it will be difficult to get out.
On the other hand, banks appear substantially undervalued. A Credit Suisse model based on interest rates, PMIs and EURUSD, for example, indicates that bank shares have 50% upside even in a severe economic slowdown scenario.
We feel the current equity rally may have a little more room to run, and thus hold the banks, but stops are tight and we expect to dial risk exposure back down in the coming weeks.
The majority of the portfolio is invested in a mixture of US and European Financials. We have emphasised quality, and are avoiding Financials with low levels of profitability or those with the highest exposure to a potential Nord Stream 1 shutdown.