WRITTEN BY INVESTMENT STRATEGIST, HAROLD STRYDOM
Scenario modelling has formed part of Peregrine Wealth’s investment philosophy for two decades, and it enables us to better understand potential market outcomes and construct stronger portfolios. The Peregrine Wealth Asset Management team has a core or “High Conviction” scenario three-year view, which is expressed as macro and market assumptions including economic growth, inflation, interest rates, price-earnings (PE) multiples, credit spreads, to list a few. Our asset valuation models produce expected returns for various asset classes, based on these assumptions. This section is used to summarise our High Conviction view and the resulting asset signals.
We currently find ourselves in very uncertain economic times, and a single “High Conviction” scenario is particularly challenging to put together at this point in the cycle. We acknowledge that there are currently a number of potential outcomes for the global economy. This report is based on a scenario where we see global economic growth come in below capacity over our three-year modelling horizon. Central banks have made their objective to bring inflation back under control clear, and some form of demand destruction is likely during the process. This implies we are likely to experience below capacity growth over the next three years.
Our view on the United Kingdom (UK) economy follows a similar theme, with below capacity growth, as monetary policy tightens further to bring high inflation under control. The Bank of England (BoE) is forecasting a recession in 2023, something that central banks very rarely do.
If it becomes clear that central banks are reversing course, meaning they turn from tightening back to easing monetary conditions, our views and assumptions will also change. We use these multiple scenarios to feed into our asset allocation process when we construct portfolios.
A longer investment horizon is crucial during uncertain times. Reduced liquidity and recession risk are likely to continue causing weakness and volatility across markets in the near-term. On a three-year outlook, and with conservative assumptions, expected returns on global and UK equity are rated neutral. Signals vary amongst regions, with the United States (US) below neutral and Europe and emerging markets (EM) above neutral. These are only signals, and we will never act on them blindly. Using Europe as an example, the war in Ukraine, high inflation, rising interest rates and energy insecurity, makes future profits from European companies particularly uncertain.
Below capacity economic growth translates into very low earnings growth over the next three years, and the path will not be a straight line. Current consensus earnings numbers are still high, but we expect the earnings outlook to weaken. After a sharp selloff year-to-date, valuations (trailing price-earnings ratios) are, however, more attractive and below our assumed exit PE assumptions in all regions. UK and US interest rates are assumed to rise further in the near-term, but also reduce again within our three-year horizon. UK and US bonds are trading closer to our fair value assumptions.
From a medium-term valuation perspective, equities are providing a neutral signal, while fixed income is a lot more attractive after sharp selloffs. See the table below for a summary of our Asset Class Valuation Signals.