Potential resolutions in both the trade dispute between the US and China and Brexit are looking a little rosier, as markets start to price in a slow return to stability. However, we remain a long way from “normal” and it appears we have been in this situation before over the past 12–18 months, with little relief in geopolitical tensions.
Geopolitics has been one of the largest drivers of the slump in global growth and corporate profits over the past year. Therefore, less stress could be a powerful catalyst for a cyclical revival. Compounding this are the cheap valuations and extreme positioning of the market that has the potential for a violent rotation into the value end of the market.
The divergence in valuations between the defensive and low volatility parts of the market and value cyclical sectors is still at heightened levels. This relative valuation bubble between value/cyclical stocks versus low volatility/defensive stocks is at a level that even exceeds the dot.com valuations of the late 1990s. We believe this reflects concerns around global growth which has been exacerbated by geopolitical issues such as the US-China trade war and Brexit, as well as slowing global growth. In our view, the market’s concerns are overdone.
The US economy remains around trend and the Federal Reserve has pivoted from tightening to an easing bias that may help steepen the yield curve. The Chinese deleveraging that was a feature of 2018 has ended and stimulatory measures are now showing their effect in activity levels. As the market gains comfort that the global economy is slowing, but not collapsing, we believe valuation parameters will normalise.
Further, any resolution or partial resolution of the key geopolitical risks will reduce the downside risk of further deceleration in growth due to elevated uncertainty. Recent dialogue between the US and China and hopes of a deal regarding trade negotiations is a significant step in the right direction.
We remain positioned to take advantage of the global economy moving away from outright bearishness and risk-off, to a more moderate growth environment. The defensive bond-sensitive and quality names remain in “bubble” territory and would be expected to correct heavily when the market moves into more rational territory. As seen during September, reversion trades in favour of value stocks can happen quickly and aggressively. Despite these moves, the valuation divergence is such that there is significant further upside potential in the portfolio as and when market valuations correct to more appropriate levels.
Brad Potter, Head of Australian Equities – Nikko Asset Management
