Global economic expansion is continuing. There has been some divergence in relative growth rates in recent months with a slowdown in China, Europe and Japan. While US economic activity remains buoyant, growth momentum is flattening.
While the market sell-off in late 2018 was disappointing, with already cheap cyclical stocks further sold-off, we continue to believe that the accommodative financial conditions in most advanced economies and additional stimulus in China will support the global economy in the medium term, albeit with some lags.
In Australia the RBA has lowered the 2019 growth outlook from 3.5% to 3.0%, though the economy remains in good health. As well as high levels of Government-funded infrastructure investment, the RBA have also noted that business conditions remain favourable and that non-mining business investment is expected to increase. The much publicised correction in Sydney and Melbourne house prices is the result of both tightening credit supply and lower credit demand. Importantly, the price declines are not a function of household financial stress and low mortgage interest rates remain supportive of household budgets.
The divergence between value and growth stocks has been widening over the last five years and has certainly picked up over the past 12 months. During the most recent sell-off, both growth stocks and value stocks fell, with a significant rotation to defensive, low volatility and quality stocks. In our view, these stocks were already priced in ‘bubble territory’. Despite the correction in growth stocks, they are still trading well above the 25-year average. Typically, value stocks outperform when bond yields are rising as they tend to be more sensitive to better economic conditions. The relationship broke down recently as rising bond yields in the US have resulted in the market becoming overly concerned over inflation and thus both value and growth stocks corrected. The tempering view from the US Federal Reserve together with the deflation of trade tensions should see underlying fundamentals becoming the primary driver of markets rather than fear. However, the flatter yield curve in the US has invoked fears of a recession and thus risk aversion is heightened.
The heavily stretched valuation gap between value and defensive, low volatility stocks implies the market is pricing in either a recession or further deflation. Given our view is that neither is likely in the short to medium term, we believe this continues to provide an attractive entry for rotation into extremely cheap economically-sensitive cyclicals.
Source: Nikko Asset Management, Brad Potter, Head of Australian Equities