Jason Todd, CFA, and the Investment Team
Monday 10 September 2018

We are not overly alarmed that developed equities have been selling off alongside what has already been a meaningful correction in emerging markets.

The most recent sell-off has not been accompanied by evidence that fundamentals are rapidly deteriorating, that financial conditions are dramatically tightening or that emerging market weakness is spilling over into developed markets.

In the absence of one or more of these factors, we continue to see increased price volatility as normal course for a bull market which is mature and global monetary policy which is transitioning to a less favourable setting.

We do not see the current sell-off as an opportunity to raise exposure to equity markets, but neither do we believe it is a reason to become more defensive than we already are (see Investment Matters – Survival of the Fittest). This is the time for cool heads and not impulsive decisions that are driven by price action, tweets or media commentary.

DM equities have substantially outperformed EM equities year to date

Source: FactSet, MWM Research, September 2018

Our preference is to maintain exposure to stocks and markets which are supported by strong economic and earnings fundamentals rather than raising portfolio risk by chasing returns in stocks and markets which have been recently sold down. We have emphasised the need for capital preservation as risk-reward has deteriorated throughout 2018 and this is reflected in our decision to be overweight cash, property and alternative assets. We are comfortable maintaining a preference for US equities. Our logic is simple. If the US leads the next global market sell-off then we think they continue to outperform given their low beta defensive status. On the other hand, if non-US weakness continues, than US equity outperformance is likely to continue given their strong earnings growth status (heads US equities win, tails non-US equities lose).

We believe the following 4 factors support our view that the recent sell-off is more technical in nature with profit taking in strong momentum and/or overvalued stocks rather than a sell-off driven by a meaningful decline in economic growth and equity fundamentals:

1. Selling remains discriminate. While emerging equities and currencies have borne the brunt of weakness, there is a clear distinction amongst those where external vulnerabilities are high versus those where this risk is low. This can be seen in the outperformance of Emerging Asian equities over both Emerging Europe and Latin America and in the substantial underperformance versus developed markets. More recently weakness in Chinese growth has added to FX pressures on those with strong trade links (i.e. Korea and Thailand) but this remains orderly.

EM weakness has not been systemic

2. Credit markets remain well behaved. We have seen limited pressure on developed market credit spreads despite the recent spike in global risk aversion and widening in emerging market spreads. We think credit markets are fundamentally well supported and we expect this to continue as long as US growth remains strong and the Fed maintains a glacial rate tightening pace. Although the trend is towards wider spreads, outside of an exogenous event we do not see immediate red flags other than typical late cycle developments such as weakening covenants.

Credit spreads are not blowing out

3. US Treasuries are not rallying strongly. To date US 10 year yields continue to bounce around the 2.80-2.95% level. This is in the middle of the 6 month trading range but well off the YTD lows of 2.73%. A small defensive bid in bonds is consistent with the rise in risk aversion but the VIX (volatility index) has a long way to rise if it is to get back to levels that corresponded with the YTD low in bond yields.

US bond yields have barely budged

4. China has begun stimulating (fine tuning). The direction of Chinese growth momentum is important for emerging markets and hence for limiting any contagion impacts to the developed world. At present China is “fine tuning” rather than providing outright stimulus and while fine tuning is unlikely to be enough to reverse the broad downtrend of the Chinese economy and market, we think it will lead to a short-term stabilisation of economic data and potentially a technical rebound in equities. This is likely to provide a boost for sentiment even in the absence of a major growth pulse.

Australian growth (-4.6%) and value (-3.6%) stocks have corrected sharply month to date

Source: FactSet, MWM Research, September 2018

Domestically, while the Australian market has weakened considerably in recent days, we retain our neutral allocation which reflects a view that we are not particularly bearish on the outlook but neither have we become more positive on straight valuation grounds.

We think the equity market recently got a little ahead of itself, with the August reporting season generally underwhelming and with post results earnings revisions broadly negative. Over the past week, Australia has suffered from the sell-off in high PE stocks and trade war concerns which have spilled over into the outlook for commodity related stocks.

The unfortunate truth for Australian equities is that they trade like an emerging market given the strong commodity link to China and a lack of earnings leverage to global growth. Because market leadership has generally been confined to either resources or internationally exposed growth stocks, it stands to reason that when both of these areas come under pressure that the market looks like it is in free fall, when in fact this is not the case.

Historically a 3.5% decline over a 5 day period has been quite common. It has occurred, on average, once a month since 1979 but not since September 2016.

Highest PE stocks have been under the greatest selling pressure month-to-date

Source: FactSet, MWM Research, September 2018

Over recent months we have recommended investors take some profit in the best performing growth stocks (see Investment Matters – Fundamentals trump fear: April-18). However, this was tactical recommendation and based on prudence rather than a view that fundamental supports for good quality growth stocks was changing vis-à-vis slower growing value stocks.

For many years we have held the view that valuations would not normalize (equalise) without a catalyst and that this would need to be higher rates (that prick a valuation bubble in growth stocks); individual earnings disappointment; or a wider earnings recovery that drives an upswing for value stocks. Market commentators continue to highlight the valuation anomaly but the question is not whether it exists but what will change it and hence what will take leadership for the market from this point forward.

Our answer? Nothing at present. Instead, we have been expecting outperformance from growth stocks to slow versus value stocks. In other words, the normalization process does not equalize valuation, but rather it begins to equalize relative performance. If we are wrong, and leadership has rotated away from growth and towards value stocks, than investors should be prepared for even more muted price returns because low PE stocks are more sensitive to earnings growth and we are not yet seeing a strong cyclical upswing.

Industrial stocks trading on >15x PE and with >10% upside to price target

Industrial stocks trading on <15x PE and with >10% upside to price target

As a result, we retain our preference to growth companies which are able to maintain earnings momentum and have high quality and transparent franchises. Offshore earners are best placed to avoid the political distractions at home while benefiting from the soft A$ which is the release valve for rising global economic uncertainty.

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