Via the excellent Damien Boey at Credit Suisse:
Globally, equities have very much been a momentum and quality story in early 2020. Value factors have badly underperformed, having bounced hard in late 2019. We have seen a very sharp risk-off rotation in alpha terms, even as the market has gained.
Having said this, the momentum and quality rotation has been nowhere near as sharp in Australia, in part because of some dramatic turnarounds in beaten-up stocks during the early stages of reporting season. And for context, we should also note that the value rotation in late 2019 was nowhere near as sharp in Australia as it was abroad.
Are we merely seeing factor volatility, or something more? Is Australia truly different? In this note, we share some thoughts on both views.
In previous articles, we have demonstrated that as volatility rises, global factor performance dispersion also rises. With the emergence of the COVID-19, and a host of other political risks on the horizon, volatility has trended higher in early 2020. Arguably with it, factor performance dispersion has increased. But increased dispersion cuts two ways. It could mean that some markets really decouple from the rest of the world. Alternatively, it could simply mean that factor performance within countries becomes a lot more volatile. Put differently, rising volatility alone does not tell us a compelling, and lasting story about factor decoupling.
Fundamentally, Australia has some natural shock absorbers. One is the Federal government’s capacity to spend on over-draft-like terms with the RBA, effectively printing money through fiscal deficits. Another is the AUD/USD, which tends to depreciate very sharply during risk-off episodes. Interestingly, the AUD/USD has become roughly 3% undervalued recently. Despite falling commodity prices and concerns about world growth, Australian-US yield differentials have widened in Australia’s favour, with the RBA recently taking on a much more neutral policy stance. Therefore, the fundamental, fair value of the currency has not changed from just under 70c, but the currency itself has depreciated, offering some easing support for the economy.
At an earnings level, our market model based on credit growth, commodity prices and currency, suggests that earnings are undershooting macro fundamentals by roughly 5%.
Then there’s the organic bottoming-out story in the economy to consider. Pre-COVID-19, and bushfires, there was evidence that the construction cycle was lifting domestic demand out of the doldrums. More timely data such as business and consumer confidence, suggest that pestilence and natural disasters have not made things dramatically worse in January/February, although we should note that our activity tracker is not yet registering strong (above-trend) growth.
So overall, the Australian market has a fair number of buffers to draw upon during this challenging period. The economy and earnings have some built in resilience, supporting the case for value and cyclicals. Should we not therefore take the view that Australia is different to the rest of the world?
We have a lot of sympathy for the contrarian view, which has been clearly expressed by investors during reporting season. But given the heavy dependence of our economy on global drivers at present (demand for commodities, housing), we struggle to justify fighting global trends. At a global level, our thesis remains as follows:
- The equity risk premium will rise faster than the risk free rate, supporting the valuations of defensive and growth stocks over cyclicals, notwithstanding any near-term earnings recovery underway.
- Economic growth is likely to peak and trough in the same year. The ISM is getting off the canvass – but forward-indicators of the ISM, such as US core retail sales, and loan demand in the Fed’s Senior Loan Officers’ Survey are clearly peaking out. Peak growth momentum, is a problem for valuations.
- Rising volatility is likely to prompt de-risking among minimum volatility, risk parity and passive funds, increasing de-leveraging risks in fairly illiquid conditions. And de-leveraging pressure undermines the performance of value factors, because it causes asset prices to drive fundamentals (earnings, dividends, book values) lower, reducing the efficacy of anchoring strategies.
Also, factor rotation signals are likely to shift more heavily towards momentum and quality, and indeed, have done so recently.
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- Morgan Stanley: US pandemic shaping as much worse than Italy - March 31, 2020