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Published on: Friday, November 02, 2018

By Andrew Clifford

The potential of a China slowdown, exacerbated by the trade war, and the impact of ongoing rate rises in the US, have seen investors once again become risk averse. Specifically, this has meant avoiding companies that face any degree of uncertainty and focusing instead on companies that are perceived to be immune from external factors like trade tariffs. Often this is expressed by commentators as a preference for “growth companies” over “cyclical businesses”, but many more companies have been caught up in the sell off than the traditional cyclicals, extending to sectors such as financials and lower-growth technology stocks. The exception has been energy stocks, which have been helped by higher oil prices over this period.

Geographically, this has translated into significant outperformance by the US market as it has a much higher representation from those strongly performing sectors than the rest of the world (the technology, healthcare and energy sectors together account for more than 47% of the MSCI US Index, compared to approximately 28% for the MSCI AC World ex US Index). Generally, the weaker geographic markets have been those with a greater weighting in cyclical and financial stocks throughout this period. Additionally, the emerging markets have suffered as a result of the stronger US Dollar increasing the cost of funding for external debts, most notably in the case of Turkey.

From an investment point of view, it is worth observing that the strong performances in areas such as technology and healthcare have been driven by stocks that, based on our research, were already expensive by historical standards. Software stocks and internet companies that have been central to the strong performance of the technology sector in recent months are now valued against their revenue base at levels only exceeded in the technology bubble of 2000, as illustrated in the following charts.

While the valuation of biotech stocks is not so readily demonstrated by reference to comparable historical data, valuations are stretched, and the record number of new biotech IPOs is also strong confirmatory evidence. By stark contrast, six months ago, the deepest value was to be found in the North Asian markets of Korea, China and Japan, and yet these markets have performed poorly over the period.

This has led us to conclude that, outside of the favoured growth stocks, markets are pricing in a future that is substantially different from the world that can be observed today. Essentially, cyclical stocks are factoring in a significant slowdown in global growth. While this could be the case, there are a number of reasons suggesting that the picture may not be quite so grim: 

The scope and impact of the China US trade measures put in place to date are limited relative to the broader economic backdrop. As such, the trade war would need to ratchet up significantly to further impact on markets.
 There is an underlying futility to the trade war that needs to be resolved with a face-saving political solution for its proponents. It is instructive that the US has now come to an agreement with Canada and Mexico on trade that achieves little substantive improvement on the existing North American Free Trade Agreement (NAFTA), but represents a political win for the Trump administration. While a resolution will take time and there may be further damage before one is reached, it is not entirely unrealistic to expect a deal with China at some point.
 Meanwhile, China has moved to stimulatory policies to underwrite growth. As they have done in past, such policies will likely achieve some of their intended effect.
 While higher interest rates should ultimately slow the US economy, given the existing strength in labour markets and the availability of ongoing fiscal stimulus, a slowdown may well be further out on the horizon.

To sum up, markets are currently positioned in a very defensive manner, and any lessening of the fears that have driven stock prices in recent months could well see them move higher. Of course, there is always the possibility of some new issue arising, especially in a world where balance sheets are weak and interest rates unsustainably low. But for the moment, investors appear to be leaning very heavily in one direction. More often than not, it pays to head in the other direction.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs and objectives.

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