Curmi & Partners

Economic stabilisation not enough to sustain great rotation

By Robert Ducker 

Stocks have surged this year, recovering sharply from last year’s substantial losses as investor sentiment picked up and fears of an imminent recession abated. Most indices have so far delivered double digit returns, with Europe’s STOXX 600 index delivering a total return of 23.1% (all prices up to 2nd December 2019) since the start of the year.

As has been typically the case since the Global Financial Crisis, European stocks have lagged their US counterparts so far this year in local currency terms (Europe has outperformed the US just 3 times since the crisis). A key difference between US and European stocks is their tilt to growth and value. The former has a larger exposure to growth stocks (generally stocks that offer higher earnings growth potential) while Europe is considered to be more value oriented (typically stocks that trade on lower valuations and pay higher dividends). This decade has been characterised by lacklustre economic growth with a downward trend in interest rates and inflation, which is generally supportive for growth stocks.

Much has been written about the great rotation that started last summer as risk tolerance ticked up. Investors turned their attention away from stocks that typically have lower volatility and stronger balance sheets to more cyclical names. The debate over whether value stocks will finally outperform growth over a sustained period of time intensified and has been a key talking point in recent weeks.

In Europe, value stocks delivered a total return of 13.6% from mid-August compared to 10.3% for growth stocks. Looking at sector performance, Industrials (+15.4%), Materials (+14.8%) and Financials (+14.5%) have been the top three performers on a total return basis in Europe. These sectors are cyclical and their financial performance is typically strongly correlated to macro-economic expectations. This implies that investors could be expecting economic conditions to improve markedly in 2020.

This move was even more pronounced in the US, with value stocks outperforming growth stocks nearly two times over (14.0% vs. 8.4% in local currency terms). Unsurprisingly, given the value element described earlier, since mid-August, the Europe STOXX 600 has outperformed US’s S&P 500, with the former generating a total return of 12.1% compared to a total return of 10.9% (in local currency terms) for the S&P 500. Over the past 11 years, growth has outperformed value eight times on an annual total return basis.

The current debate remains whether this rotation will fade in the near term as it has done over the past decade. In our opinion, for this rotation into value stocks to persist, investors would require a significant pick-up in macroeconomic conditions, lower trade tensions/geopolitical risks and rising inflation expectations, basically a reversal of the conditions which have been true since the crisis.

There are early signs that the global economy has bottomed out. In the US, strong consumer spending supported by very low unemployment, rising wages and low mortgage rates is propping up the economy. The picture is more clouded in Europe, where weakness in Germany has been a concern, but improving trade data should support the economy in the coming months. Elsewhere, Spain’s political issues have again come to the fore, whilst Brexit remains unresolved.

The news flow around the US/China trade negotiations points to an improvement in the global trade outlook for 2020. In October, President Trump announced that a partial trade deal has been reached with China. However, over a month has passed and no formal agreement has been signed. The recent move by the US to back Hong Kong protests could complicate matters further, but news flow that China announced new measures to protect IP theft, a key demand by the US, suggests that there is increased willingness to reach a deal. The most likely scenario still remains that a “Phase 1” deal can be agreed between the two nations, possibly leading to lower tariffs which could reduce friction for global trade in the next year.

Finally, despite the market rally and the uptick in investor sentiment, inflation expectations remain largely muted. The US 10 year breakeven rate (measures what investors think inflation will be over the next 10 years) is currently at 1.7%, below the FED target of 2% and slightly above where it was in the summer (+0.09% since mid-August) but well below levels seen at the start of 2019 (-0.34%). In Europe, the 5Y5Y inflation swap rate (represents the expectations of what the five year inflation rate will be in 5 years time) currently stands at 1.2%, which is also below ECB target of 2%, summer levels (-0.04%) and the start of 2019 (-0.39%).

On balance, the current high valuation gap (a positive for value names) together with modest economic growth expectations (a positive for growth stocks) provides a dilemma for investors going into next year. With so much uncertainty, the best way to position an equity portfolio is to have a combination of both.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.