It’s often said that’s its darkest before the dawn and that certainly applies to markets. Only a few weeks ago bond yields were hitting record lows and the equity market was being driven by defensives and high-quality growth stocks. The economic outlook was deteriorating, there was no end in sight to trade wars and central banks had started to cut rates again. In recent weeks, we’ve seen a sharp rotation to cyclical value stocks and bonds yields have moved higher as the market is seemingly seeing the light at the end of the tunnel. The market often has false starts at turning points so whether this rotation has legs will depend on whether growth recovers.
The key question is whether we are going through a mid-cycle slowdown or entering a new global recession? Much has been made of the yield curve inverting and heralding doom. However, policy generally remains highly accommodative with real interest rates at negative levels all over the world and becoming more so as central banks have eased. Employment has also remained robust along with household income and spending. The real weakness in global growth has stemmed from the manufacturing sector, but this has so far been contained.
Much of the slowdown in global growth has come from China which has been the biggest marginal contributor to growth in recent decades. It is easy to point the finger at trade wars in driving this, but China’s growth rate has been slowing for some time as it’s battled with excessive leverage across the corporate sector and environmental challenges. A lot of the slowdown in global industrial production can be attributed to a sharp slowdown in the automotive sector after several years of booming growth. This has occurred in different countries for various reasons, but China has seen one of the sharpest reversals of growth over the last year or so. The trade war is certainly having an impact here, but subsidies for electric vehicles being cut and a general economic slowdown are also weighing. This has impacted manufacturing activity in many industrialised countries, most notably Germany which has slipped toward recession with auto exports being one of its largest trade categories. This reversal in growth will also have triggered inventory destocking right through supply chains and compounded the slowdown. There is some evidence that global auto sales are now beginning to stabilise and recover.
The market is certainly telling us that we have reached the nadir in growth as it has looked through several significant downgrades from companies. In recent months cyclical stocks such as Incitec Pivot, Boral, CSR, Sims Group and Pendal Group have all been downgraded and are now generally trading higher and materially so in some cases. This reverse is also true for many high-flying stocks that are coming under pressure as the market rotates in search of value.
It is certainly worth having some exposure to value, but given the recovery is not visible yet you need to be careful not to buy something that looks cheap just before it downgrades and the market decides the rotation is over. Our preference for some exposure to improving risk appetite and a recovery in global growth is Bluescope Steel. Flat steel demand should rise as global industrial production recovers at a time where iron ore supply is also rebounding. This should benefit steel making margins and volumes moving forward. Bluescope is probably cum an earnings downgrade in the short term, reflecting tougher trading conditions, but this could almost be a positive given the way other cyclical stocks have reacted to downgrades in the market.
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