In this update we explore five themes of relevance to investors.

Please note the views expressed in this bulletin are those of the author and do not necessarily reflect AMP Capital’s house view.

Theme 1: Something a-SKEW

The SKEW index suggests an elevated level of fear among investors, most likely as a result of global risks such as concern around growth in China and potential for Emerging Market (EM) financial stress.

The CBOE SKEW index – which can loosely be explained as an indicator of demand for tail risk hedging (i.e. hedging against large downside price movements) – has clocked up some significantly higher readings in the past week. In an up-trending market this indicator usually acts as a smart money indicator, i.e. it sends a non-contrarian signal. Indeed, a spike in the SKEW has been a leading indicator to most of the sell-offs/corrections during this bull market. The exception was toward the depths of the financial crisis (i.e. toward the market bottom). While risks such as Fed rate hikes are front of mind, global risks are giving investors the most amount of indigestion at the moment. A recent fund manager survey noted 75% of participants see a China recession or EM debt crisis as the most concerning tail risks. These risks even spooked one Fed member to forecast negative interest rates in 2015 and 2016, and the September FOMC statement explicitly addressed it: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” So the spike in tail risk hedging is certainly understandable, but again, it reflects the increasingly pessimistic investor sentiment. So if those global (EM and China) risks settle down, or improve even a little bit, then it will be back to business for risk markets (and the Fed).

Theme in pictures

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

Theme 2: Cyclicals vs defensives

There is no strong valuation case for cyclicals vs defensives, but the recent underperformance of cyclicals could unwind if growth accelerates.

One way of breaking down the S&P500 is into sectors that are more cyclically sensitive (financials, energy, materials, industrials, consumer discretionary, IT) and those that are less cyclically sensitive or ‘defensive’ (utilities, consumer staples, telecom services, healthcare). At times it can be attractive to take a tilt to more cyclical or more defensive sectors. Typically this will be when there is a high degree of confidence in the economic outlook (cyclicals benefit during an economic recovery and accelerating growth; whereas defensives perform much better in a downturn or recession). Extremes in valuation can also help identify attractive risk vs reward setups, e.g. when relative value is stretched to extremes. The performance of cyclical sectors vs defensive sectors can also give clues as to the state of the economic cycle, e.g. notable outperformance of defensives would be a warning sign. There has been some minor underperformance of cyclicals vs defensives recently (as a result of the cyclical commodity exposed sectors and US dollar exposed sectors). The US domestic economy seems to be continuing its solid footing, so the swing factor is probably commodities and the dollar (or in other words, the global economy).

Theme in pictures

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

Theme 3: Value vs growth

At the margin, relative value probably favours value stocks – a lift-off in rates and yields might be required before value can outperform growth.

Another way of splitting the S&P500 is into ‘value stocks’ (those trading on lower valuations) and ‘growth stocks’ (those trading on higher valuations). Again, it's a case of monitoring for extreme swings in relative value as a guide for value vs growth tilts. Value stocks are sometimes relatively more cheap than usual (e.g. 2000) and sometimes relatively less cheap than usual (e.g. 2007). Recently value stocks have been underperforming, yet relative value is around middle of the range (maybe a little towards the lower side). The direction of interest rates and bond yields can play a meaningful role in relative performance e.g. value stocks are usually more mature companies with predictable and steady cash-flow, whereas growth stocks are often younger and higher growth companies which tend to derive the bulk of their value from large expected future earnings and a large expected future terminal value. In that sense you could say that growth stocks have a higher ‘duration’ or sensitivity to rising rates. So you would probably expect value stocks to outperform growth stocks in a rising rates/yields environment (which seems to have been delayed for now).

Source: AMP Capital, Bloomberg

Theme 4: Small caps vs large caps

Relative value is mildly supportive for small caps and the economic backdrop is also somewhat supportive, but it’s far from a high conviction call.

Another lens on US equities is the split between small companies and large companies. Small caps sometimes perform better when the US domestic economy is growing strong and the US dollar is rising because they’re often more reliant on the domestic economy, whereas larger companies typically have more offshore earnings. Also, the Russell 2000 small cap index has relatively less energy companies. That probably helps explain some of the small cap outperformance over the past year. At this point you would call the price action about middle of the range, and the relative valuation signal likewise about middle of the range (if not slightly under). In the absence of a relative valuation signal, if the theme of a stronger US domestic economy and strong US dollar continues, it will probably be supportive for small caps vs large caps

Theme in pictures

Source: AMP Capital, Bloomberg

Theme 5: Australian equities vs global equities

The unwinding of the commodity supercycle has returned Australian equities to a valuation discount vs global equities, which is grounds for becoming incrementally more positive on Australian equities vs global equities.

Comparing the ASX 200 vs MSCI World equities (in local currency) simply on price (as with the analysis above), there has been a clear link between the commodity boom and the relative performance of the ASX 200 vs global equities. Remembering that along with the commodity super cycle, the ASX had also come from a starting point of extreme undervaluation vs MSCI world (which was partly a result of the dot com boom). With the end of the commodity super cycle, the ASX has seen a prolonged period of underperformance and has returned to a valuation discount against global equities (vs valuation premium in the past 5-7 years). This is a notable development because as we know, starting point valuations are hugely relevant for future investment returns. You could probably say that the commodity/currency aspect could still have some downside but it too has unwound significantly from the overshoot of the past decade; so at this point I would say that we’re closer to the bottom of the range on that front. Therefore, the headwinds caused by high relative valuations and the commodity supercycle unwinding may nearly be done. Incrementally, this begins to present a more positive case for Australian equities relative to global equities.

Theme in pictures

Source: AMP Capital, Bloomberg

About the Author

Callum Thomas, MMgt (finance), MMgt (banking), BBS (finance), Investment Strategist

Callum is an Investment Strategist in the strategy team of the Multi Asset Group at AMP Capital. Callum has a passion for global macro investment strategy and constantly strives to generate unique and innovative insights that help inform the strategy team's dynamic asset allocation process. Callum is responsible for researching a range of asset classes and global macroeconomic themes to aid in formulating investment strategies across the Multi-Asset Group. He also keenly collaborates with the global equity and fixed income teams. Callum originally joined AMP Capital in June 2009 as an analyst in the investment business of what was then AXA New Zealand. He previously worked in strategy at the New Zealand Stock Exchange.