International investors own close to half of Australia’s stock market, meaning sentiment towards the outlook for the Australian economy and corporate earnings plays a large role in determining how our market performs.

When things are looking good, particularly compared to other regions in the world, it tends to outperform, benefiting from its perception as being a safe haven in times of turbulence.

This chart from Citibank shows the performance of various Asian markets in the years following the global financial crisis, benchmarking it to the performance of the MSCI Asia-ex Japan index in US dollar terms.

Australia’s stock market, shown in blue, has performed well against the vast majority of its Asian rivals over that period.

At least it was until recently. Now, instead of Australia’s market being the standout performer, Asian stocks are now starting to find their feet.

A shift is under way.

According to Tony Brennan and Mark Tomlins, equity analysts at Citibank, that means it could be time to go underweight Australian stocks.

“It’s hard to argue other than for an underweight position in Australia in regional portfolios,” the pair wrote in a note released earlier this week.

“After the global financial crisis, the Australian market outperformed for a while as commodity prices and the AUD rebounded, and then underperformed when the boom ended, and then once again made gains last year as commodity prices bounced.

“But in the past two months, the market has given back last year’s outperformance, as retracing commodity prices, weaker consumer spending, and the introduction of the bank levy have led to modest earnings downgrades, against upgrades in Asia itself.”

And Brennan and Tomlins expect that trend to continue, suggesting that the cyclical pick-up in the global economy looks set to benefit Asian markets far more so than in Australia.

“In Asia, the broad-based global pick-up of the past year, with recovery in trade and industrial activity, has lifted growth, and Citi economists expect it to continue to, as demand elsewhere offsets likely moderate slowing in China, and low inflation keeps interest rates low for some time,” they said.

“Asia’s recent earnings upgrades could well continue, as they often gather momentum in an upswing, and while Australia’s downgrades could abate, if commodity prices have overshot and other weakness is limited, strong upgrades seem less likely.”

Brennan and Tomlins point the chart below showing market valuations based on 12-month forward consensus earnings forecasts, showing that in comparison to the broader MSCI Asia-ex Japan index.

“As well as earnings upgrades commonly gathering momentum in an upswing, Asian markets have also often re-rated, and so far that has only occurred to a modest degree, whereas the Australian market multiple is already reasonably high,” they say.

Adding to their view that an underweight Australian exposure is warranted, they suggest that the risks for the Australian dollar seem more skewed lower than higher, something that seems more likely to “detract from than add to returns in US dollars”.

The view presented by Citi provides an excellent reminder that Australia’s market is in competition for foreign capital, and can be vulnerable to outflows should domestic economic or earnings conditions weaken or if they improve in other regions.

It also offers an alternative investment strategy for local investors, particularly those who have been dismayed by the recent selloff on the ASX which has seen the index give back all of its early-2017 gains.

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