Market update: why the long face?
Share market volatility in the past few weeks has renewed uncertainty — even gloom — and diminished investors’ taste for risk. There’s European public debt and Chinese economic tightening worries, along with regulatory action against US and European banks. Concerns around Australia’s planned ‘resource super profits tax’ haven’t helped the impact on our shares and dollar either. While none of this sounds very good, here’s why it’s probably not a bear market — and certainly not time to throw in the investing towel.
Global economic gloom and doom has returned, descending upon share markets, commodity prices and commodity currencies, such as the Australian dollar (down 13% from its US$0.9351 peak). From April highs, US, European, Japanese and Asian shares have fallen between 10-14%, while Australian shares have fallen 16%.
There are 4 key factors behind these falls, says Colonial First State: a “3-speed” global economy; ongoing worries over sovereign debt levels in Europe; moves to banking and financial re-regulation; and then some Australian-specific concerns.
So why now — when everything was looking good again? Is the cyclical recovery in shares over? Should investors be concerned? If not, then what should you be looking out for?
Key drivers
Dr Shane Oliver, Head of Investment Strategy and the Chief Economist at AMP Capital Investors, explains the factors pushing this slump:
- Europe: despite the aggressive support package, investors are still concerned about the effect austerity measures will have on the economic growth of Spain, Greece and Portugal; whether the debt of stronger Euro-zone countries will be “tainted by association”; and long-term questions about the euro’s survival
- US banks: legal action for transactions in sub-prime mortgage debt, plus moves to tougher regulations and taxes has investors concerned
- European banks: the same concerns re the same moves towards a tougher regulations and taxes
- China: worries that the tightening to cool a property bubble and inflation will lead to the long-talked about “hard landing” for the Chinese economy
Australian share falls have been magnified by:
- the proposed “resource super profit tax” (RSPT) possibly making Australia less attractive for mining capital
- that same proposed tax signalling additional taxes on other industries making “super profits”
How you feel about the RSPT depends heavily upon whom you ask and what sector of the economy you come from, but, says Colonial First State, “there is a strong view that the proposed RSPT, the way in which the government went about announcing its arrival and the public nature of the debate over its merits or otherwise, has added to Australia’s country risk premium”.
Shane Oliver agrees the concerns have still had an impact, although says they are “arguably overblown”.
Australia is also seen as highly exposed to any downside risks in China.
All of these things, compounded by market expectations that the Reserve Bank of Australia (RBA) has interest rates “on hold”, have sharply dragged down the dollar.
The total effect has been to weigh down the Australian share market. This is because foreign investors are not willing to buy Australian shares when the currency is falling sharply.
While the markets were looking good after the strong run-up into April, bear-market memories are still fresh, so the timing of “those other issues” has left investors “pretty skittish”, in Dr Oliver’s words.
‘Three speed’ doesn’t help
The global economy recovered from the deep recession of 2008–09 with a “2-speed” global economy — expected strong growth in Asia and some larger developing countries (such as Brazil), but much slower growth in the developed world (the USA, UK, EU and Japan).
However, says Colonial First State, the recent trend has been to a “3-speed” global economy, and the uneven nature of this recovery has added to investor uncertainty.
They explain this “3-speed” global economy thus:
I. economic growth is still expected to be strongest across Asia and the other developing nations (and it’s important to note that it’s this group that remains most important to Australia)
II. economic data from the USA, Canada, NZ and Japan suggest their recoveries are becoming more firmly based
III. but ongoing worries over sovereign risk in both Europe and the UK will see only minimal economic growth in the years ahead
It’s a correction, not a bear
While AMP’s Dr Shane Oliver is not saying the markets have bottomed — “measures of investor fear are yet to fall to the levels that are normally seen at market bottoms” — he is very happy to say this slump is a correction. And not the start of a new global bear market.
Why? Four reasons:
1. “Leading indicators”
These are still pointing to the global economic recovery continuing. (This is the opposite to 2008.) These “leading indicators” are:
- Spain, Greece and Portugal: yes, aggressive tax increases and spending cuts will see them stay in recession for several years, but at 16% of the “Euro-zone”, these countries are not big enough to drag Europe back into recession.
- northern Europe benefit: while our focus is on the south, businesses in northern Europe are actually benefiting from the euro’s fall and easy monetary conditions — Germany particularly (only 6% of its exports go to Spain, Greece and Portugal, but 60% goes outside Europe).
- the rest of Europe is fine: despite the debt crisis in southern Europe late last year, key business conditions indicators in the rest have had no impact
- lack of “contagion” spreading: European authorities acted quickly to head off “contagion” regarding sovereign debt, and there’s no sign of any “disease” spread to public debt in the USA, UK, France and Japan
2. Strong profit reporting seasons
Another reason Dr Shane Oliver cites to back a correction, not a bear, is the strong recent profit reporting season in the USA, Europe and Asia. But it’s even better in Europe, where the proportion of results beating expectations is at its highest in at least 5 years. This, he says, augurs well for future profit growth.
3. Easy global monetary policy
Shane Oliver says global monetary policy is not consistent with the start of a bear market. Before the 2007-09 bear market, policy was tightened to deal with rising inflation. Now, it’s very easy, with near-zero interest rates in key countries and short-term rates running well below long-term bond yields.
Europe’s situation will ensure such easy global monetary policy for longer. This is being reinforced by still-falling underlying inflation rates in Europe and the USA. Inflation in the USA (excluding food and energy) has now fallen to just 0.9% — its lowest since the 1960s — further pushing out any US monetary tightening into 2011. Continuing low global interest rates are very positive for share markets.
4. Brake stays on for China
The final reason we’re seeing a correction, not a bear, say Dr Oliver, is the unlikelihood the Chinese will ease up on the brake. There are increasing signs the property market in key Chinese cities is coming off the boil (some Beijing house prices are down 25%) and the Chinese share market has fallen 28% from last year’s high. When this easing does occur, it will remove a big weight from Asian and Australian shares, commodity prices and resources stocks. On top of this, shares are now very cheap again.
A word on Europe
Government bond yields in Portugal, Spain, Ireland and Greece remain well below the peak levels seen in the weeks before the announcement of Greece’s finance rescue package in May.
This is positive, but questions are now around the pace of Europe’s economic growth in coming years. Lifting taxes to boost government revenue, and cutting government expenditure (by winding back generous pension systems and public sector wages) will help reduce budget deficits, it will also slow economic growth rates.
Colonial First State makes the point that while this may not be new to economists, it appears to only recently be being factored in by markets. So is probably behind the “skittishness” Shane Oliver refers to.
It’s neither good nor bad, just something to note.
A quick word on US banks
Colonial First State says something else to note is that while the final look of a re-regulated US banking system remains unknown, the fact that more controls will be placed over their activities means less leverage in the banking system and slightly lower profitability and economic growth over the medium term. Hence investors’ hesitation.
Why the AUD fell
Much of the decline in the Aussie dollar has simply been driven by investors having less stomach for risk.
Colonial First State explains that where buying the AUD had been a popular trade over the past year, profits are now being taken. Our dollar is sometimes seen as a “risk” trade. As “risk appetite” falls and concerns over a slowdown in China grow, so the AUD has fallen.
On top of this are signs that the RBA’s policy tightening has begun to work (recent weakness in consumer confidence, housing finance and retail sales), pointing to the expectation interest rates will stay “on hold” for several months, as Shane Oliver has also pointed out.
History is a good guide
We can’t definitively say that because something happened in history, it will happen again, but history has proven a very good guide in financial markets (and many other areas of life).
Historical records show that after major bear markets end, there’s a distinct pattern of very strong gains in the first 12 months, followed by a “constrained and volatile ride” in the second 12 months, as the easy gains have happened and some of the stimulus starts to be unwound.
This, says Dr Shane Oliver, certainly seems to be the pattern now unfolding (so read into that the “easy gains” are behind us). As well, volatility is likely to be higher than normal, because of the problems left over from the global financial crisis (high public debt levels, poor household balance sheets in rich countries, and the eventual need to unwind very easy monetary conditions).
Colonial First State says the concerns outlined above and the reduced global desire for risk, are unfortunately unlikely to be unwound in the very near-term — meaning volatility could be hanging around for a while.
But (and here’s a good “but”), Shane Oliver says if global recovery remains on track, this current set back will provide good buying opportunities in share markets. The same for currencies, particularly the Aussie dollar: it is likely to rebound, helped by the still strong medium-term outlook for commodity prices and the reality that Australian interest rates will stay well above US, Japanese and European rates.
Sources: “Latest developments in global markets”, Colonial First State; Dr Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital Investors, “Oliver’s Insights, The return of gloom”.
Tags: investment update