Response to Market Turmoil

The current market turmoil is a worrying time for investors but it is important to keep events in perspective and not overreact to short-term moves driven by extremes of sentiment. Why have global share markets slumped since Friday? Markets have dived for three main reasons: 1. Heightened concerns about the sovereign debt problems in Europe, with the large public debts of Spain and Italy under scrutiny. 2. Investor concerns about the possibility of another US recession as some economic indicators weaken (although others, such as stronger than expected US employment figures, have lessened those concerns somewhat). 3. Late on Friday, the downgrading of the US’s sovereign debt rating by Standard & Poor’s by one notch to AA+ from the highest AAA rating because of S&P’s concerns about the economy. What are the implications of a downgrade in the US’s credit rating? The unprecedented move will be another blow to confidence in the US economy. The value of US bonds should fall and yields (interest rates) on those bonds should rise to reflect the additional risk in holding Treasuries. The effect will flow through to some extent to bond markets globally. This could have a further negative impact on equity valuations because stocks are valued relative to bond rates. Countries which retain their AAA rating, like Australia, may benefit from capital flows out of US-dollar denominated assets to countries deemed slightly safer. However, the impact on bond rates has so far been small. In reality, the US government remains a very reliable borrower not likely to ever default on its debt. As a last resort it can print the money it needs to meet its obligations. Bonds will also benefit from investors looking for a safe haven, which will put downward pressure on yields. The extent of the impact on bond markets will also depend on whether the other major ratings agencies, Fitch and Moody’s, follow S&P’s lead. Why has European sovereign debt again taken centre stage since last week? Bonds issued by the Spanish and Italian governments sold off amid concerns about their ability to repay their very high public debts, driving yields higher. Italian and Spanish 10-year bonds are at their highest yields relative to the benchmark German bund since 1999. The Italian 10-year is around 6 per cent after hitting 6.4 per cent last Thursday. Both countries have promised to implement tougher fiscal austerity programs and the European central bank has indicated it will buy more sovereign debt to stabilise bond prices. However, there is resistance from economically stronger Euro nations, in particular Germany, to financing more bond buying after the bailout of Greece, increasing investor anxiety. The outcome very much depends on the actions of governments and regulators to support the bond market. There is no sign yet of the liquidity squeeze that prompted the global financial crisis. What will be the impact on the Australian sharemarket? The performance of Australian shares is still heavily influenced by sentiment on US and global markets. In the short term markets will be knocked about by large swings in sentiment but in the longer term tend to settle around fair value. Professional investor Benjamin Graham famously wrote that in the short term the sharemarket acts like a voting machine but in the long term it is a weighing machine. Australian shares are attractively priced, based on long term averages. The US and Australian markets are both trading on a price to earnings (PE) ratio of about 11, based on forward earnings estimates. That compares with a long term average of 14 (in other words these markets are trading at a 21.5% discount). That is no guarantee that stocks cannot fall further. During the GFC three years ago the PE fell to 9. But such a degree of undervaluation did not last long. In the Australian market’s favour compared to others is the heavy exposure to the solidly growing Chinese economy through the resources sector and expectation of continued solid GDP growth in Australia of around 2 per cent per annum, as outlined last week in the Reserve Banks’ review of monetary policy. Australian policy makers also have a much greater capacity to respond to shocks to global growth than other more indebted countries by reducing interesting rates and increasing government spending. What should investors do? When market volatility and fear levels are high, investors are much more likely to make mistakes. Volatility is likely to remain high for some time. Recent events do not negate the value of sticking with a long term asset allocation strategy. This report has been prepared by by van Eyk Research Pty Ltd ABN 99 010 664 632, corporate authorised representative of van Eyk Financial Group Pty Ltd ABN 28 149 679 078, AFSL 402146 (authorised representative number 408625) and is general advice only. Past performance information is given for illustrative purposes only and should not be relied upon as it is not an indication of future performance. The report is not intended to influence you and your client’s investment decision in relation to any products contained in this report and does not take into account your client’s individual financial situation, needs or objectives. We recommend that you and your client do not rely on this report in making an investment decision and instead read the Product Disclosure Statement before making such a decision.