Many of you would be aware of the media attention regarding financial markets over the last couple of months. Approximately two weeks ago, on the 6th of August, news headlines reported financial markets had ‘buckled’ after China escalated the trade war with the U.S. sending American shares to have the biggest drop this year. The Dow Jones plunged 767.27 points, or 2.9%. The following day, Australian markets followed with a drop of 1.9%, the media announcing it was the biggest loss since December last year. Outside the media selecting emotive words to sensationalise things, the details have been correct however I thought putting some context around the recent volatility may help provide some clarity especially as markets continue to be turbulent. To date the markets are down by 5-6% from their highs reached a month ago.
Primarily, it is worth noting that only last month share markets in the US and Australia were at record highs. Global and Australian share markets are naturally vulnerable to weakness after roughly 25% gains from their December lows to their July highs. With such short term increases many investments can be pushed above fair value and are then vulnerable to a correction. This share market risk can be amplified in the period from August to October each year. You may recall the significant drop from October to December last year. It is worth ‘turning down the noise’ and remembering that periodic sharp setbacks in share markets are healthy and normal. This volatility is the price we pay for the higher long-term return from shares.
Australian All Ordinaries – past 12 months price (sourced via Google Finance)
What has caused the volatility?
To date share markets have had a fall of approximately 6% from their highs to recent lows. Bond yields have plunged to new record lows in many countries. During volatile times you will generally find that it is rarely one single event causing the market to decline. In this case it has been many, with following being the main cause in descending order:
- Trade war between Donald Trump and China
- Concerns about inverted bond yields
- Slowdown in world economies
- Turmoil in Hong Kong
- Brexit tensions
- Political uncertainty and discontent in countries including Iran, Italy and Argentina
At this stage the trade war shows no sign of concluding. Any sign of optimism for the US and China to arrive at an understanding has been diminished and the ongoing threat to any short term resolution is real. With it being an election year next year, the risk is that China may wait until after the elections. This delay will continue to take its impact on business confidence and ultimately impact manufacturing conditions worldwide. In some ways it may take further declines in the share market to provide the necessary incentive for Trump to resolve the issues.
Recent media reports on inverted yield curves have also raised concerns for some clients. Normally long-term bonds pay a higher yield than short-term bonds, reflecting risks etc into the future. In theory, a 30-year bond should deliver a much better return than a 10-year bond and respectively a 10-year bond a higher yield than a two-year bond maturity. Yield curves can flatten over time, narrowing the gap between short and long term returns. In extreme cases they invert and long term yields are lower than short term, and in some investment circles there is a belief that this is a sign of an impending recession. Other believe it is not an infallible signal and should not be a guarantee in any sense. Even if one felt an inverted yield curve was a sign of a future recession in the US, any recession has historically it has been more 15-18 month later! Therefore we have time. In Australia we have had many yield curve inversions over the years without a recession.
There is also much evidence to show that world economies are also slowing. We believe this is the biggest future factor and needs to be monitored. This naturally impacts all markets and will continue to cause volatility as each central bank struggles with policy stimulus and cutting interest rates to encourage growth. This is very different to last year when the Fed was tightening, and why in my Christmas newsletter in December last year I highlighted the next interest rate movement would be down. We have had two rate decreases since.
In the short-term share markets could still fall further as trade and growth uncertainties remain especially as we go through the seasonally weak months ahead. Moving to cash or fixed interest is always an option, however timing the market is always very difficult over the short term. In addition, the difference of grossed-up dividend yield on Australian shares (5.7%) and the Australian 10-year bond yield of 0.94% is at a record high. The difference in return between the grossed-up dividend yield and bank term deposit rate (2.0%) is also significant. In other words, after removing any share market volatility the income with shares is significantly better – i.e. while shares may decrease in value, the dividends from a diversified portfolio doesn’t significantly fall over the short term.
At this stage, due to the potential cheapness of shares when compared to falling bond yields, we expect investors will decide to maintain their portfolios over the short term. We also expect interest rate decreases to stimulate the economy a little further. With no recession over the short term, we expect share markets will be higher in another 6-12 months’ time. As highlighted above, there are many factors that impact share markets and things can quickly change. We do believe the world economies are slowing and therefore for those who are risk adverse and have short term objectives, now is the time to reconsider your appetite for risk, not during a midst of any correction.
For those who would like to discuss the above with your Financial Adviser please call the office on (08) 9474 2255.