A comment on Equity Market Volatility
The market’s recent weakness (the S&P/ASX 2001 is down 9.8% and in the US the S&P 500 is down 7.1% from their recent highs) has been the result of a confluence of factors, in particular, i) continued US Federal Reserve rate rises as well as rising bond yields, ii) escalating trade tensions between the US and China, iii) stretched market valuations, iv) challenges in some emerging markets and v) a turn in some global economic indicators suggesting a slowdown in global growth. We discuss each factor in turn.
The US Fed is likely to continue to gradually raise rates for some time while US bond yields are also likely to continue to move up on inflation concerns. However, some perspective needs to be taken in response to the rise in US bond yields where, despite recent increases, bond yields are below levels that prevailed in 2011, and have just moved up from a 40-year low. Trade tensions will remain for some time with recent indications that they may actually deteriorate. The actual impact of tariffs on earnings is, so far, quite small however this may change if the tariffs continue to increase and some companies have reported higher input cost as a result of their tariffs in the latest reporting season. The stretched market valuations contribute to investor concern during periods of weakness and can aggravate declines initially.
However, with the correction valuations have moved closer to fair value, reducing investors sensitivity to shocks. The challenges in emerging markets will continue as long as the US Fed raises rates and the $US remains strong as both these factors are negative for their economies. Finally, while some indicators are showing a growth slowdown, growth remains positive. Investors’ major concern is a US recession however we see this as unlikely in the next 12 months.
More recently, it appears that the US Fed Funds rate is likely to rise faster than expected and the strength of the $US has also become a concern. In addition, US technology company earnings growth have become more uncertain. Discussing each factor in turn we note that the US Fed has re-iterated its intention to continue to gradually raise rates until the end of 2019. These increases will be supported by the need to ensure that the gradual increase in wage growth in the US does not lead to inflation i.e., the Federal Reserve is trying to control inflation before it moves up significantly. US bond yields, critical in equity market valuations, are also likely to continue to move up on inflation concerns. Also, important to bond markets, is that the US Fed is withdrawing liquidity from this market. Effectively this means that there will be additional upward pressure on bond yields, placing some pressure on equities.
The $US has continued to appreciate against most major currencies. This strength will reduce the price of imports into the United States, but it also reduces the earnings of US companies which generate around 40% of their earnings from offshore sales. As the $US strengthens the value of their exports decline. As equity markets are always sensitive to earnings growth or changes in earnings, the ongoing strength of the $US has seen US investors become more concerned about this impact on 2019 earnings.
A final factor impacting the markets recently has been the steep declines in a number of the well-known US technology stocks which have led the market up and were trading on very expensive valuations. For example, Facebook is down 34.6% and Amazon is down 20.0% from their recent highs. Recently a supplier of Apple announced an earnings warning which the market interpreted as an indication that Apple phone sales were slowing. Apple fell 5.0% on the day of the news indicating how sensitive the market is to earnings changes. However, technology stocks in general are still trading at significant price-to-earnings multiples and therefore may continue to impact the US market until investors are comfortable that their valuations match their earnings outlook.
In Australia, the environment is somewhat different. First, the RBA is unlikely to move interest rates for some period of time and second, earnings growth is expected to be around mid-single digits to June 2019 supported by reasonable economic growth. A final factor in terms of the Australian market that is different to the US, is that the domestic technology sector is very small at 3.3% compared to the US market at around 20.0% i.e., there is not a large, very expensive sector to drag on the market as valuations decline.
While we cannot rule out further weakness in markets over the short-term, at this stage there are no major economic factors indicating a major bear market is likely. Importantly for most major markets, the primary drivers of share prices, earnings, and interest rates, while changing, are not adjusting precipitously, and current volatility reflects investors adjusting their expectations. Changes in the overall earnings outlook remain supportive of the market and interest rates while gradually increasing in the US are, at this point, unlikely to be a major headwind.
Some cash reserves are useful for funding requirements and to bring back into the market once the above concerns are behind us. We re-iterate our comments by Peter Lynch who reportedly said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Of note here is that returns for the ASX 200 Accumulation Index between 1996 and Sept 2018 were 9.0% p.a. However, if an investor missed only 10 of the best days over that time, the return falls to 6.5% p.a2. Taking aggressive positions away from your strategic asset allocation in light of the current risks and issues in the market is unlikely to be profitable. Our recommendation is to have a long-term investment plan and stick with it.
What you need to know
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1 At the time of writing, Nov 14th, price only Index
2 JP Morgan Funds Australia, Guide to the markets, 4Q18
Source: AMP Financial Planning – Market Correction Comments (14th November 2018) – view original