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What’s behind the share market volatility?

Market falls – are investors chasing shadows?

While markets continue to experience volatility in the short term, the longer term view for economic growth remains positive.

While the Chinese sharemarket and currency stabilised a bit on Friday and US jobs data was positive, investor nervousness remained, pushing Eurozone shares down another 1.7% and the US S&P 500 down another 1.1%. As a result of the poor global lead, the Australian Stock Exchange (ASX) 200 futures fell 80 points, signaling a weak start to trade for the Australian sharemarket today.

The poor start to the year clearly warns that global growth concerns remain, that commodity prices are still under downwards pressure and that volatility in investment markets will likely remain high.

What’s behind the sharemarket volatility?

Many of the same worries from 2015 have triggered a poor start to the year for shares, including a sharp fall in Chinese shares and the value of the Renminbi (RMB). This in turn has caused renewed concern about the Chinese economy and has led to more commodity price weakness and fears of an emerging market crisis. Soft US manufacturing data and geopolitical risks – this time regarding Saudi Arabia/Iran tensions and North Korea – have also contributed to sharemarket declines (with US shares falling -6%, Eurozone shares -7.2%, Japanese shares -7.0%, Chinese shares -9.7% and Australian shares -5.8%).

Commodity prices have also fallen, with the oil price now at its lowest since 2009 and bonds rallying with safe haven buying.

However, it is worth putting these developments in some perspective:

The latest fall in Chinese shares may have a bit further to go but looks to have been exaggerated, driven mostly by fears and regulatory issues around the sharemarket and currency. The main drivers were:

Implications for Australia

Australian economic data releases over the past two weeks were mostly soft. November retail sales were solid and the trade deficit fell slightly, but remains high. Meanwhile, the services sector PMI softened significantly in December, building approvals for November provided further evidence that the contribution to economic growth from home construction will slow this year, December home prices showed a further loss of momentum, and lending to investors continued to slow in November.

Our view remains that with global growth remaining fragile, commodity prices weak, mining investment still falling and housing’s contribution to growth set to slow, that the RBA will have to cut interest rates further this year.

Outlook for markets

Worries about China and the US Federal Reserve are likely to drive continued volatility in the short term until some stability returns to the RMB and US dollar, and hence in commodity prices.

Beyond the short term, we still see shares trending higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. However, volatility is expected to remain high.

Very low bond yields point to a soft medium-term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation.

Commercial property and infrastructure are likely to continue benefiting from the ongoing search by investors for yield. National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of the Sydney and Melbourne markets. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the Australian dollar is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the Australian dollar undertakes its usual undershoot of fair value. Expect a fall to around US $0.60 by year-end.

What impact does this have on AMP Capital’s long term view?

Globally, while volatility is likely to remain high and a further correction is possible, we see little risk of a recession or bear market in global shares at this point in time. What we have is a sharp adjustment of market sentiment and extreme fear without a real change in the underlying economic backdrop. We also expect the Chinese government will support economic growth through strong monetary policy easing and other measures which, in turn, should help support growth in China and the broader emerging markets. We will continue to watch and monitor the market, and will make necessary changes to our portfolios as the situation evolves.

It’s worth noting that sharemarket falls boost the medium-term return potential from shares – simply because they make shares cheaper – and once sharemarkets bottom they are invariably followed by a strong rebound. Trying to time the bottom though is always hard, so averaging in after falls makes sense for those looking to allocate cash to shares.

Final thoughts

While it’s been a poor start to the year for equity markets, and risks do remain high in the short term, our expectation remains for better returns this year than we saw in 2015. Sharemarket valuations are reasonable – being cheap relative to bonds and bank deposits – and global monetary conditions are likely to remain very easy, which should help ensure a rising trend in sharemarkets.

While sharemarket falls can be distressing they are a normal part of the way the sharemarket works. Market falls are usually made worse by recessions (notably US recessions) and a combination of prior overvaluation, investor euphoria and significant monetary tightening. While current sharemarket falls could still have further to go, our analysis suggests that economic fundamentals remain strong.

If you have concerns about your personal investments, please contact your Elodus financial adviser.

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