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Investment Market Impact Briefing

Equity Market Instability

·         Volatility has returned to the equity markets over the course of the last month. They have been driven mainly in the US market. Given its size, at 60% of world equity markets, it has knock on effects to virtually all other equity markets.

·         Day to day swings in the major US equity market indices have become bigger and have pushed the VIX index, a market traded measure of volatility up to 24, a level much higher than that reached during the sell-off in late January and February of 2018.

·         We need to remind ourselves that the day to day swings are very short term in nature, although we also need to review whether there is a longer-term shift happening. In the absence of such a shift in conditions, the current sell-off will likely prove to be short lived, with equity prices recovering and reaching new highs, as they have a number of times in recent years including earlier this year.

·         The proximate causes of this most recent sell-off include:

 

  1. Rising concerns about the severity and the duration of the trade dispute between the world’s two biggest economies. This is not at all clear, nor will it be for some time to come, given the opaque decision-making processes of the both the US and Chinese governments.
  1. The rise in US long-term bond yields, with the US ten-year Treasury yield rising to 3.26% p.a. in early October, before falling back to 3.07% p.a. later in the month. It looked as though it was headed above 3.5% p.a., a level which we had identified as a threat to equity market valuations and prices.
  • It is expected that the continuation of fiscal stimulus in the US due to the major tax cuts of 2017 will add to GDP growth for the next year or so. Eventually, the fiscal stimulus will stall, particularly if the Trump Administration is unable to legislate more stimulus, faced by a hostile Congress in the wake of next week’s mid-term elections. Meanwhile, the fiscal stimulus already in place will be supportive of corporate earnings. For example, the index of US Manufacturing Confidence is back to its highest level since 2004.
  • At the same time the continued rise in the Federal budget deficit puts upward pressure on long-term bond yields as the US Treasury has the task of selling $1 trillion worth of new bonds at a time when the Federal Reserve is reducing its bond investments by $US 600 billion per annum. In our valuation assessment we have allowed for an increase in the bond yield to around 3.5% p.a. and equity markets are still fairly priced from a longer-term point of view.
  • More broadly, both monetary and fiscal policy in most major countries are supportive of economic growth as well as financial asset prices, supporting a recovery in equity market prices.
  • While focusing on the medium to longer term factors driving equity prices, we should be mindful that episodes of short-term volatility in the US equity market will become more frequent and severe in the unstable policy environment being driven out of Washington and may eventually have a more significant cumulative effect on market sentiment, changing to a more persistent fall.
  • While equity market prices are expected to recover from this most recent bout of weakness, as they have before in the last three years, due to the supportive factors noted, financial market sentiment as measured by price momentum, which tends to have an effect on the subsequent twelve to eighteen-month period, is becoming less positive. Eventually over the next year or so, it may well turn negative and offset the valuation factors.
  • Based on our long-term valuation analysis, all major equity markets, including the US, are fairly priced. At the same time, momentum indicators are becoming less stable and may be weakening in their effect on prices over the next one to three years but have not yet turned negative from a medium term (1 to 3 year) point of view.
  • For the time being keep a neutral or benchmark weight to Australian equities and International equities but be prepared to reduce allocations both Australian and International equities at some stage in the next twelve months. This could be done progressively by reducing allocations to equities by selling stocks or funds following market recoveries from what are expected to be a series of market downturns.
  • We will continue to monitor the valuation and momentum factors as well as other qualitative factors that affect equity markets and report back on a regular basis and recommend any significant changes in strategy that are needed.

 

·         Using a medium to longer term valuation perspective, the two main drivers of equity prices are the long-term bond yield which affects the Price Earnings ratio and the rate of growth of equity earnings. The bond yield is still supportive and so is the rate of earnings growth.

·         We continue to monitor the level and the shape of the US bond yield curve closely as it has been a good forward indicator of recessions and downturns in equity markets. So far, the curve has flattened but not yet turned negative, nor has the US ten-year Treasury bond yield yet reached the historically sensitive range of 3.5% to 4.0% p.a.

·         The third quarter rate of growth in earnings of the S&P 500 in the US is likely to be 22.4 % year on year, down only slightly on the earlier consensus estimate of 23.4% made in July.

·         Yet short term sentiment has deteriorated with Amazon reporting a second straight quarter of record earnings and its stock price falling 7.7% in after-hours trade. Similarly, Alphabet fell 3% after posting a 37% rise in earnings. Therefore, we need to consider the possibility that a significant shift in sentiment or momentum is occurring.

·         More broadly, the US economy’s growth rate appears to have slowed, from a reported +4.2% p.a. rate in June to +3.5% p.a. at the end of September, which was reported late last week. Closer inspection reveals that a 3.5% fall in exports due to a stronger US dollar, coupled with a 9.1% rise in imports, as businesses rush to beat the lift in US tariffs from 10% to 25% in January, combined to cause the biggest drag on GDP growth in 33 years. These are real effects of the Trump trade war but without them the US economy would have grown at an eye-watering 5.3% p.a. rate in the September quarter.

 

This document and its contents are general in nature and do not constitute or convey personal advice. It has been prepared without consideration of anyone’s financial situation, needs or financial objectives. Formal advice should be sought before acting on the areas discussed. This document is a private communication and is not intended for public circulation other than to authorised representatives of the Madison Financial Group and their clients. The authors and distributors of this document accept no liability for any loss or damage suffered by any person as a result of that person, or any other person, placing any reliance on the contents of this document.

 

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