Markets in free fall: How worried should you be?

Another terrible day on the ASX is unfolding  as tanking Chinese sharemarkets wipe out the past two years of gains (at 3.15pm (AEST) the S&P/ASX200 index was down 4 per cent cent to 5007, the biggest intraday drop since 2007). Is it a correction or something more serious?

Whilst news headlines appear dominated by China, there are several themes that are driving the share market and will set the agenda for markets in coming weeks

First the timing of the US Federal Reserve’s rise in interest rates continues to hold investors attention. Investors have now grown used to near zero interest rates for more than 6 years and there is naturally fear that raising them will threaten the still fragile US and global economies. Note: The Fed minutes of the July FOMC showed policy makers judged conditions for higher rates have not been met just yet.

Ahead of the hike, markets are following some classic behaviours. According to JP Morgan “Performance of the S&P500 and the U.S. yield curve are broadly in line with the average of the run-up to the last five rate hiking cycles. There are, of course, many warnings that equities will struggle when rates start rising, and in the short run history bears this out”.

A softening China is having global implications. The Chinese economy is in the mist of a long-term slowdown as they move towards growth based on consumerism and productivity rather than exports and capital expenditure. The Chinese central bank’s move towards a more market orientated currency value is important in this process. We believe this is the motive behind the Yuan devaluation and not a currency war.

Far more worrying is China’s reduced demand for commodities. Given that Chinese demand for raw materials was perceived to drive the great bull market last decade, their lower demand means lower prices, in turn keeping a lid on global inflation. It is, however our view that the Chinese government will intervene with a stimulus plan for the economy (to hit their 7% growth target) and this will stem the heavy selling we are seeing in US oil companies.

Third, the growth advantage that emerging markets once offered appears to have diminished. The slowdown in China is not helping and the devaluation of the Yuan has helped accelerate the collapse in emerging market currencies (down 36% from their 2011 high, source AMP Capital). The emerging world now accounts for 50% of world GDP and so their problems are weighing on global growth and investor sentiment as to the longer-term consequence.

Fourth, Greek PM Tsipras announced his resignation and the country is now headed for another election (September). While Greece and the Eurozone have agreed on a third bailout program the IMF is likely to insist that Greece’s debt burden is reduced before participating in the bailout with a decision due in October. Collectively this is causing short-term nervousness.

It is worth noting just how isolated the recent weakness in the Greek economy is from the broader Eurozone. As a result the most recent Greek crisis is likely to manifest itself as a temporary blip in Eurozone wide confidence, and little more.

Fifth, commodity prices are in a secular bear market reflecting an over-supply in almost all raw materials, slowing growth in China (still consumes about half the world’s metals) and a resurgent $US (the currency in which most commodities are priced). Add to this our domestic reporting season and local shares are not being helped by a somewhat disappointing start. So far 46% of companies have beaten expectations and 61% have seen profits rise from a year ago. Sounds ok, but it is down on what was seen in February reports. Given the tendency for good results to come early there is a risk of slippage as the reporting season continues (source AMP capital). On the positive there has been no suggestion of a contraction to dividend payments. From the investors perspective this can be considered more a valuation rather than income correction.

What does it all mean?

In a nutshell, we are learning that the market has a very low tolerance for uncertainty and instability – we are caught in a negative feedback loop (falls in the Chinese sharemarket feed into weakness in Europe and the US and then Asian markets fall again in response to that).

Is this the beginning of a new bear market? As Sir John Templeton once observed “bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria”.
At the moment we do not see a great deal of euphoria to speak of – shares are not unambiguously overvalued; they are not over loved by investors. It is our view that this is not the beginning of a new bear market, the world economy is not going into recession and interest rates are not going up. Markets are correcting, which is what they regularly do, and in the process coming back into better value.

We must also be mindful of the reporting season. Traditionally weak, this has happened in the past: between July and October last year, the markets fell around 10% and within four months were back high again. Longer term investors should brace for a comeback as we are likely to see the bargain hunters move back in as the selling momentum starts to abate.

Internationally we think Wall Street will hold up. Stocks had been priced high after a six-year bull market run and there is little evidence to suggest that the US economy is heading for trouble. This pullback is healthy and the market was probably overdue for a breather.

Finally we must remember we are investing for income. If you panic and take your money out of the stock market what is the alternative – cash at 2%, property at inflated prices offering little return? Our advice; sit tight, the pendulum can not swing in one direction forever and when it does stop swinging fair value will be the outcome.