MFM Group News - October 2018

Recent Share Market Volatility

This market correction should create buying opportunities……..the question is when?

Following an extended period of unusually low volatility, share markets have experienced a noticeable decline in the last two weeks. As at 12th October the United States S&P 500 Index had declined 6.4% since the start of the month, with the local S&P ASX 200 Index down 5.4%. These declines have brought the U.S. market level back to where it was in mid-June; with the Australian market now trading around levels last recorded in mid-April.

What caused share markets to fall?

With no apparent fundamental trigger to what was a relatively sudden correction, commentators are struggling to identify an agreed cause of the recent sell-off. Slightly elevated share price valuations combined with the ongoing U.S.  - Chinese trade dispute are the commonly cited reasons. However, both these factors have been with us for some time and while they may have been contributory factors, they don’t explain the timing of the correction. 

As was the case with the pullback in February and March, concerns over rising inflation in the U.S. may have also been a factor in triggering the latest price fall. Oil prices hit a 4-year high last month. In addition, the decision by Amazon to lift the minimum wage paid to its employees to $US 15 (from a general minimum of $US7.25) could have been more significant than the market first viewed. The decision potentially highlights the inevitably that strong economic growth and tight labour markets in the U.S. will eventually feed through to higher inflation. Share markets are concerned about rising inflation because it is likely to force interest rates higher, thereby making equity valuations less attractive on a relative basis.  It is the relative basis that is the key here.

The view that inflation is near the top of the list of market concerns is also consistent with the surprising lack downside movement in commodity prices over recent days, and the fact that bond yields have been relatively steady. The U.S. 10 year Government bond yield, at 3.16%, has fallen just 0.05% towards the end of last week - but remains well above its month opening level of 3.06%. If the correction was only due to worries that trade tensions would ultimately lead to lower economic activity, then falling commodity prices and falling interest rates would be expected to have accompanied the equity price decline. The fact that neither commodity prices nor interest rates have reversed (higher yields) materially, suggests factors other than fears of an economic slowdown are behind the correction.

Where to from here?

Short term movements in share markets are notoriously difficult to predict, given the role played by sentiment and emotion. Now that price falls have been triggered, the desire of investors to take profits from what has been a very extended bull market could result in further downward momentum in prices. Within this environment, the share market may have heightened sensitivity to any news of further upward pressure on U.S. wages or inflation.

This share market activity needs to be viewed in perspective.  Periods of price weakness on share markets are a very normal phenomenon.  The volatility corrections create is ultimately the reason why share markets are priced to create long term returns well above the risk free rate of interest. In addition, it should be stressed that the current climate has few similarities with the GFC period. Profitability in the financial and corporate sectors remains strong (indeed increasing) and there are no signs of any major dysfunction in markets. The absolute level of interest rates is still low and liquidity in markets is strong.

Should share prices weaken further, opportunities emerge for investors to redeploy capital from defensive investments and alternative asset classes into equities. However, caution is required in considering any entry into a falling market. It is perhaps still an early phase of this correction and it may be difficult for confidence to fully return prior to the U.S. mid-term elections in November. Given the extent to which the policies of the Trump administration have been associated with a strong share market, any dilution in the administration’s authority resulting from these elections may have a negative impact on equities. Alternatively, any confirmation of the status quo will probably be the catalyst for a return of investor confidence.

Opportunities for active investors

In addition to providing opportunities to potentially buy equities at a lower price, share market corrections also typically generate large disparity in price movements between different types of stocks. In recent days we have seen a large sell-off in the information technology sector – both here and abroad. Generally, higher “growth” stocks trading with high price to earnings multiples have been hardest hit. This disparity in price movement between stocks creates opportunities for active managers to add value. The recent experience of some active managers underperforming because their “value” disciplines have steered them away from more expensive stocks may be reversed through this period of correction.

The Australian resource sector may stand out as an area of interest for active managers. Commodity prices have held up relatively well and the $A is priced attractively for exporters at around U.S. 71 cents. Therefore, the pull back in price within the Australian resource sector could be seen as an opportunity for active managers looking to capitalise early on cheaper valuations.

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This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.

Melbourne Financial Management Group Pty Ltd (ACN 600 540 378), trading as MFM Group, is an authorised representative and credit representative of Hillross Financial Services Limited, Australian Financial Services Licencee and Australian Credit Licensee (232705).

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by MFM Group on 14 October, 2018

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