CURRENT GLOBAL SHARE MARKET VOLATILITY – 25 AUG 2015

By Paul Nicol

The past few weeks have seen increased volatility and sell offs across share markets both here in Australia and overseas. Markets have become particularly volatile especially in the last couple of days with our share market shedding over 4% yesterday. The Australian share market has now fallen 10% during the month of August so far.

The mood of the share market has turned negative very quickly with major apprehension about the world growth outlook, largely influenced by a weakening Chinese economy. Many investors are revisiting their fears from the Global Financial Crisis (GFC), but the issues gripping markets right now are very different.

So what is happening?

It is mainly about China. Although assessing economic data out of China is problematic, there are a number of indicators that suggest the Chinese economy is slowing quicker than the authorities are implying. This domestic weakness in China is flowing through to asset markets around the world, particularly commodity markets.

A major complexity the Chinese authorities are trying to manage at present is a credit-fuelled property bubble which has enabled China to maintain its incredible run of growth through the GFC. However, now China has to deal with a massive excess supply of property that is causing construction activity to contract along with a range of other linked sectors in the Chinese economy, as millions of homes lie vacant.

China’s property boom has created approximately three to four years of excess supply, comparable to recent property booms in the US, Spain and Ireland which all ended in deep recessions and financial crises.

Steel production, cement production and rail freight traffic have all slowed materially or contracted in the year to June 2015. Import data shows that domestic demand is also weakening. Given the reliance of China’s economy on housing and the associated industrial complex, China’s recent GDP growth estimates are now being assessed with scepticism by the market. A potential bursting of China’s property bubble poses a major risk to both the country’s stability and the global economy.

The fact that the US Fed about to start hiking rates is also causing volatility. The start of the last two major interest rate tightening cycles by the Fed in 1994 and 2004 were associated with falls in US shares of 9% and 8% respectively. Investors have now grown used to near zero interest rates for more than 6 years in the US and there is naturally fear that raising them will threaten the still fragile US and global economies.

Meanwhile, growth in Australia is being held back by a relentless downturn in commodity prices. However, falls in the Australian dollars (compared to the US Dollar), together with encouraging monetary policies from the Reserve Bank, are providing a cushion to maintain reasonable growth rates.

Is this a correction of something worse?

Dr Shane Oliver of AMP commented yesterday – “The important issue to consider is whether current weakness is just a correction or the start of a new bear market?” It is a great question, but very difficult question to answer.

In our opinion, share market valuations look sound. Once the gap between share market earnings yield (dividends) and bond yields is allowed for, shares now look cheap again.

And whilst global economic growth is looking more challenging by the day, China is unlikely to allow growth to slip significantly lower. While downside risks have clearly escalated, we do not expect an uncontrolled deceleration of the Chinese economy. With over $3 trillion in reserves, the Chinese government has both the ability and willingness to cushion its economy.

We again remind clients that growth investments have two return elements, the income returns or dividends and then the capital return which often attracts all the attention as it moves day to day in the listed markets.

With the net yield on Australian shares now standing at 5.1% per annum (twice that of interest-bearing alternatives such as term deposits), it is likely we will see some support for share prices in the market shortly. We continue to focus our clients’ portfolio on defensive and reliably higher yielding investments with an expectation that prices should stabilise shortly.