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Roller Coaster of Emotions

It’s been a volatile 10 days or so for investors but markets have since somewhat recovered.  Much uncertainty is behind this amplified volatility but the US recovery still underpins a positive global outlook.  Despite slowing, China is likely to remain a source of growth.  Amid volatility, bargains appear – patience and vigilance can pay off.

The roller coaster ride over the past 10 days or so changed from panic in global equity markets to a strong rallying back later this week.  Our Australian market fell by 11.7% from its end of July high point before rallying back around 5% since Monday.

Meanwhile, volatility peaked.  A popular measure of volatility is the Chicago Board Options Volatility Index (the VIX), which provides an indication of implied volatility. This indicator is often referred to as the “investor fear gauge”, because it reflects investors’ best predictions on near term market volatility. In general the VIX starts to rise when investors become anxious and lessons as an investor becomes complacent. While it doesn’t directly correlate with the Australian market (it’s based on options traded on the US S&P 500), it’s a good indicator given the interrelationship of financial markets.

The chart below shows the VIX over the last 5 years (excluding the GFC):

VIX5yr

Ten years of the VIX charted below, compares this with the Global Financial Crisis:

VIX10yr

So, what triggered this recent bout of volatility?  It was uncertainty about several concerns, including:

  • Lingering concerns over the Greek debt crisis,
  • Correction of the Chinese share market,
  • Concern about slower Chinese economy, and consequent
  • Devaluation of China’s Yuan currency (and relative appreciation of the USD),
  • Uncertainty about when the US will lift interest rates,
  • Rapid fall of global oil and commodity prices, and
  • Deflation risk – stubbornly low inflation despite unprecedented global monetary stimulus.

While fear prevails, very few stocks swim alone – whether markets rise or fall, most are dragged along in the current.  This is exactly what recently occurred with indiscriminate selling across global markets.

We wrote to our clients about this volatility early this week, noting that in the short-term the market will find it difficult to settle without a more certain outlook for these key issues (most of all, markets hate uncertainty).  Fortunately, it didn’t take long for more sober analysis to bring back buyers at the lower prices.

The US:

New York Federal Reserve President William Dudley said on Wednesday that an interest rate rise in September is now “less compelling”.  The market had been pricing a Fed ‘lift off’ at about a 50% chance earlier this month – it subsequently reduced down to about 22% chance this week.

We think the US economy remains the key impetus for positive global momentum.  Its recovery remains on track, illustrated by a range of economic data, including:

  • Gains in monthly non-farm payrolls average 210,000
  • Unemployment is 5.3% with declining long-term unemployed and people working part-time that would prefer full-time over the last year
  • Wages growth has been mild but should gain momentum as labour markets tighten, assisting retail sales growth
  • Improving household finances
  • Positive housing momentum

The US Federal Reserve’s meeting in mid-September may still lead to the first official interest rate increase this cycle, though financial market jitters and China slowdown concerns may make December the more likely launch date.

China:

In China, recent manufacturing data showed a contraction (measured by the Purchasing Managers Index – PMI).  This triggered market concern that China’s manufacturing sector might be weaker than previously thought.

China’s share market took heavy falls recently from an over-inflated, bubble-like position.  It created anxiety that this loss of wealth might spill over into consumer confidence in China with impact on consumer spending and borrowing.  But this did not eventuate (despite high borrowing among those investors) because most Chinese aren’t invested in shares and Chinese stock markets are small versus their GDP when compared with more developed stock markets.

The initial response to devalue the Yuan shattered confidence in how authorities were handling things because this came after previous strident comments that they wouldn’t be devaluing.

Devaluation helps China’s exports but hinders the US in comparison and may re-energise post GFC currency/trade wars.

Nevertheless, the People’s Bank of China injected financial liquidity into the system this week and then later cut benchmark interest rates 0.25% to 4.6%.  This seems to have calmed nerves and restored some financial stability.  Perhaps it also signals to the market that Chinese policy makers are serious about their 7% growth target this year.

We think China will remain a source of growth – with about 25 trillion Yuan ($US3.9 trillion) bank deposits still locked up as reserves and its benchmark 4.6% interest rate, China’s central bank has ample room to stimulate growth with monetary policy initiatives if later needed.

Europe:

European growth remains fragile but is supported by extraordinary monetary stimulus, its lower euro and improving consumer sentiment due to improving employment.

Our key take-outs from this recent market volatility:

For some years we’ve encouraged investors to expect slow growth with occasional high volatility as markets adjust. China’s slowing growth is not news but recent rapid market correction was a result of investor fear that it might be slowing more than previously assumed.  When this kind of volatility occurs, markets often oversell the fundamental values of individual assets.  We believe this happened once again in recent days.  So, what should investors do?

  • As always, patience and a cool head are major assets for investors
  • Be prepared for higher volatility, especially in equity markets and be prepared to exercise patience
  • Keep focussed on quality assets and companies that are financially strong, well-managed with competitive advantages in growing sectors likely to prosper in future
  • Though we don’t believe any of the concerns discussed above are likely to derail the long-term global economic expansion, market catalysts such as these are unlikely to disappear. This underscores the importance of being risk–aware and strategically allocated
  • Diversify your portfolio – trying to ‘time’ when to buy and sell markets is almost impossible to consistently achieve.  Those who manage to sell at a peak, look back honestly and realise they were unable to buy back in at the best time
  • Seek to buy assets with sustainable yield – volatility creates opportunities to buy attractive assets more cheaply. We are seeing some of this on display now as the overall selling of a stock market can indiscriminately oversell some excellent assets

Important Disclaimer:  All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.