Wednesday, January 13th, 2016
World equity markets continue their gyrations which have been a common occurrence throughout 2015 and more specifically in the recent December Quarter.
Specifically the Australian share market index traded through an 8% price range throughout the recent quarter. It was particularly volatile during the last two weeks of December. The market fell (once again) towards 4900 mid-month before rallying hard to reach 5300 at the end of December.
The December fall was a reaction to the decision by the US Federal Reserve to increase cash rates by 0.25%. This was the first lift in US cash rates for 9 years. Remarkably the cash rate had not moved in 7 years despite the recovery in the US economy that had been seen in the significant growth in employment over the last 3 years.
This market fall and the subsequent recovery was a rerun of many previous market moves. Indeed the monotony of market falls and recoveries and vice versa has created an unhealthy level of complacency that will surely be challenged at some point. The recurrent volatility has little to do with value and is driven by cheap and plentiful liquidity that continues to be provided by major Central Banks.
The maintenance of lax but supportive monetary policy settings across the developed world for some eight years will have consequences. The problem is that the consequences can only be speculated upon before they are ultimately felt. This is because this economic period and the economic settings are unique in world economic history. We have no historic precedent to draw upon and asset pricing is moving in uncharted waters.
We can observe that the low interest rate cycle of the last 8 years was a construct of major Central Banks. However, today’s low market interest rates are a reflection of a sober economic outlook. That outlook can be summarised as a period of both generally lower growth and low inflation in developed economies. We would therefore speculate that the most likely economic scenario for most of the developed world is “deflation”. A re-run of Japan’s decades of low growth but on a grander worldwide scale.
The inflexion point into this low growth era has been passed and markets are grappling with the reality that investment returns are now going to be low (“single digit”) and consistent with low economic growth.
Across the world there remain many economic and asset market challenges. A rising US dollar is not good for the US equity market as it constricts listed company profits. Sustained low yields in Japan reflect a demographic time bomb. Across Europe low growth and high government debt stymie recovery. Whilst in China both investor and consumer confidence is being challenged by extreme equity price volatility and a depreciating currency. The devaluation of the yuan is an unwelcome development that forces the pace of world deflation.
Australia enters 2016 with its enduring quest to transform its economy from a resources based one to a “services for Asia” focused one. It is easy to say what has to be done but the transition may require an income shock that Australians are clearly not prepared for. Further, the hope for transition is creating a two tiered pricing market for Australian equities. Companies regarded as established but low growth entities are being marked down. Younger companies that promise dynamic growth are being aggressively priced as if they have no risk of failure or disappointment.
Our job as investors is to allocate capital to companies that are fairly priced based on their real opportunity after assessing their real risk of success or failure. Today the real opportunities are limited and we caution about believing that investment success is a function of identifying companies that can achieve short term price bubbles without delivering an enduring business model. However, we acknowledge that is how the equity market is currently behaving and this is the direct result of many years of low cash rates and supportive monetary policy settings.
The ultimate effects of such policies is playing out across markets and the true investment skill will be in identifying and trading bubbles rather than investing in them.