The US S&P 500 fell around 7% in October following six consecutive months of positive returns. The fall was not confined to the US market with Australia’s S&P/ASX200 suffering similar falls, as have other regions. The definitions of a “correction” and “bear” market are arbitrary, but it has generally become accepted that a market fall of more than 10% from its recent peak is considered a “correction” while a 20%-plus decline is considered a “bear” market.
What has driven recent falls?
The sharp declines seen over the last couple of weeks reflect increased trepidation in both domestic and offshore markets with renewed concerns surfacing around the softening residential housing market and as investors continue to digest the implications of the Royal Commission into misconduct in the banking, superannuation and financial services locally, while global markets continued their sell-off on ongoing concerns of interest rates rise and geopolitical risks with intensifying trade tensions between the US and China, declining oil prices, the market fear of a hard Brexit and other peripheral political uncertainties including the Italian budget crisis. Higher interest rates have the capacity to slow economic growth and, in turn, company profits while at the same time increasing the attractiveness of non-equity related investments such as bonds. Similarly, heightened geopolitical risk generally sees a flight to safety and when it involves the Middle East the potential impact on oil prices can flow through to the rest of the economy in the same way as higher interest rates.
The chart above shows the S&P500 over the past few years. The share price fall seen earlier this year was similarly driven by higher bond yields when stronger than expected US wages growth prompted a spike in bond yields. Similar equity falls were seen in mid-2015 and again in early 2016, also driven in part by higher US bond yields. These previous corrections were also accompanied at the time by concerns that markets could be on the verge of another Global Financial Crisis (GFC). However, markets recovered when it became clear that economic momentum had not been derailed by inappropriate monetary policy, geopolitics or other unwelcome influences.
Are we at the tipping point this time?
US monetary tightening has progressed further but it does not appear that the fed funds rate or bond yields are so high that they would derail current growth momentum and tip the US economy into recession. Both bond yields and the fed funds rate were at least 2% higher prior to the last two significant equity market declines, namely the tech crash in 2000 and the GFC in 2008. Furthermore, interest rates in Europe and the UK remain at historical lows – that is, global monetary settings are by no means tight.
In the economic sphere, there are few signs that US consumers or business have lost confidence and are curbing spending or investment. Rather, most indicators continue to suggest the US economy will continue to grow at a moderate pace through the remainder of 2018 and into 2019.
Is your portfolio appropriate?
As always in financial markets, the current state of play matters less than what’s changing at the margins. While people always seem to see things with more clarity after the event, no-one actually knows the future or whether the selling will continue or abate. One thing we do know is that stocks are now cheaper than they were a month ago and that’s a good thing for future returns.
Predicting the timing of market corrections and recoveries is difficult, if not impossible. Calls from some quarters to reduce or completely remove equities exposure following recent corrections would have seen investors miss out on subsequent recoveries, but what if this time they are right and equities continue to decline? In my view the long list of issues suggests some caution is warranted, however great opportunities emerge during sell-offs as sellers become less discriminatory, It can often represent an opportunity to buy quality businesses in the market at a discount. While there is a range of risks at present, we do not see the excess that existed pre-GFC, and as a result see the pullback as more a long overdue valuation adjustment. To provide some context, post the falls in October, the Australian equity market is currently trading on 14x forward price-to-earnings. This is in-line with the long-term average, highlighting that valuations have improved.
While periods of market volatility cause nervousness in the short term, I believe they’re actually a positive occurrence for the market in the long term as they lower the risk of a larger flare-up. We firmly believe that the market now presents opportunities for investors, given reasonable valuations and against a backdrop of ongoing domestic and overseas economic growth, and while equity markets appears good absolute value, it still remains a stand-out in terms of relative value against other asset classes such as cash and bonds due to earnings and dividend yield.
If you have any concerns about how the recent market movements may have impacted your investments or wish to discuss any other matters in relation to your financial wellbeing, please feel free to contact a member of our Wealth Management division who will assist you.