14 Feb 2018
Markets are struggling for direction at present as competing forces push and pull investor sentiment and confidence. The current volatility we’re witnessing in equity markets both locally and globally is nothing new, but does come after a very long period of largely uninterrupted growth with the lowest levels of volatility on record.
Whilst the headlines (aka the noise) would have you believe that we’re now in a bear market or that the bubble has finally popped, the reality of it is that we’re just seeing a rather normal pullback in equity markets which have risen very strongly over the last 12 months or so – eg. the broader US equity market (not the Dow Jones) was up 22% in 2017 whilst the technology heavy NASDAQ was up nearly 30%.
What caused the change in investor behaviour?
The main protagonist is the US, specifically potential US central bank policy change. What’s driving this is the recent uptick in wages, a soft US dollar, rising commodity prices (particularly energy), and increasing US government budget stimulus (eg. tax cuts) at a time when fiscal stimulus isn’t needed. Whilst none of the trends in data is new, the market has begun to fret that an inflationary spike might force the US central bank’s hand into a potential misstep (ie. raising rates too quickly).
Whilst US economic data has been healthy and improving for some time, the data is still well behind where it should be in light of the amount of stimulus the US central bank and government have provided since the GFC and given where we are in the business and economic cycles. What has caught everyone by surprise is how quickly and strongly economic data points have improved in Europe, and to a lesser extent, Japan.
Improving economic data is generally supportive of asset price growth in the long run, but not if it forces central banks to remove stimulus too quickly.
What exaggerated the market movements?
Investors taking profits is nothing new. But 2 things are rather unique or different this time around, and are somewhat linked:
- The rise of exchanged traded funds (ETFs) and passive investing
- The disregard for valuations
The rise of ETFs now means that when investors take profits, they’re not being selective as to which stocks they trim or sell nor are they being selective as to how much they trim from each stock. What they are doing is pushing a button to sell their ETF, which holds the whole market, which then sells the whole market indiscriminately. The same is true for passive investing. Like with everything, there are positives and negatives to ETFs and passive investing.
The disregard for valuations is really a function of the rise in momentum investing, which has been exacerbated by rates and bond yields being too low for too long. Investors generally prefer to buy the overvalued investment whose price keeps rising, but don’t want to buy or top up the undervalued investment whose price is moving sideways or downwards. Momentum trading works until it doesn’t and valuations matter over the medium to longer term.
Has anything really changed?
Nothing has really changed from a fundamental perspective over the last few months. Global debt levels are now higher than they were pre-GFC. Yes, stimulus needs to be removed, but in a measured and well telegraphed fashion so as to not cause a full market meltdown. Remember, the easiest way to get rid of debt is to inflate it away, and inflation is better than deflation. A little of bit of inflation with slowly rising rates are conditions that are still broadly supportive of both equities and bonds.
What should investors do?
We continue to believe that all central banks will be very slow and measured in reducing and then removing stimulus over multi-year periods. However, central banks will use rhetoric, or silence in some instances, to help cool asset price growth where it’s out of line with underlying fundamentals. Right now is key in point.
As such, in managing your portfolio, it means that we are:
- Ensuring your portfolio has adequate diversification across and within asset classes, including the use of investments with different styles and approaches, and the use of differentiated return sources such as infrastructure and alternatives (where appropriate).
- Not stretching for or chasing yield, which may come under pressure in a rate rising environment.
- Actively reviewing the positions held to ensure they’re robust enough to navigate the market environment ahead
- Taking advantage of opportunities when they arise, and only where appropriate
- Not making knee-jerk reactions to noise - ie. market movements that have no basis
- Still focused on the medium to longer term
If you would like to learn more, attend one of our information seminars or discuss how this could work for you, family or friends, please don’t hesitate to contact us.
