An update on recent market volatility

Since peaking in November 2007, the Australian sharemarket fell 16.9% by 31 January 2008. Over January 2008 the market fell 11.3%, wiping away most of the gains achieved during 2007.

The primary cause of the market’s weakness and its volatility is the health of the US economy. There are concerns that the US will slip into recession during 2008, indeed some think it’s already there.

Denting US economic growth has been its sub-prime mortgage problem. Loans were made to people who simply couldn’t afford it. Eventually the borrowers defaulted and some US banks and other financial institutions reported very large losses.

At the same time, the US home building sector has been shrinking and acting as a drag on the economy.

Even though the US Federal Reserve has reduced its official cash rate, borrowing costs for businesses in the US have risen. This is also hurting the economy and business profits. Lenders are simply charging higher interest rates to customers with lower credit ratings. In the past they had been charging too little but the sub-prime problem has made all lenders more conservative. In some cases, financial institutions are unwilling to lend at any interest rate. This is called a credit crunch or liquidity crisis.

The link between the US economy, its banks and its sharemarkets is through earnings or profits. When the economy slows, profit growth slows. When the economy goes into recession profits tend to go backwards.

Given that earnings drive sharemarkets, the thought of falling profits unsettled the markets. When large US banks reported actual losses and when economic indicators pointed to a slowing economy, US investors decided it was time to sell and Australians followed suit.

Despite the fact that the Australian economy is strong and growing, investors became nervous. Would a US recession hurt our resources boom?  Are our banks also going to report losses?  Would higher interest rates in Australia hurt Australian companies?  Would higher mortgage rates hurt the building sector?

There were too many uncertainties for investors to cope with and January saw 12 consecutive days in which the Australian sharemarket fell.

Australia is not alone in experiencing market weakness. Since the start of the year, the US Dow Jones Industrial share price index has fallen 7.5%. In the United Kingdom the FTSE 100 index is down 13.1% while in Japan the Nikkei is down 16.2%.

What impact will US rate cuts have on the market?

On 22nd January the US Federal Reserve cut its official cash rate by 0.75%, from 4.25% to 3.50%. This cut came before its regularly scheduled meeting and was larger than any previous moves in its cash rate. On 31st January it cut its rates by a further 0.50% to 3.00%.

These cuts were aimed at easing pressure in financial markets and also at generating future economic growth. The cuts cannot stop the US economy from slowing over the next six months but they can cushion the fall and set the scene for future growth.

They can also act as a circuit breaker for the sharemarket, convincing investors that the economy will return to more robust growth over time.

What is Colonial First State doing in response to this market volatility?

Colonial First State invests in a wide range of markets. In each market the fund managers aim to provide returns for investors by following robust investment processes and an investment philosophy that has been developed over time.

Market volatility does not change this, in fact it is these times where it becomes extremely important to stick with your investment philosophy and not panic. Market volatility is inevitable, however by following our proven investment philosophy and selecting quality investments, we ensure we are working towards meeting the objectives of each fund over its suggested timeframe.

Is another drop in markets likely?

There will be further volatility. However over time, the sharemarket will grow with the Australian economy and the outlook for the Australian economy is positive. In fact, at present the Australian economy is growing so rapidly, the Reserve Bank is seriously thinking of lifting cash rates again to slow us down.

The weakness of the sharemarket, in light of the strength of the Australian economy, can be frustrating. But markets are affected by sentiment in the short-term and so far in 2008, sentiment has been negative.

In the short-term there will be periods of weakness and periods of strength.We cannot pretend that problems associated with the US sub-prime market are over. We cannot pretend that slower US economic growth won’t hold back global economic growth. We must accept that bad news out of the US, Europe and Asia will hurt sentiment from time to time.

But we also know that central banks around the world are cutting interest rates to ease the pressure on businesses and consumers. The upcoming Australian profit reporting season should show that profits in Australia are growing with the economy and the demand for Australian resources remains strong. However we believe share prices will continue to be driven by negative sentiment in the short term.

What should an investor do in these times?

Fear, greed and patience are some of the dominant emotions associated with the sharemarket. At present, fear seems to have the upper hand.

Despite the recent falls in the sharemarket, share prices are still up 11% since early 2006 and up 75% since early 2003, so it’s important to put these falls into context and remember what your long-term goals are. If you are thinking of making changes to your investments, it’s important to consider all the implications of this. If you switch or withdraw from your existing investment, the possibility of the investment recovering is lost forever. So, it’s important that you weigh up the chances of an investment recovering and we also recommend you talk to your financial adviser as they will have a better understanding of your personal financial situation.

back to top