Introduction

Share markets have seen a bit of volatility and a pullback over the past month. This has been particularly so for Australian shares. This note looks at the key drivers and whether it’s just a correction or a new bear market.

Drivers of recent volatility

Our view for this year has been that shares would have positive but more constrained returns than seen over 2012 and 2013 and that volatility would increase. Our basic reasoning was that with shares no longer dirt cheap, investors would have to depend more on earnings growth for share market gains and this would be more constrained and uncertain. Until recently it has been relatively calm though despite a range of worries and deep scepticism amongst many commentators. Lately though, it seems the worry list has intensified and this has been reflected in increased volatility. The list of worries includes the following:


The seasonal pattern in US and Australian shares

Source: Bloomberg, AMP Capital

While US and global shares have had only modest pullbacks of around 3 to 4%, Australian shares have been particularly hard hit with a fall of 7% reflecting the overlay of global concerns along with:

The correction in shares could go further: US shares, which tend to lead global markets, are only off slightly so far whereas corrections often go to 5 to 10%; nervousness is likely to intensify in the run up to the end of QE3 later this month; nervousness in Europe may well continue until uncertainty is cleared up around banks with the ECB to announce results of stress tests later this month; and finally seasonal weakness often runs into October. However, we view this as a correction, not the start of a new bear market.

A correction, not a new bear

There are several reasons why what we are seeing is likely a correction, rather than a bear market. First, valuations are not extreme.


Share market valuations

Source: Bloomberg, AMP Capital

This is evident in the previous chart which is based on a range of measures including a comparison of the yield on shares with that on bonds. Recent share market weakness has pushed valuations well into cheap territory again.

Second, the global economic cycle is a long way from posing a major threat to shares. The global economy is growing, but it’s uneven and sub-par. This is a blessing in disguise:


Global growth okay, but not booming

Source: Bloomberg, AMP Capital

As a result, global monetary policy is set to remain easy.

Finally, we are still a long way from the sort of investor exuberance seen at major share market tops. It seems everyone is talking about share market corrections and crashes. In Australia, the amount of cash sitting in the superannuation system is still double average levels seen prior to the GFC and Australians continue to prefer bank deposits and paying down debt to shares and superannuation. There is still a lot of money that can come into equity markets as confidence improves.


Australians' remain cautious regarding shares

Source: Westpac/Melbourne Institute, AMP Capital

So absent a left field shock the most likely outcome is that, while shares could see more downside in the next month, this is likely to be limited with the bull market to continue.

The threat from geopolitics and pandemics

Perhaps the main potential source of left field shocks are the current geopolitical threats, but our reading is that these are unlikely to pose a fundamental threat to global growth:

What does this mean for Australian shares?

If global shares have more short term downside then so too will Australian shares. However:

As such Australian shares are likely to see a strong rally into year end. Just bear in mind though that Australian shares are no longer the relative outperformer they were last decade. This decade is likely to see continued underperformance versus global shares as the commodity price super cycle is now going in reverse resulting in a headwind for the local share market and the falling $A (which we see heading down to $US0.80 or lower) will boost the value of offshore shares.

Concluding comments

The rough patch we have seen in shares lately could go a bit further. However, the bull market will likely remain intact thanks to a lack of overvaluation, the benign economic cycle, easy monetary conditions and a lack of investor euphoria.

 

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.