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Is this the correction we’ve been waiting for?

It might have felt like a freight train for those close watchers of global share market: first a rumbling in the distance, when selling first started and volatility lifted on Friday in the United States. Then, by the start of trading on Monday, we already had a fair idea of what was coming. Here, Dr Shane Oliver unpicks the recent market movements and whether he believes this is just another correction or the start of something prolonged.



This is the correction I’ve been waiting for, but the answer to this question will depend on your interpretation of what’s occurred in markets this week and where we could go from here.

It might have felt like a freight train for those close watchers of global share markets: first a rumbling in the distance, when selling first started and volatility lifted on Friday in the United States. Then, by the start of trading on Monday, we already had a fair idea of what was coming.

Two days of selling on the Australian Stock Exchange where no sector was spared, before a bounce back on Wednesday. Then selling resumed again on Friday following another bumpy ride in the US. The largest companies index in the world, the S&P500, continued its dizzying gyrations right through to the end of the northern hemisphere’s working week. From their highs to their recent lows, US and Japanese shares have fallen 10 per cent, Eurozone shares have fallen 8 per cent, Chinese shares have fallen 9 per cent and Australian shares have lost 5 per cent.

What’s normal?

It’s worth noting that periodic corrections in share markets of the order of 5-15 per cent are healthy and normal. 

During the tech com boom, from 1995 to early 2000, the US share market had seven pull backs greater than 5 per cent ranging from 6 per cent up to 19 per cent with an average decline of 10 per cent. During the same period the Australian share market had eight pullbacks ranging from 5 per cent to 16 per cent with an average of 8 per cent. All this against a backdrop of strong returns every year. 

Meanwhile, during the 2003 to 2007 bull market, the Australian share market had five 5 per cent-plus corrections ranging from 7 per cent to 12 per cent, again with strong positive returns every year. 

More recently, the Australian share market had a 10 per cent pullback in 2012, an 11 per cent fall in 2013 – remember the taper tantrum? – an 8 per cent fall in 2014 and a 20 per cent fall between April 2015 and February 2016 all in the context of a rising trend. 

Global shares have seen the same type of movements described above. In fact, share market corrections are healthy because they help limit a build-up in complacency and excessive risk taking. 

Along for the ride

It’s probably no surprise self-directed investors and those who manage their own SMSFs might be particularly attuned to the current market movements; analysis of the latest holdings and behaviours of a sample of SMSFs shows funds had been trimming their cash positions towards the end of last year and increasing their international equities allocations.

Exposure to international equities increased from 13.1 per cent to 13.9 per cent, according to the latest SuperConcepts numbers, a survey of 2640 funds. Meanwhile, cash levels built up last year dropped quite markedly. This indicates many funds drew upon their cash reserves to buy global shares, the survey finds.

For those with discretionary savings to invest, it’s been a difficult time to be on the sidelines holding cash with only meagre returns on offer. 

Returns produced by share markets globally as well as at home leading up to this sell off have been strong. The S&P500 index rose a staggering 6.7 per cent this year alone leading up to the early February correction and 2017 stands out as an anomaly year for share market returns. 

While it’s probably too early to say for sure, I believe we may have seen the worst of the selling. My view is this is just another correction and not the start of something prolonged and fundamental related.

A comment on the underlying fundamentals and prospects for economic growth as we’re seeing it in a moment, but first a quick summary of the drivers behind this plunge as I see it:

First, the trigger was the concern that US inflation would rise faster than expected, resulting in more aggressive rate hikes by the US Federal Reserve and higher bond yields. Flowing from this was the concern that the US Fed might get it wrong and tighten too much causing an economic downturn and that higher bond yields will reduce the relative attractiveness of shares and investments that have benefitted from the long period of low interest rates.

Second, after having not had a decent correction since before US President Donald Trump was elected and with high and rising levels of investor confidence, the US share market was long overdue a correction.

Finally, and related to this, the speed of the pullback looks to have been exaggerated by the unwinding of a large build-up of so-called short volatility bets – that is, bets that volatility would continue to fall – via exchange traded investment products that made such bets possible. The unwinding of such positions after volatility rose further pushed up volatility indexes like the VIX index, and that accelerated the fall in US share prices. 

The critical question 

The critical question is whether the US economy is heading for a recession, because as we know, the US share market invariably sets the direction for global shares including the Australian share market. Historical experience tells us that slumps in shares tend to be shallower and shorter when there is no US recession and deeper and longer when there is.

We don’t think a recession in the US is around the corner – at the end of the day the post-GFC hangover has only just faded, with high levels of confidence helping drive stronger investment and consumer spending. 

Also, while US monetary conditions are tightening, they are still easy. The Fed Funds rates of 1.25 - 1.5 per cent is still well below nominal growth of just over 4 per cent. The yield curve is still positive and in fact has been steepening lately as long-term bond yields have been rising relative to short-term interest rates, whereas recessions are normally preceded by negative yield curves.

In addition, tax cuts and their associated fiscal stimulus are likely to boost US growth at least for the next 12 months.

Finally, we have not seen the excesses – massive debt growth, overinvestment, capacity constraints or excessive inflation – that normally precede recessions.

So for these reasons, the pullback in the direction-setting US share market should be limited in depth and duration to a correction and we remain of the view that returns from shares will be positive this year. However, it’s increasingly clear that it’s going to be a more volatile year than last year and that share market sectors that are sensitive to rising interest rates and bond yields are likely to remain relative underperformers.
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