Share Market Correction Marks A Return To Normality

One of the most surprising aspects of the current economic cycle has been the extent to which strong global economic growth has persistent with an absence of upward pressure on wages. Labour markets in the United States and Japan have been operating at levels close to full employment for some time, which would normally be expected to be accompanied by rising wages as employers bid up the price of increasingly scarce workers. Globalisation, with the ability of firms to shift production away from more expensive work places, was the most often cited explanation for the lack of wages growth. Whilst there is no doubt some validity to this explanation, not all production can be re-located and the forces of supply and demand will still ultimately prevail on labour markets. This was evident with the release of January hourly wages data for the U.S., which showed the annual growth rate increasing from 2.7% to 2.9% - the highest growth rate since June 2009. The release of this data last Friday, following weeks of firming bond yields, appeared to be the main catalyst for the correction experienced on share markets over recent days.

Although the spike in U.S. wages is not totally unexpected, it has led to upward revisions in inflationary expectations and provided further momentum to rising bond yields.  Higher bond yields reduce the attractiveness of equity market investments in relative terms. As a result, share markets have fallen, thereby boosting the future earnings yield available on equities and helping to restore the margin between prospective returns from “risk free” government bonds and equities.

How far have markets fallen?

The equity market correction has been material. At the time of writing (6^th February) the Australian share market had experienced a decline in value of 4.7% over two days. This fall has been less than the two day fall in the U.S. S&P 500 Index of 6.1%. However, as indicated on the accompanying chart, the U.S. market had experienced a considerably stronger rally over recent years than the Australian market and was operating at more elevated valuations. This was consistent with the stronger earnings growth generally associated with much of the U.S. market. 

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The above chart also provides some context around the size of the current correction. The fall in prices experienced so far this month has returned valuations to where they were as recently as the December quarter of last year.

Are further falls likely?

Short term movements in share markets are notoriously difficult to predict, given the role played by sentiment and emotion over the short term. There is a possibility that a combination of investor fear and computer program selling could see further downward momentum in prices. However, underlying economic fundamentals do not currently justify a more extended “bear” market. Over time, it is expected that investors will refocus on company earnings fundamentals, which generally remain solid against a backdrop of improving global economic growth. In fact, it is the strength of this growth that has triggered the market’s current focus on inflation and higher bond yields. Some adjustment in equity prices to reflect higher bond yields is warranted; however, unlike the environment surrounding the Global Financial Crisis, there are not major systematic imbalances or corporate and financial institution distress weighing on the outlook for company earnings. Having wages and inflation rise in an economic upswing is a very normal phenomenon and is the economy’s way of allocating resources as they become more in demand.

Is the outlook different for the Australian market?

Although the Australian share market has participated in much of the correction experienced on overseas markets, there are some significant differences in the local environment that may influence the ultimate outcome, as outlined below:

• The Australian market has not experienced the same growth in share prices over recent years as several key overseas markets. As such, valuations here are arguably not as “stretched” and the need for any adjustment may be less.

• With banks and resource companies representing such a large slice of the Australian market, our market may behave differently in response to the changes in the global macro-economic environment. More specifically, it could be argued that a rise in interest rates is positive for banks as it allows them to restore some lost interest margin. For resources, the absence of any deterioration in the outlook for global economic growth combined with slightly higher inflation could be favourable for commodity prices and earnings.

• Australia’s economic growth trajectory is currently more subdued than that of the U.S. and expectations of interest rate rises and inflationary pressures here are more muted as a result. Therefore, the change in valuation relativities between bonds and equities may be less significant here and a less material equity price response may be warranted. 

Hence, should prices on the Australian share market continue to decline, buying opportunities may emerge. In particular, stocks that are exposed to the global economic cycle, such as resource companies, may continue to be well positioned for earnings growth. Additionally, if, as we expect, Australian interest rates lag behind overseas yields, downward pressure may be exerted on the Australian dollar, which is currently trading above longer term fundamental values. A lower $A would create earnings growth opportunities for Australian export orientated companies, as well as helping to protect the value of overseas equity investments held by Australian investors on an unhedged currency basis.

If you would like to discuss any of the above or other matters that may have a potential impact on your financial situation, please do not hesitate to contact us on 02 8824 7881.

Yours sincerely

  Shitij Mann, Dip FS(FP)

AMC, M.B.A(UTS Sydney), C.S, B.Com

Authorised Representative of AMP Financial Planning Pty Limited

ABN 89 051 208 327 AFS Licence No. 232706

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