Markets drop as fear grows about global economy

Financial Index Australia Pty Ltd
Investment Committee

Overnight, the stockmarket in the U.S. fell by around 5% which is a significant fall comparable to the worst days of the GFC in 2008/2009. We saw this happen a few times through that period before recovering strongly.

The U.S. market has been in serious retreat over the past few days (and weeks) after having risen very significantly over the last two years anticipating a sustained economic recovery. It is clearly feeling disappointed about the outcome.

With the major concerns of U.S. and European government debt seeming to be irreconcilable and any number of indicators showing the quality of the economic recovery turning more negative, has resulted in a capitulation on the stockmarkets.

The Australian stockmarket has been disappointingly tracking overseas markets probably more in sentiment than in substance. As we know, our local economy is not plagued with alarmingly high government debt or high unemployment. Unfortunately, our small market does get buffeted hard when investors start to panic sell when they see big markets take a bad turn. 

The trigger for Wall Street came out of Europe amidst debt-related confusion. After its scheduled review, the European Central Bank (ECB) left its cash rate unchanged. With so much debt in the Eurozone (and with so many governments teetering), it is the only thing the ECB could do. The reality is that banks and bondholders are demanding higher interest rates for the higher risk. European markets were already tanking as Wall Street opened last night and the trend continued across the Atlantic.  

It was a “sell everything” session including gold and silver. In response, with more people chasing the greater safety of cash, the $US, the Euro and the Pound all rallied higher. The Aust dollar has been falling in the last few days as it is more closely tied to commodity companies in the stockmarket. It has fallen from U.S$1.10 to $1.04. The only positive, if there is one, is that a fall in the value of overseas investments is offset by any corresponding fall in our dollar thereby cushioning the fall. 

What now?

This time last year, Wall Street fell by 17% before the U.S. Federal Reserve Bank announced a second large stimulus package which resulted in a bull run in the stockmarket. Many believe the Fed has no choice but to do it all again.

Until there is more clarity around what is happening, markets will continue to be choppy and sometimes highly volatile as in the last 24 hours.

With a continued environment of high volatility, uncertainty, social and geopolitical turmoil, investors need to have strategies to manage this. Your portfolio with us is not exclusively in the U.S stockmarket nor even the Australian. 

We remind you that sensible portfolio construction should have risk reduction strategies applied to it. These range from spreading you funds to different sectors such as cash/term deposits, fixed interest (bonds), property as well as shares. Inside these sectors further diversification is applied by blending managers for their different skills and different decision making processes as to where, when and how to buy across sectors and markets on your behalf. Beyond this there are other strategies applied to minimise risk. Theses events even offer great opportunities to buy undervalued assets because people are panic selling.

The robust nature of manager selection and fund blending within the Financial Index framework gives us confidence going forward that the panic market movement will be short term and sanity will return. Our client portfolios will not suffer anything like the full market downturn because of the significant diversification across assets and fund managers.

Fixed Interest portfolio

Higher credit rated portfolios will gain from the recent turmoil. As more investors shift toward defensive assets, yields tend to fall pushing up bond returns. Returns significantly above 6.5% are expected. Credit margins have expanded.

Australian Shares- Active portfolio

The impact on each active manager will differ. Current portfolio positioning by some managers such as Schroders and Huon (see manager specifics 100 Leaders Fund below) should provide returns above the benchmark index due to the strategies they follow. Value strategies engaged by Dimensional and Index funds will underperform in the short term.

 Australian Shares- Passive portfolio

 Passive strategies are expected to provide performance in line with market indices. In the current market climate, active management is preferred.

Unlisted Property

Unlisted property is unlikely to be affected at this time; particularly properties with minimal leasing or financing concerns. The property cycle has historically lagged the listed sharemarket so we don’t expect any immediate negative valuation changes based on market volatility. 

International share exposure

An underweight position in overseas equities has been held leading up to this. Some managers, particularly those with long/short strategies should outperformed . Unhedged funds will benefit from the fall in the AUD overnight as mentioned above.

Emerging market

These are likely to remain counter cyclical to developed markets, with recent losses likely to be materially lower than anything in the US and Europe. 

Manager specifics

100 Leaders Fund

The portfolio of the 100 Leaders Fund has been focussed on protecting the downside of the portfolio, whilst also being exposed to a bounce in markets. It has been concentrating positions at the largest most liquid end of the market. As a result it has very little market exposure today, although it continues to be invested to take advantage of cheap valuations.

Its focus is on sustainable dividend yield, low gearing and minimal exposure to global economic contagion. 

Banks now look cheap as they are trading close to book value (i.e. the underlying value of their net assets) with high (~ 9% fully franked) which we believe is sustainable. Aust Banks have very little direct exposure to toxic sovereign debt.

Huon remains optimistic on the prospects of equity markets. It has managed to avoid any significant capital losses in the current market environment and is well placed to benefit from any rebound.

Schroders

Has a bias to industrials with earnings exposure to economies where a stronger economic cycle exists (i.e.Asia) or to domestic industries where cyclical debasing has already occurred, such as Pathology. This balancing act has dominated the past three years and will continue to dictate the assessment of not just future likely returns, but also risks, in the portfolio.

Kapstream

Kapstream (a noted bond and fixed interest manager) believe there have been a couple of key improvements to the global  financial world that should prevent another 2008 crisis.  Firstly, we are less likely to have a systemic banking failure in the US as bad debt has been written off by the too-big-to-fail banks and fair amounts of capital have been raised.  Secondly, there is a significantly lower amount of leverage being employed in the system, including the leverage used by hedge funds.  This isn’t to say new risks haven’t arisen, they certainly have, such as a systemic European banking crisis, but we have been preparing for both this crisis and the future opportunities that should arise out of the crisis.

Over the past few months Kapstream have continued to reduce portfolio risks and built both cash reserves our overall liquidity position in order to withstand such bouts of volatility, changes in interest rates and corporate spread widening.  

This will allow the fund to better take advantage of opportunities in coming weeks and months.  We see government bonds continuing to rally in the short-term but feel that holding longer dated bonds is not attractive. We expect to find exceptional opportunities in higher-yielding / higher-rated assets with limited risk, as the flight-to-quality story unfolds.

Pengana

Despite positive developments in the US and European debt crises, persistently poor economic news has led to plummeting equity markets and a "flight to safety". Consequently bond yields have rallied despite the sovereign debt issues that persist in many developed markets. The fund believes that that the long term course of G7 yields is upwards but that bond yields may remain low until there is evidence of more stable economic growth. The portfolio remains underweight to treasuries and has a low duration portfolio of assets relative to its benchmark. 

The portfolio contains some corporate debt (global investment grade corporate debt and US bank loans), but we have intentionally avoided poorer quality corporate debt that has rallied significantly since 2008. The portfolios corporate exposure is highly diversified and concentrated in the high quality debt of the largest companies. Bank loans have relatively lower credit ratings but move more independently of broad debt markets due to their unique characteristics, but may be affected if the US economy slows and falls into a further recession. However this is not our expected scenario: we anticipate continued slow growth with periods of high volatility, as we are experiencing now.

The portfolio also contains emerging market debt but it is important to recognise that the recent market moves are a reaction to the poor economic performance and debt issues facing developed economies, not emerging. Emerging markets face other issues, such as growing inflation, but they should be less affected by recent developments, the main risk being a sell down due to investors simply moving to “less risky” assets, such as developed government debt.

Approximately one third of the portfolio is invested with relative value managers that hedge the directionality of their investments. They are therefore more insulated from moves in yields and changes in investors’ risk appetite. We look to these managers to generate consistent returns through all market periods and they have demonstrated their resilience through challenging periods in the past.

Overall, we would expect through this period that the portfolio will under perform the benchmark however returns in an absolute sense should remain solid. Over the past few years we have been through a number of volatile periods on the path to economic recovery and expect that this may not be the last one.

We trust the above commentary has been helpful in giving you an overview of what is happening in the markets and what Financial Index’s view is relative to that. We will continue to keep you informed.

If you have further concerns please have no hesitation in calling your adviser for specifics around your portfolio.