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Living with Volatility - Big Sky Financial Solutions

Living with volatility



The past few months have been extremely volatile in investment markets. Some would say they have been reminiscent of the Global Financial Crisis (GFC), particularly in early August 2011 when markets experienced wild price swings on a day-to-day basis.

The catalysts for this higher volatility have been well documented:

  • The long term nature of deleveraging and the price it is extracting from the global economy.
  • Fears of another global recession with clear signs of weaker growth in the US and Europe;
  • On-going financial instability and insolvency problems in Europe given the heightened risk of a Greek debt default, a dithering European political response, and some European banks requiring emergency ECB overnight funding;
  • Expectations that the US Federal Reserve would implemente more policy easing in September but with equity investors ultimately being disappointed with the yield curve flattening strategy chosen by the Fed;
  • US retail investors choosing to withdraw from markets completely, until the outlook becomes clearer - August was the first month since September 2008 that there was a net outflow from US equity, bond and cash funds. The same pattern is evident in Australia as investors favour term deposits, despite declining yields.

As the chart below shows, we are nowhere near the pre-GFC levels of market volatility of 5%p.a. and it may be that market volatility at levels around 10%-15% is to be expected for the foreseeable future.


It's all about Deleveraging



We are moving into an uncertain world which is putting stresses and strains on economies and financial institutions. The developed world is in a period of deleveraging which is likely to impact markets for a considerable period of time. This is because the amount of leverage in the global economy is huge and was accumulated over a long period of time (at least the last 20 years). So unwinding the leverage cannot take place overnight. A recent study by McKinsey indicated that 6-7 years was a reasonable expectation of how long it might take. One only has to look at the experience of Japan after its speculative real estate bubble burst in the early 1990s to see just how long deleveraging can take. In the decade following the bust, Japan experienced seven calendar years of sub -2% growth and the Japanese share market fell by 65%!

While the US real estate bubble was nowhere near as large as Japan's, unwinding the leverage in the US economy will still take time. The current deleveraging cycle started with the GFC in 2008 when the US government stepped in to bail out ailing financial institutions that had lent far too much money to the US housing market. At that time, government assistance helped US banks and corporates to start deleveraging but, in reality, the problem was simply passed to the US government that purchased much of the debt. In addition, US government spending rose significantly under the Bush Administration and taxes were cut, so the US Government is now to indebted that it needs to do its own deleveraging to avoid an unsustainable fiscal position in years to come.

Similarly in Europe, the current bout of uncertainty over soveriegn debt levels and the insolvency of the banking system have their roots in the explosion of leverage that took place after the creation of the Euro in early 1999. European authorities (the ECB and the national governments in the core) are now being called upon to bail out European banks and insolvent peripheral countries or face the prospect that some may default or be forced to exit monetary union.

Deleveraging has a price



The other aspect of deleveraging that markets must deal with is the cost - in this case, the contractionary effect it is having on the global economy. Reducing debt to more sustainable levels requires a period of austerity, lower government spending (and the flow-on into the provision and employment in all government services), higher taxes, reduced consumption and increased household saving. All this is clearly evident in Europe and the US at present and are likley to continue for some time.

These themes are not conducive to stability, confidence and strong economic growth. A prolonged period of slower earnings growth may be looming for the major developed economies. Global earnings forecases are already being downgraded for FY12 in response to all these developments. The International Monetary Fund preficts very low levels of growth in the developed economies, as shown in the table below.


The road ahead



Regardless of how markets are gyrating, the Australian economy is in a much better position that the US and Europe at present.

Australia's sound banking system (with negligible exposure to Europe), very low level of sovereign debt (only 6% GDP) and monetary policy that has the scope to ease if the economy enters a period of significantly weaker growth, help explain the relative attractiveness of Australia compared to other develped economies at present.

Another one of the reasons that the Australian economy is holding up so well is the increased integration of Australia into the economic cycle in Asia, particularly China, due to our vast supply of natural resoruces and Asia's corresponding demand for these products. To illustrate this point, consider the destination of Australia's merchandise exports - over the twelve months to end July 2011, 26.5% went to China whilst only 3.7% went to the US.

All this suggests that the Australian economy should be partly insulated from further weakness in the US due to its links to China where growth appears more robust and sustainable. The main risk for Australia is if the People's Bank of China PBOC is forced to tighten policy more aggressively in the face of a reacceleration in inflation. In this scenario, Chinese growth could slow more sharply and for a prolonged period. This would clearly be a negative development for the resource sector of the Australian economy which has been the main engine of growth for Australia in recent years. Resource shares would be vulnerable in this environment.

Looking forward, markets are likely to remain volatile as the outlook for global growth is uncertain and investor confidence is unlikley to return until a lasting solution to Europe's debt problems is negotiated. There is much uncertainty, and the one thing that investors hate most is uncertainty. However, it is important to try and look through periods of volatility in markets and having a long term view of your investments.

This may be easier said than done, but panicking and selling your investments when markets get volatile can often result in you missing out when the investment environment settles down and markets start to recover. Share price weakness may not be justified, as periods of extreme volatility often result in discriminant selling of all stock in the market regardless of their longer term prospects. In this environment, volatility can create investment opportunities.

Sources:
Aviva Investors
International Monetary Fund

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