To help you understand what’s going on with the sharemarkets we have put together a short webcast featuring Hans Kunnen, Head of Investment Markets Research at Colonial First State. This webcast will take you through some of the questions that you may be asking yourself such as ‘What is driving the current volatility?’, ‘How close is the US to recession?’ and ‘What is the outlook for 2008?’.
You may be understandably concerned about the recent volatility in investment markets. So to continue to keep you informed of what’s happening we provide a further update and cover:
Just prior to the federal elections in November 2007, the Reserve Bank of Australia (RBA) effectively declared war on inflation. It lifted interest rates in early November and followed this with further increases in February and March 2008.
In order to curb rising inflationary pressures, the RBA felt that it had to slow the pace of growth in the Australian economy. The prospect of weaker earnings growth by Australian companies sent the sharemarket tumbling.
At the same time, problems with sub-prime lending in the United States were coming to a head. US banks were announcing large losses and negative sentiment towards the US sharemarket spilled over into Australia.
The US sub-prime problem also reignited investor’s awareness of risk. This led to a sharp increase in the interest rates at which companies could borrow money, if indeed they could borrow money at all. The banking system faced a crisis, a shortage of cash to borrow, otherwise known as a liquidity crisis. This would disrupt company earnings and contributed to the fall in the sharemarket.
In the US, the authorities were faced with a slowing economy and a liquidity crisis, or what has been known as the “credit crunch”. In Australia our economy was still growing strongly but the financial system did face the problem of a lack of funds to borrow.
To assist its economy, the US Federal Reserve reduced US official interest rates. Interest rates have been reduced from 5.25% in September 2007 to now stand at 2.00%. It also injected cash or liquidity into its banking system and assisted the takeover of Bear Stearns, a large investment bank that was close to collapse, by rival bank JPMorgan Chase. The US government also chipped in by announcing $150 billion in personal tax cuts.
Around the world, and including Australia, central banks acted to ensure that banking systems had funds to continue operations. In the United Kingdom, the government went to the length of taking control of Northern Rock, a bank that was facing difficulties.
From early November 2007 to mid-March 2008, the Australian sharemarket fell almost 25%. The S&P/ASX All Ordinaries share price index fell from 6853 points to 5163 points. Since then it has risen approximately 15% to around 6000 points (as at 16th May 2008).
The fall in the Australian sharemarket was more severe than in other major markets. This was because Australia had to cope with rising official interest rates as well as the liquidity crisis triggered by US sub-prime lending.
The recent recovery in sharemarkets came as authorities around the world stabilised and supported their financial systems, and as the US reduced its official interest rates. While many problems still remain, the immediate crisis appears to be behind us.
The problems we still face relate to the pace of economic growth in the US and Australia. If higher interest rates in Australia slow the economy more than expected, then companies may issue further profit downgrades or profit warnings. This could unsettle the sharemarket.
Of particular interest will be the profits of banks. This group of companies make up around 20% of the sharemarket and their businesses have come under short-term stress due to rising interest rates. Banks have had to pay significantly more for the funds they borrow in global capital markets and this will affect the demand for loans by their customers for at least the remainder of 2008. The proposed merger of St George and Westpac adds a new dimension to the sector. One of the drivers of the proposed merger is to allow greater access to funding at a more attractive rate.
The road to recovery in sharemarkets requires that US house prices stop falling. Falling house prices and low demand for US housing lie behind the losses that US banks have been reporting for the last six months. A further cut in US interest rates may help, but US official interest rates have already been cut substantially.
When it becomes clear that official interest rates in Australia have stopped rising, investor confidence will be boosted. Due to ongoing inflationary pressures, this stage has not yet been reached. It remains possible that the RBA will lift interest rates again.
Finally, recovery will come when the market for corporate borrowing, known as the credit market, becomes fully operational again. At present, the desire to lend to companies is low. Trust needs to be re-established so lenders will offer interest rates that reflect the true risk of each transaction.
Despite the gloom in markets we do well to remember that parts of the Australian economy are still booming. The resources sector has seen the prices of coal and iron ore rise significantly. Share prices in the resources sector have recovered most of the ground lost in the early months of 2008. Rains over much of Australia should assist rural incomes and rural exports.
Finally, the boost to markets from takeover activity is not dead. In recent months, takeover bids have been made for a number of Australian companies. The bidders believe that at current prices, including a takeover premium, there is value in their takeover target.
There are issues to be resolved but Australia remains well placed to grow over the next five to ten years.
Fear, greed and patience are some of the dominant emotions associated with the sharemarket. At present, fear appears to be subsiding but some nervousness remains. Over time history has shown it is the patient investor who reaps the rewards.
Despite the recent falls in the Australian sharemarket, share prices are still up 20% since the beginning of 2006 and up 90% since the beginning of 2003.
In the current environment sitting tight could be a sensible strategy, but each investor has their own individual circumstances so you should speak to your financial adviser first.