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:
What has caused some share prices to fall so sharply?
Australian shares fell sharply in the early weeks of 2008. At one point, the share market was 20% lower than its peak in November last year. Despite a partial recovery, at the end of February the market was still 17.2% below its high point. Recent volatility has both offshore and domestic roots. The volatility of 2007 was caused primarily by issues arising out of the United States as fears of a recession arose. The volatility of 2008 is largely home grown with the Reserve Bank of Australia (RBA) lifting interest rates and declaring war on inflation.
What exactly is the sub-prime market?
Translated literally ‘sub-prime’ means ‘below best’, which is a reference to the credit rating of the borrower. In other words, sub-prime mortgages are loans granted to people who may not have the ability to make repayments and those who would not have qualified to borrow money under normal circumstances. Many of these loans have moved into default, meaning that lending institutions began losing money. Investors then started selling shares in these financial institutions. |
Issues in the US economy
In the United States, low interest rates and relaxed lending practices fuelled a housing boom. Many high-risk (sub-prime) borrowers obtained loans that, over time, proved difficult to service. Housing construction in the booming US market outpaced housing demand. As a result, prices began to fall. For many borrowers, the value of their home fell below the amount they owed to the bank. As borrowers defaulted, banks (and other lenders) were forced to sell houses in an already distressed market. This meant that outstanding debts could not always be recovered. Rising defaults saw several large US banks report losses. This punished their share prices and led to weakness in bank shares world-wide. Losses didn‘t stop with US retail banks. Investment banks had repackaged these mortgages and on-sold them to investors world-wide. When defaults began in the US, these repackaged mortgages fell in value and investors lost money. Fears of a US recession, mounting losses and increasing uncertainty saw a reassessment of risk globally. Lenders became unwilling to lend and borrowing rates rose sharply. Companies faced crippling increases in their borrowing costs and in some cases found it almost impossible to refinance debt. None of this is good for shares. In 2007, there were periodic bouts of market weakness. By November, investors world-wide were moving out of equities. The news didn‘t get any better during December and January and markets continued to decline. The slide in share prices was arrested during February but markets remain volatile.
The Australian economy
Australia escaped most of the direct sub-prime losses, but has been caught up in the fallout. Australia also has to cope with the challenges of the resources boom. Borrowing rates for Australian companies rose with the rest of the world in November. A number of companies faced difficulties refinancing their debts. The listed property market was hit particularly hard as the sector had significantly high borrowings. Negative sentiment towards the global banking sector applied additional pressure on Australian banks and financial institutions. Despite good business growth and minimal exposure to subprime debts their share prices fell. Of greater concern to Australian investors has been the RBA‘s outlook for the economy. The resources boom has helped push unemployment to its lowest levels in over 30 years. Consumer demand has been strong and inflation is rising. In the face of the threat of inflation, the RBA has been lifting interest rates and is intent on slowing Australia‘s economic growth. The economy is still expected to grow in 2008 but at a slower pace than what was envisaged during 2007. A slower economy means fewer opportunities for earnings growth. This is bad for companies and share prices.
Are we there yet?
A number of things must happen before investor confidence returns. US interest rates must fall further to take pressure off consumers and companies. US house prices must stop falling to stem both the impact and the rate of defaults across the US mortgage sector. Australian interest rates must stop rising.Credit markets must arrive at appropriate borrowing rates for Australian companies. Presently, lenders are being very conservative. As the market identifies who the good borrowers are and who the not-so-good borrowers are, appropriate rates can be applied and businesses will face a more certain borrowing environment. None of this will happen overnight but the process is underway.
What is Colonial First State doing in response to this market volatility?
Colonial First State is involved in a wide range of markets. In each market the portfolio managers follow processes and an investment philosophy that has been developed over time. In volatile times we re-examine our investments to ensure they fit our criteria and investment philosophy. We cannot avoid market volatility but we can select investments that will best meet the objectives of each fund. Those investments will vary from fund to fund.
Is another drop in markets likely?
There will be further volatility. However, over time the sharemarket should grow generally in line with the Australian economy. The outlook for the economy is still positive over the medium term. The short-term outlook is less certain, hence the market volatility. Rising interest rates aren‘t helping – but rates won‘t rise forever. As the economy slows, inflationary pressures will abate and the need to increase interest rates will end.
What should an investor do in these times?
Fear, greed and patience are some of the emotions associated with the share market. At present, fear appears to be the dominant of the three. Over time it is the patient investor who can reap the rewards. It‘s important to keep recent volatility in perspective and remember your long-term goals. If you‘re thinking of making changes to your investments, it‘s important to consider all the implications. If you switch or withdraw from your existing investment, the possibility of participating in any recovery is lost forever – your losses are locked in. You should talk to your financial adviser. They will have an understanding of your personal financial situation.
Where to next?
