Cheaper than you think

Risks may have risen in the markets but central banks stand ready to cushion falls.

Summary: The latest financial stability review from the International Monetary Fund suggests risks have increased for equity investors due to the emerging markets and shrinking liquidity. However, it also highlights that equity valuations aren’t as stretched as they were before the GFC – providing some comfort for investors. 

Key take-out: With liquidity risks likely to not be as bad as the IMF believes and equity valuations not too stretched, investment markets are probably more stable now, not less.

Key beneficiaries: General investors. Category: Shares.

The International Monetary Fund’s (IMF) latest financial stability review was solemn reading. Overall, the IMF suggests that risks have increased over the last six months – and you can get a bit of an idea as to where those risks lie by looking at chart 1.

On the Australian market investors will be watching carefully this week to see if we can finally crack the S&P/ASX200 6000 mark. Likewise, overseas investors are examining whether the US markets where the NASDAQ just reached a new record high can continue in the right direction.

For investors everywhere there are mixed signals, but one signal that sent a tremor through the markets in recent days was reports that the IMF had expressed concerns on market stability. Specifically, there were fears surrounding the IMF suggesting that risks in the market  have increased over the last six months.

You can get an idea of how the IMF has been assessing the situation in Chart 1.

Chart 1: Market risks have increased

In the chart above, the top half (with red headers) shows risks, while the bottom half (with blue headers) shows conditions.  As you can see from the chart, the IMF is concerned that the areas where risks have increased include emerging market risks and market and liquidity risks. At the same time, monetary and financial conditions have eased, while risk appetite has deteriorated.

So should investors be comforted or alarmed by all of that?

Well, to try and get a sense as to whether you should be concerned, we have to drill down into the detail, so let’s take the main areas where the IMF has heightened concerns.

An increase in market risks sounds bad, and on a raw read, the IMF seem to be saying that market and liquidity risks are similar to what we saw at the height of the GFC. You can’t see that in the chart above, but the level of risk the IMF observe in the data is the same as market and liquidity risks observed in the third quarter of 2009. Starting from the outer web, both are at about 3 or 4 lines in.

On the face of things, that seems to suggest reason for heightened caution in how you approach your own investments. However, it’s important to note that while the level of risks observed is the same, the nature of those risks is different.  In 2009 the IMF was concerned about short-term money markets freezing up – in fact, banking in general freezing up, and the threat that posed to a broad array of asset prices.

In 2015, the concern is about the disparate monetary policies in the US and Europe – well, the threat of it – and the surge in exchange rate volatility this has induced.

Within that, the IMF are also concerned about bond values while ironically supporting the idea that monetary policies around the world should continue to be ultra-loose.  A major concern here is whether liquidity will dry up in the bond market once central banks start to tighten. That is, who will want to buy government bonds off central banks?

In the emerging markets the IMF has concerns about falling commodity prices, political instability and foreign denominated debt holdings. On China, the IMF suggests that the key risks are related to the property sector decline.

These concerns are all reasonable. The main question is one of degree. The IMF sees these risks as elevated. My own view is that some of these risks are overstated by the IMF and I certainly wouldn’t compare market and liquidity risks now to 2009.

Specifically, while I respect the concern that bond yields could rise sharply once central banks start to tighten, the reality is that if they did, central banks would simply crank the printing presses up again to get bond yields lower.

Similarly, China’s property bubble has deflated. Prices are falling at low single digit rates and supply has been curtailed. Despite this, credit growth remains robust and the broader economy is on a strong footing. That is, there has been no spill over from the property slowdown – other than for Chinese stocks to surge 100 per cent!

In any case, noting these concerns, the IMF produced another interesting chart which should put these risks into some sort of perceptive for domestic retail equity investors. Take a look at chart 2 below.

Chart 2: Equity valuations are elevated but less so compared to pre-GFC

It’s what the IMF call a ‘heat-map’, and its meant to show graphically how asset valuations have changed over the last decade or so. There is quite a bit there, but for brevity, I’d simply draw your attention to the top three rows.  That’s the equity valuation heat map for the US (top row), Europe second row) and the emerging markets (bottom row).  

Red means values are rich and green means cheap. As you can see, the IMF suggests that equity valuations are stretched in the US, and, slightly less so, in Europe. OK, so that’s all good and well and nothing we don’t know. What’s really interesting about this heat map though is that it suggests as stretched as equity valuations are right now that they are still cheaper than in the three or four years prior to the GFC. There was lots of red during that period.

That’s an interesting contrast. Risks are more elevated now than say in 2005 on the IMF view, but equities are generally cheaper.

In my opinion that’s not necessarily a bad environment for investors.  Nearly all the lift in risk is associated with either central bank policy or emerging markets. On the former, we know that rates are going to remain low for a very long time, and at the first sign of trouble central banks will be printing again. That’s the main reason why I’m not as concerned as the IMF about volatility due to disparate central bank policies. Truth of the matter is I think they’re really going to need exit together.

As for the latter, well if you’re risk averse, just stay away from emerging markets!  That leaves us with the IMF’s more interesting point about equity valuations.

It’s in that sense that investment markets are probably more stable now, not less. The broader global economic backdrop is benign and improving on the latest figures – Even Europe!

More to the point, where else are global investors going to go? With that in mind, and without some clearly defined imbalance in the developed markets, investors can perhaps relax a little more.