Despite the revival in world equity markets over the past six months, its renewed optimism is still very fragile. It seems it doesn’t take much to shake markets, and recent data on lower-than-expected growth in China, or a fall in the price of gold, are enough to send jitters through the markets.
On top of this, there are other major events that can cause serious problems around the world if they go unchecked.
Examination of the world share markets can help investors decide which events are temporary set-backs to the market upturn, and which are more serious threats to global economic health.
Overview of world share markets
Events in Cyprus and North Korea have caused a bit of a pause in the market resurgence that started in May 2012. Cyprus was significant, not because of its size but because of precedents set in the European Union's handling of the affair.
The head of the European Central Bank, Mario Draghi, commented the European Central Bank (ECB) would "do what it takes" to preserve the euro. It was Draghi's comments that triggered the current market strength, as it was taken to signal a clear commitment by the ECB to preserve the euro. As a result, markets start to recover from their very depressed level.
However, events in Cyprus have shaken some of this confidence, after the government initially proposed a measure that would have seen ordinary bank depositors hit with a ‘tax’ on their savings. It therefore appears to have drawn a very clear line between ‘doing what it takes’ and ‘absolutely anything’ to save the euro.
While the decision to give rich Cypriot bank depositors a massive haircut was unpalatable, it wasn't that long ago depositors in Icelandic Banks also got a nasty surprise. A few years later and Iceland is actually looking pretty good. So it’s possible to draw the conclusion that tough measures, while unpopular in the short-term with the electorate, could in the medium or long-term be in the best interest of the economy and the people.
There is no doubt European countries, with very few exceptions, are struggling to get their economies back on track. As a region, Europe continues to struggle with high production costs, dodgy bank and state finances and extreme unemployment in southern regions. Unemployment is so high in troubled southern countries there is a real risk of civil unrest, which hampers the implementation of necessary reform. Chart A shows the difference in unemployment rates within Europe.
Unemployment Figures in Europe
Chart A – Source: Bloomberg – latest figures available as at May 2013
We’ve already seen the debacle of the Italian election, and this is just the latest example of a trend where politicians who promise anything to reduce the financial hardship of the population, regardless of how unsustainable or impractical the promise, are given power.
How long this kind of situation can continue is unknown, but any sensible evaluation of the situation suggests that at some point, some hard decisions will need to be made, no matter how unpopular.
The rhetoric from North Korea obviously isn't helpful for anyone – least of all North Korea. Conflict in Asia has the potential to derail the world growth engine of the past few years. However, even the North Koreans must realise that they have nothing to gain by actually going to war.
We can assume China would take a dim view of activity that impairs its growth prospects. While the brinkmanship has stepped up a level, the most likely outcome is this too will blow over.
The US is looking much stronger, as the economy has been swamped with cheap money for some time. A low exchange rate and low borrowing rates finally appear to be breathing life back into US industry, providing welcome relief on unemployment. Chart B shows the growth in employment over the past 12 months.
Chart B – Source: United Department of Labor as at March 2013
Recent data coming out of the US, such as housing and employment figures, has been positive and, coupled with low interest rates, suggest the US is well on the road to recovery.
Japan is a real outlier. Recent efforts to reflate the economy have been very well received by equity markets (the Nikkei is up 33.3 per cent in the first four months of 2013), and the collapse of the yen will help recovery. But let’s face facts: we've been here before. While policy changes are encouraging there are still plenty of things that can go wrong.
Impact for Australian investors
Despite these setbacks, equity markets have been performing really well. The S&P/ASX 300 Accumulation Index of Australian shares is up 7.6 per cent in 2013 to 31 May, and US based S&P 500 is up by over 14.0 per cent, and has exceeded its historic high.
The Australian market as a whole will do okay over the long-term, thanks to the Australia’s access to natural resources. But there is a supply response coming in iron ore production that will lower commodity prices, and this may be a drag on Australian equity markets in the short-term.
While capital works in the resources sector may be near their peak, these projects will ultimately flow through into improved production that will benefit the economy generally, though there may be some painful adjustments. Expect the prices of resources companies to be volatile.
Outside of resources, Australian companies are struggling with a high Australian dollar, and higher interest rates than international peers. It's hard to see them improving without a radical fall in the Australian dollar.
Factors driving markets
Equity markets are no longer undervalued. In fact, the Australian market is starting to look pricey. Nevertheless, we believe equity markets still have a way to go given the very low returns from cash and bonds.
Low interest rates and bond yields effectively determine the price of all assets. Prospective returns from these assets are currently very low. Over long periods of time the equity risk premium, loosely defined as the extra return investors expect from equities over bonds, has been stable.
Therefore, low interest rates ultimately imply higher prices for growth assets, which ultimately flow through to lower prospective returns. It’s fairly easy to justify paying a higher price for equities, property and other investments in this environment.
In the short-term, this is really positive for markets, as prices are more likely to rise as the price of growth assets adjusts to the lower interest rate environment. However, in the longer term it means we will all have to get used to lower returns from all asset classes. In other words, we probably will all need to start saving more than we thought to fund retirement.
Investment opportunities worldwide
Investors really wanting to take advantage of opportunities in equity markets should consider international equities as well as Australian equities. Compared to some international equity markets, the Australian market is relatively restricted in certain sectors.
For example, some of the emerging technologies around 3D printing look really interesting. 3D printing has the potential to automate many production processes, which in due course could restore the competitiveness of a more expensive, labour intensive industry. Companies at the forefront of this technology could be revolutionary.
Other tech companies, such as those in computing and social networking, are now mature. But the social change brought about by the revolution in shopping habits is still in its infancy.
In this new world, companies that have a strong brand will excel. Consumers that are dealing with faceless vendors over the internet are more likely to buy a trusted brand, given they have little reason to trust the vendor.
Managing opportunities and risks
There are always both opportunities and risks in equity markets. Opportunities take time to play out, and adverse events always seem to be reflected in markets immediately. If investors keep a close eye on their objectives, and make sure their portfolios remain appropriate for their circumstances, they may be more prepared to respond to changes in the market. Among other things, that might mean taking profits as equity values rise – if the portfolio risk is creeping up.
As always, diversify, diversify, diversify. Almost all investors will benefit from an allocation to growth assets, particularly equities. Conversely, it’s easy to confuse boundless optimism with delusion. Even the happiest optimist should make sure an investment portfolio reflects not just attitude, but personal circumstances.
For more information about how you can invest in Australian and international equity markets, speak to the Financial Adviser's here at Leenane Templeton.
Source: Australian Unity, May 2013