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"Artificial market cycle... trouble ahead" says past CEO of ASX
February 17, 2018
Elmer Funke Kupper, past CEO of the ASX says:
This view says that we can expect much more material volatility and falls in equity markets towards the end of 2018 or in 2019. Here is why.
First, even after recent falls, US equity markets are expensive by historical standards.
The S&P 500 price-to-earnings ratio, price-to-sales ratio and dividend yield are all still outside historical levels. Some excellent work done by John Hussman of Hussman Funds suggests that at the current valuation levels the S&P 500 will deliver close to zero returns over the next 12 years.
Part of the problem is interest rates. It seems that markets have assumed that ultra-low interest rates justify ultra-high equity valuations. They forget that low rates tend to correlate with economic weakness and lower growth. The net effect on valuations may be quite limited.
However, the reality is even worse than this. In recent years we've seen artificially low rates as a result of central bank policies, leading to artificially high valuations in equity and bond markets. This will have to unwind.
Second, despite the end of the "artificial cycle", investors are still largely positioned for a low volatility and low rate environment. The assets they own suggest they expect conditions to remain largely unchanged.
Third, diversification between asset classes will not save investors. Monetary policy settings have driven equities, bonds and real estate all up. And since they rose together, they are more likely to come back to earth together when settings change.
This is also the view of Sue Gosling, head of MLC Investments, November 2017.
But for this with a bit of knowledge of history, people will remember that in 1994, we had a modest fixed interest crash (bond yields rose about 2%) leading to a similar correction in share markets,. Chris Joye reminded us of this in AFR 17/2/2018.
A couple of indicators suggest that there is a more dramatic "correction" coming later this year or in 2019. The Eurodollar market, US money supply and US credit growth all point to weakness.
The real issue, however, is the economic environment in which all this will play out. The US Fed is winding back its quantitative easing program and is expected to raise rates. Ten-year US Treasury yields have increased from 2 per cent to 2.82 per cent in the last few months. It will not take much to create a self-reinforcing "crunch" that affects consumers, businesses and financial markets.
Australia has followed the rest of the world and developed an addiction to debt.
More concerning than government debt, however, is household debt. At 200 per cent, Australia has one of the highest household debt to income ratios in the world. Household debt at this level will limit economic growth, as funds are diverted to service debt in a rising rate environment. Moreover, this level of debt will increase the severity of any downturn in the housing market, should it come. The bottom line is that I would expect more material market volatility later in 2018 or in 2019. Positioning one's portfolio to limit downside risk and benefit from the downturn makes sense.