Why the United States sold down and its effect on Australian Investors.

The rationale that the media have offered for the sell-off over the past couple of  days is that investors took fright at strong economic data therefore having to discount the likelihood that interest rates will increase at a faster pace than had been expected.

While this is the likely proximate cause of the decline, it does not explain the magnitude or rate of decline that was witnessed over the past few days.   A large part of the selling occurred as a result of a number of different investment strategies, that invest purely on the basis of past price performance or volatility, having to reduce their exposure to the share market given the increase in volatility.

As many of these investment strategies employ rule-based models, they can become price insensitive at critical junctures in the market, as such they are selling no matter the underlying price to ensure exposures are kept within acceptable limits per their investment mandates.

Such behaviour can also be self-reinforcing to some extent - where this forced selling leads to a further increase in volatility and/or market declines, which means these funds have to further reduce their exposure.  Given that these funds command a reasonable portion of the US share market, we expect that over time we will witness more bouts of volatility purely on the basis of these funds having to de-lever further over time in response to changes in non-fundamental factors.

This market pull back is different to the GFC.  There has been strong growth in the US and China over the past couple of years, their markets have outperformed the rest of the world.

The US now has low unemployment and pressure on wages growth along with an improving economy, this leads to the need for rate raises in the US.  A rate rise will affect the price of bonds and increase funds flowing into the US as investors chase higher yields.  Keep in mind that the bond market is larger than the share market.  Couple this with the fact that the US market has had a gain of around 45% since November 2016 it is not a surprise that it was going to pull back.

So why does it affect Australia and other markets?

A drop like this does not affect Australian companies.   BHP mined the same amount of ore over the past couple of days as it always has and people shopped at Woolworths like usual.   It was business as usual and profits continue to flow and dividends will be paid.  The issue is large Australian fund managers have exposure to world markets as such they also need to rebalance their exposure levels which in turn forces a sell down of shares here in Australia.

It does not mean that the companies are worth less, although some may be depending on their individual links to the US market.   For those who hold shares directly no action is required unless you think one of your individual shares is going to be affected or is about to go broke.  We continue to monitor the market.  We would not be surprised to see our market pull back to around 5680 points given our market has rallied 7.7% since November 2017.

Australian companies look fully valued at present.  The housing market looks to be cooling, unemployment is very high, interest rates are at all-time lows and inflation is running at 1.8%.  Our economy is at a point where infrastructure spending needs to start to stimulate it, however, right now our political situation is not allowing this to happen.

If measures are not put in place soon to stimulate the economy and create jobs we may see investors look to reduce exposure to the market and sit on the side lines.   This will provide a buying opportunity given companies are paying high dividend yields well above the cash rate.

If you have any concerns about your portfolio please give us a call on 4771 4577 or email your adviser.

Best Regards

Jason Fittler
B Com, Dip FP
CPA - Financial Planning Specialist and CPA - SMSF Specialist