Where is the market heading?

After declining in April and May, global sharemarkets stabilised in June. Matthew Sherwood, Perpetual's Head of Investment Market Research, discusses the recent turbulence in financial markets and the implications for investors.

Recent market activity

During May 2010 the combination of sustained European government debt concerns, signs of a mid-cycle slowdown in China and the resource super profits tax, underpinned poor Australian sharemarket performance (-6.8%) and things only slightly improved in June. Since these global headwinds surfaced in mid-April, returns in listed property and global equities have also been negative, whereas typically defensive assets such as bonds have outperformed by a wide margin (see Chart 1).

Investors may also be concerned about the prospect for a double-dip global recession and its impact on earnings.

The bear case for a double-dip global recession

The primary concern for the market is high European government debt. This could trigger an economic downturn if markets lose confidence in the willingness of European governments to alleviate this problem.

While several countries have announced significant tightening to fiscal policy, their economic recovery has not yet gained a strong foothold. And despite the reduction in government spending, deficits are expected for a number of years. These factors raise concerns about the fragility and potential volatility of the economic outlook.

Any double-dip recession in Europe would be sparked by deterioration in global attitudes to risk and an associated rise in bank funding costs. If this was to happen, it would be quite dire, as interest rates in most major economies could not be reduced any further. Also, governments would not be in a good position to sell large amounts of bonds to the private sector and increase spending without triggering major disruptions in financial markets.

The bull case for sustained economic recovery

In contrast to the turbulence in financial markets, recent data has confirmed that the global economy is expanding at an average pace. Modest US employment growth has positively impacted US consumer spending. Chinese investment, exports, retail sales and credit all continued to rise in April after a strong increase in the March quarter and there was a similar trend across most Asian economies.

Even though Europe remained the primary drag on global growth, activity in Germany, their largest economy, continues to be strong.

Is the glass half full or half empty?

Clearly there is some support for both the bull and the bear view of markets. But even though there is some good news, it is hard to envisage that the present strength of the recovery will persist given that fiscal stimulus is being wound back in many countries and that households globally continue to reduce their debts and curb spending.
Corporate earnings are likely to be impacted

Although the US economy is currently growing, this is unlikely to keep going at the same pace. The US Government may struggle to lift its spending by 2.1% given the poor state of their Budget which suggests that economic growth would slow (as might be the case in Europe and Japan).

This growth environment in highly-indebted advanced economies will have flow-on effects to corporate earnings growth, which indicates that lower returns can be expected in global sharemarkets.

In contrast, most Asian economies do not have high government or household debt. As such, these economies should continue to experience strong growth, underpinned by their widespread industrialisation and urbanisation.

Australia's biggest risk is inflation, not growth

Despite the European and US issues, Australia is well positioned to take advantage of the growth in Asia with over three-quarters of our exports now going to the region.

Over the last year, around 40% of our exports went to the 10 countries with the strongest potential economic growth (based on population growth and savings and investment rates). Mining investment is also predicted to remain strong.

These factors suggest that the medium to long-term outlook for the Australian economy remains intact. The challenge for the next few years will be how Australia can accommodate the mining boom, without triggering a serious rise in inflation.

Australian sharemarket performance

Despite the positive outlook for the Australian economy, the government debt concerns overseas have impacted the Australian sharemarket.

However, on a positive note, the declines in market prices have resulted in market valuations approaching attractive levels. This could represent a buying opportunity if Europe stabilises and the domestic economy and corporate sector remain intact.

Implications for investors

Despite an improvement in June, there is likely to be considerable market volatility ahead as investors debate whether the bulls are right and the global recovery obtains a firmer footing or whether the bears are right and a prolonged decline takes hold.

Whether investors believe that the stabilisation of markets in June represents the beginning of the end for fears of a double-dip global recession or the end of the beginning for market volatility induced by government debt stress, Australia’s outlook remains positive. Meanwhile, the long-term rationale for remaining in shares remains intact in that earnings growth is presently solid, interest rates remain historically low and valuations appear to be attractive.

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