We thought it was worth expanding on our commentary from Friday given the weakness in markets over the weekend / today.
Firstly the current move appears to be liquidity driven as money exits emerging markets equities and risk assets following the Chinese currency adjustment. Essentially the move in the currency has forced some changes in global asset allocations as investors anticipated further deflation in the emerging market currencies. This has then begun to feed on itself. In much the same way the move up in markets in February / March were a little hard to reconcile, so these falls seem a little removed from fundamentals. The market’s relentless focus on negative news at present was highlighted by the fact equities sold off early last week when Chinese housing data was too strong (on the basis that it signalled China would not undergo a stimulus program) and later in the week sold off on weak manufacturing data. The Chinese economy is weak and this is well known by markets.
From Australia’s perspective there are a range of reasons to be more optimistic.
1. The size of the fall of 15% is quite a substantial correction especially given the economic outlook has not changed substantially. Sentiment indicators have turned sharply negative (which is a bullish indicator) and investors are heavily underweight emerging market positions.
2. Valuation and yield is supportive. The PE of the market is now 14.7x which is slightly below the past 15 year average. However the yield at 6.8% grossed up (5.1% without franking) looks very attractive relative to low interest rates and relative to global comparatives.
3. The risk for markets appears to be in the resource related sectors. However resources represent only 15% of the market (was 30% a few years ago) and the declining A$ will provide a cushion for the non-mining sectors of the economy (and their earnings).
4. Corporate balance sheets remain in good shape. Net debt to equity sits at 40% compared to 55% pre GFC. There are some pockets of stress in resources and mining services but it is not widespread.
5. Australia has greater ability to stimulate the economy with interest rates at 2% (high compared to other markets) and Government debt at 23% of GDP.
In a liquidity driven market we are looking for events that could trigger an end to the selling. We see the following possibilities:
1. A Chinese stimulus package would be helpful but it would need to be large enough to restore some confidence to Chinese investors. There is speculation of the liquidity injection this week.
2. Markets become absolutely cheap enough. We are probably close in this respect although we do not think the US is there yet. However given the speed of the falls it is not that far off causing valuation support to cause a change in asset allocations and money back into equities.
Overall it is important to separate out the noise of the market during these types of selloffs and focus on the fundamentals of the companies in the portfolio. Those companies with good balance sheets and quality businesses can emerge stronger from these types of disruptions.