The sharp pullback in share prices during February saw significant news coverage and created concern for many investors. Understandably so, as US, European, Chinese and Japanese share markets were down 8% to 10% from their highs, while the Australian share market was down 5%. These falls followed a 12-month period of unusually low volatility in global markets.
The main trigger for February’s sell-off related to concerns that US inflation will rise faster than previously expected, due to a strongly recovering economy and tight labour market. With limited excess capacity in the US economy, and further stimulus being injected from President Trump’s tax cuts, the US Federal Reserve is likely to continue raising interest rates over the next few years to keep inflation at the 2% target.
Rising interest rates are a headwind for asset prices, although this is in the context of a strengthening global economy which has gained sufficient momentum to be weaned off ultra-low rates instituted since the Global Financial Crisis.
Against a backdrop of a strong global economy the outlook for corporate profits is robust, which suggests that the risk for share markets in 2018 is not earnings growth, but rather the price that investors are willing to pay for those earnings. For instance, the price-to-earnings (P/E) ratio, a method of valuing companies, is above historical averages for the global share market and even more stretched in the US. While the Australian share market is relatively not as expensive, it too is above historical averages.
While elevated valuations alone are unlikely to trigger an equity market correction without some type of an external shock, investors should be prepared for lower prospective returns. The effect of ultra-low interest rates over recent years has been to push up asset prices (including shares, property and infrastructure), effectively pulling future returns forward to the present. Accordingly, future returns are likely to be lower than if asset prices were starting from lower levels than today.
Overall, we remain optimistic on global shares given the synchronised global growth environment, improving corporate earnings and US tax cuts, all combining to currently outweigh the growing headwinds from higher interest rates. While the tensions around trade are a risk for the global economy, a trade war between US and China at this stage appears unlikely given the damage this would inflict on both countries.
The recent volatility is unlikely to be a one-off event in 2018 given the extent that valuations are looking extended in some areas. In this environment, investors should ensure they are appropriately diversified, as a mix of exposures can help to reduce overall volatility within a portfolio.
With markets looking uncertain, please feel free to contact a BDO adviser if you would like to discuss your portfolio.
The information in this document reflects our understanding of existing legislation, proposed legislation, rulings, etc., as at the date of issue. In some cases, the information has been provided to us by third parties. While it is believed the information is accurate and reliable, this is not guaranteed in any way. The information is not, nor is it intended to be, comprehensive or a substitute for professional advice on specific circumstances.
The financial product advice or information in this document is of general nature only and has not taken into account the investment objectives, financial situation or particular needs of any particular person. Before making an investment decision on the basis of the advice above, a prospective investor needs to consider, with or without the assistance of a professional adviser, whether the advice is appropriate in the light of their particular investment needs, objectives and financial circumstances.