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Newsletter 5

8 Feb 2018

Why did the market crash and then re-bound?

Thank you all for the very positive feedback on my last email regarding the major stock market correction. As you will be aware financial markets have re-bounded recovering some, but not all the ground it lost. I thought I should provide my understanding of what has happened.

Firstly and most importantly we are all aware that interest rates have been very low (below historical levels) across the globe.  In some countries real interest rates (after adjusting for inflation) have been negative. This situation of very low and negative real interest rates has been a deliberate policy of governments and central banks of the major economies (USA, Japan, Euro zone and UK) to counter the impacts of the Global Financial Crisis (GFC). Many of you may say that was 10 years ago and you are correct, but the effects are still impacting us today, albeit as time goes on less so. However, there are new challenges emerging that must be addressed by governments, notably government budget deficits, lack of growth in real wages (in Australia real wages are growing in the public sector and are falling in the private sector) and potential trade wars. Just before President Trump flew to Davos he imposed a 30% tariff of Chinese solar panels.

With very low interest rates there has been an asset boom (property prices and equity markets) have increased, as the cost of money is cheap. Central Banks and governments want to increase interest rates so they return to more “normalised” levels without impacting on the economy. This is a delicate balancing act.

The Dow Jones major correction started because there was good news about employment growth in the US. Why? Because financial markets saw the US economy overheating meaning interest rates would increase faster than anticipated, so investors decided to sell.  10 year US treasuries traded close to 3% (up from 2.5%) for the first time in many years. This is an important benchmark as US mortgage rates are priced on 10 year US treasuries.

Most of the trading on stock exchanges around the world is now driven by “algorithmic traders” (code words for computers) where sell and buy orders are automatically triggered by percentage movements in the market. So when a downward movement reaches a trigger point, then a sell order automatically happens and this then drives the markets lower which could trigger more sell orders.  If you think about this at a macro level where there are many algorithmic traders all operating with the same or close trigger points, then the downward spiral become self-fulfilling. This is what happened. The few days since investors have taken a deep breath and looked at the economic fundamentals of economies and companies and came to the view that they had overreacted. This is not to say that the market will continue going up, but more likely trade side-ways (directionally neither up or down) for a while as investors wait for more economic news and corporate earnings before determining their next step.

So what’s next?  Financial markets may be more volatile than they have been in recent years. It is therefore important not to panic and sell as this is when a loss is realised. It is important to accept the volatility and adopt a consistent and regular approach to investing. This approach means that you should accrue the benefits of dollar cost averaging (buying on the ups and downs) and should in the long run deliver returns.

If you wish to discuss please feel free to contact me.

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