In the last week or so, we have seen an escalation in volatility in the Australian sharemarket. This follows a month of significant volatility in global equity markets, resulting in price declines of between 7% and 10%.

A perfect storm to blame

Elevated geopolitical risk, persistent issues in Europe, US monetary and fiscal policy, slowing growth rates in China, falling commodity prices and large moves in foreign exchange rates have had a marked impact on investor sentiment recently. 

These factors in isolation can affect markets to varying degrees but the recent interaction between all of them has been a strong negative influence on investor sentiment, and has created the recent increase in sharemarket volatility globally.

Geopolitical risks have increased markedly over the past couple of months. 

In particular, the rise of the Islamic State (ISIS), the increased pandemic risk from Ebola and the ongoing tension between Russia and Western Europe over Russia’s active support for the Crimean separatist movement in the Ukraine, have dominated news-flow and soured investor sentiment. 

This perfect storm of negative global events has resulted in a loss of confidence in sharemarkets around the world as investors ask if things will get worse. 

Of course that’s possible, but more bad news has already been factored in to many sharemarkets to some extent. 

In fact, we believe, based on current valuations, that now may be a good buying opportunity both here and selectively overseas.

The positive news is that, globally, inflation is contained and US growth, while modest, remains positive.

And China is still looking at around 7% p.a. growth (albeit that being a little lower than expected).

Further, corporate profitability is strong with balance sheet improvement post the Global Financial Crisis increasing the stability of corporates.

So, looking through this recent volatility, the foundations for a return to more stable sharemarkets are in place.

Impact of US Interest Rates

Global markets have for some time placed significant emphasis on the Federal Reserve (Fed) and the continued wind down of its bond buying program called Quantitative Easing (QE).

The likely timing of the next increase in US official rates continues to be a dominant driver of investment markets.

The QE program is due to end this month after being wound back consistently and predictably over the past year.

With the end of QE the market has speculated that the logical progression for the Fed is to increase official interest rates.

To address this speculation, Fed chairperson Janet Yellen has committed to low interest rates for the time being and has intimated that it will be a considerable time before interest rates rise, making it clear that rate changes will be data dependent rather than calendar based.

Despite these assurances, and US inflation and growth rates remaining subdued, the ending of QE along with a ‘flight to quality’ buying by risk conscious global investors in light of recent events, has seen the $US strengthen against most major currencies.

In Australia’s case the $A has depreciated by approximately 9%. The relative decline in the $A has occurred in part due to the expectation of eventual rising rates in the US which would narrow the difference between their interest rates and ours, which in turn puts downward pressure on the $A.

The $A has also come under pressure as a result of the weaker than expected economic data from China.

Given the strong trade links between China and Australia, particularly given their demand for our iron ore and coal, any weakness in expectations for Chinese growth should result in a poorer outlook for Australia’s export sector which is dominated by resources.

For this reason, offshore investors wishing to maintain their $US purchasing power have sold $A-denominated assets, key among these being Australian listed company shares. 

This created something of a vicious circle as more selling of equities by foreign investors acted to push both the share market and the $A lower.

Europe Continues to Struggle

Elsewhere on the global front, European data over the past month has been far from positive, forcing the European Central Bank (ECB) to cut interest rates to all-time lows of 0.05%, placing pressure on ECB President Mario Draghi to honour his previous commitment to do ‘whatever it takes’. 

Adding to this, sentiment indicators from Germany (Europe’s largest economy) sank into negative territory for the first time since November 2012, lending support to the IMF and World Bank cuts to global growth projections for the remainder of 2014 and 2015. 

In our view, while Europe continues to deal with its economic issues, the valuation of its equity markets remains relatively attractive and should present selective buying opportunities after this recent bout of volatility.

Falling Commodity Prices a Contributing Factor to global volatility

Commodity prices in general have responded to the weaker global growth expectations and fallen. 

And, contrary to the usual situation at times of elevated tension in the Middle East, the oil price has been falling dramatically. 

This has in turn been detrimental for the Russian economy with oil being Russia’s largest export (around 58%). 

This has acted to elevate Russia’s interest in the Ukraine as the majority of the natural gas Russia supplies to Western Europe is transported in pipelines traversing the Ukraine. 

Clearly control of these pipelines is significant in gaining surety of the revenues for natural gas sales. 

This conflict, and the sanctions the EU has imposed on Russia for its active support of the Crimean separatists, further serve to increase geopolitical tensions and global sharemarket volatility. 

Australian Banks and Resource Companies Back to Fair Value

In the Australian sharemarket, we have witnessed a decline of close to 10% over the past few months, which has effectively eroded the gains for calendar 2014 to date. 

Bank shares and mining shares, the two largest sectors in the Australian equity market, have suffered the largest falls for differing reasons. 

The banking sector, which has experienced very strong returns over the past few years, has recently been faced with the prospect of regulatory changes to bolster the strength of Bank balance sheets to bring them in line with higher global standards and strengthen the domestic banking system to withstand shocks in times of crisis. 

The Murray inquiry is currently considering these changes and speculation around the likely outcome has negatively impacted Bank share prices. 

That said, the major banks are trading at valuations as low as 12-13 times current earnings and with fully franked dividend yields between 5.6% and 6.1%. 

With net interest margins remaining steady (or possibly more favourably following reductions in term deposit rates), bad and doubtful debts remaining at very low levels, lending growth at about 5% sector wide and earnings per share expected to be at around 7% p.a., the sector now looks relatively attractive. 

Resource companies have been significantly affected by Chinese economic data released in mid-September. 

The data indicated that Chinese industrial production growth was the lowest since the 2008 global financial crisis, which has increased doubts that China’s 7.5% p.a. target annual growth rate will be reached. 

As China is Australia’s largest export destination, this news was not good for Australian resource companies. 

Over the past few months, there has been a massive increase in export volumes of Australia’s key commodity, iron ore. 

Steep declines in iron ore prices have resulted and these falls coupled with the aforementioned decline in Chinese industrial production, have hurt domestic sentiment. 

As a result, resource companies are also looking more attractive from a valuation perspective for investors than they have for a while.

Australian shares look attractive

Despite these global and domestic issues, from a valuation perspective Australian equities are generally not expensive and are tending toward being attractive relative to the 20 year trend of the price multiple of current earnings.

Interestingly, a declining Australian dollar favours a number of sectors that will aid Australia’s transition from being a mining led economy to a more broadly based economy. 

For example, Australian manufacturers and exporters are more cost competitive under a lower $A.

Tourism operators are likely to experience a boost in profits as Australia becomes a cheaper destination for foreigners. 

Further, the retail sector, which suffered heavily from the high A$ and adapted by reducing costs and providing online offerings, will also be a beneficiary.

A Time to Buy? We think so.

It is important to remember that sharemarkets are bound to go through periods of higher volatility from time to time, and that investment in quality assets is a long term endeavour. 

As a consequence, we believe clients should stay the course during periods of higher volatility. 

Particularly when, as is the case now with current earnings suggesting that sharemarket valuations are attractive, the risk of a major equity sell off is low (in the absence of an unforeseen external shock, of course). 

In fact, at these current valuation levels, it may prove to be opportune to review portfolios in a positive light.

Financial Planning Services are provided by Scott Millson, Authorised Respresentative of Australian Unity Personal Financial Services Ltd AFSL: 234459