Most share markets remain attractively priced, despite recent volatility and bad news

Given it’s close to the end of the year, we thought it would be timely to send you the thoughts of Tim Farrelly – our asset allocation consultant – on what’s currently driving markets and the outlook for long term returns.

Much has happened in investment markets over the past six months – some good, some bad – but overall our optimism for long term returns from most share markets hasn’t altered.

We’ve seen the Australian and US share markets fall by 9% and 8% respectively in the past few months, only to make rapid recoveries.

We’ve also seen the Australian dollar tumble against the US dollar which has been good news for investors in international equities and for the Australian economy in general (because a lower Australian dollar makes our exports more competitive internationally).

The trigger for much of this volatility was speculation that the US Federal Reserve (the Fed) would raise interest rates earlier than expected. The good news is that the Fed is unlikely to now lift rates early as the high US currency is already acting as a handbrake on the economy. If the Fed was to raise interest rates it would threaten to choke off the still tentative US economic recovery.

If the Reserve Bank of Australia (RBA) were to lift cash rates by even 0.5% the likely result would be a rising Australian dollar which would act as a handbrake on the Australian economy.

In turn, low US interest rates make it difficult for Australian interest rates to rise. If the Reserve Bank of Australia (RBA) were to lift cash rates by even 0.5% the likely result would be a rising Australian dollar which would act as a handbrake on the Australian economy. And that’s the last thing we need right now.

We have also seen substantial falls in the prices of resources, particularly iron ore, our largest export. These falls, only partially offset by the fall in the Australian dollar, have clearly been bad news for the resources sector of the market. The falls in prices may or may not prove to be permanent. If they are permanent then returns from the resources sector are likely to be modest but not disastrous. This is because as a result of the falls in commodity prices the prices of BHP, Rio, Woodside and the like have also fallen. They now represent better value than before and, if commodity prices rebound, the resources sector may prove to be a bargain.

Finally, the regulation of our major banks has come under scrutiny with suggestions they will be required to hold more capital in future. This would bring mixed blessings to investors. Bank share prices may fall somewhat but the security of the bank hybrid securities will be improved if the banks are required to hold a bigger buffer. The banks, if better capitalised, may be less attractive than in the past but should still provide solid returns, most of which will come from dividends with a little capital growth. Overall they should still produce returns around 9 – 10% p.a. over the long term.

For all of that, the investment outlook hasn’t really changed

The recent volatility and bad news hasn’t changed our long term views. We believe most share markets remain attractively priced compared to secure assets, and that interest rates in Australia and the US are likely to stay low for longer than many expect.

Our Tipping Point chart below summarises longer term prospects for the major markets. Markets that are classified as cheap are forecast to produce returns that beat term deposits (TDs) by 5% p.a. or more, those at fair value are forecast to give returns between 2.5% and 5% p.a. better than TDs, whereas fully valued assets are forecast to beat TDs by less than 2.5% p.a., and overpriced assets are forecast to produce returns below those generated by TDs.

Equities Table

The standout observation from this chart is that Australian shares appear to have a fair amount of headroom left in terms of capital growth before we should become concerned about their long term valuations. The same applies for most international share markets. This is a time to be fully invested in equities.

The only area of significant caution is the US share market which has enjoyed a stellar run in recent years and, while it may continue to do so for some years yet, there is certainly less potential for it to generate high returns over the long term.

What should we do now?

  • Disregard the volatility of share markets. It is just short term noise which does not reflect the long term prospects for those markets. Staying invested in diversified portfolios of reasonably priced quality assets is a very sound investment strategy that usually pays off handsomely in the long term.
  • Slowly move international equity exposures away from the US; slowly because the US share market may remain strong for some while yet but in the long term we think it will produce lower returns than other share markets.