The return of volatility

It’s a new year and it’s a new game!

After an almost fifteen month hiatus, volatility has suddenly returned in a big way. We can be excused for forgetting what it feels like to have market volatility after a year in which the S&P 500 in the US did not retrace more than 3% at any period in 2017. To be clear, last year was an unusual year in the sharemarket. To use last year’s record low volatility as a standard measure to forecast future returns would be downright misleading. It seems like the first four months of this year is making up for the lack of volatility last year, clearly reminding investors that markets can go down as well as up. As well, when markets have been on a one way street upwards and when valuations are beginning to look quite rich, it does not take much to trigger a sell-off.

The main few culprits for this year’s volatility have been the following –

1. The fear of a trade war especially between China and the US.
2. Data privacy and breaches by FaceBook that has brought the technology sector under scrutiny.
3. Interest rates rising.

Let’s summarise the three points above, along with our views on them.

Trade war tensions

No one likes to have a trade war as it creates a lot of uncertainty with no clear winner at the end of it. Therefore, after a long period of relatively friendly trade relations between countries, especially between China and US, President Trump put fear into markets after announcing a tough new stance on China’s trade policies. China has played along, threatening to place tariffs on certain imports. In effect, both sides are playing chicken. If trade tensions continue to escalate, this may put pressure on equities in the short term.

Over time, we expect both parties will come to the table to negotiate. However, Trump can only be seen a wild card by some observers and his comments continue to create short term negative affects on markets. While we hope this does not become a prolonged battle, we ultimately think that this will simply be “noise” over the medium to long term.

FaceBook, data breaches and privacy

With technology front and centre of our daily lives, it was concerning to read several weeks ago that a firm out of the UK had misused data on the FaceBook platform by using them to sway voters during the November 2016 US presidential election. This breach has become a giant public relations nightmare for FaceBook.

Whilst we think there could be some minor negative effect on FaceBook’s earnings growth in the short term, this sort of scandal could ultimately be better for the sector over the longer term. It will make many technology platforms that hold a lot of user data be better managed and security over information data sharing be better screened. As these large technology staples such as Google, Microsoft and Amazon get larger and more dominant, we see a day when the US Government may force them to split into two or even three separate companies.

Our stance on these sorts of scandals have always been to shut out the noise and focus on their long run earnings capability. Although we could expect consolidation over the shorter term with some large technology names due to their recent strong returns, we see their longer-term dominance and earnings trajectory to still be intact, albeit at a slightly lower level of growth. What we have observed is that technological change is here to stay and will only speed up over the next decade. We do not see the point of holding back but instead embrace this change. After all, technological change is one of the few constants that we are sure is here to stay. On the other hand, as investors, our goal is not only to recognize this growth but take valuation into account so that you are not grossly overpaying to join in this growth.

As Bill Gates observed, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten”.

Rising interest rates

While Australia has remained at record low interest rates and is unlikely to move up this year, the US has been slowly raising rates for over the past 18 months. This has gone unnoticed by the market until recently. In fact, the interest rate differential between Australia and the US has now inversed and for the first time in decades, US rates have now surpassed that of Australia. Despite this, investors continued to pile into riskier assets, not understanding the relationship between interest rates and asset value.

While it may not be cause for concern in the first few rate rises, market participants have suddenly woken up to this reality. Equity valuations are affected negatively with every rate rise as discount rates and the cost of borrowings increase, effectively putting downward pressure of valuations.

In our view, this is the single most important cause for concern for the sharemarket over the medium term. As US rates continue to go up over the course of the next two years, our domestic rates may not be immune to this influence. However, given the balancing act our Reserve Bank has on their plate, we are unlikely to see rates rise anytime soon, maybe not until 2019.

With issues like the examples above likely to keep surfacing this year, we are of the view that last year’s benign environment may not be repeated for the next couple of years and investors should expect more volatility ahead as markets adjust to interest rates and an uncertain political environment ahead. Whilst headline noises will continue to generate most of the attention, we remind our clients that it is earnings growth and the sustainability of this growth that will drive up individual share prices in the long term.

Please feel free to discuss the above or any financial matters you may have with your advisers.