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Vanguard Market Update

We are going through the worst financial crisis in our lifetime.”
- Prime Minister Kevin Rudd

A week may be a long time in politics but it’s proving to be an eternity on financial markets, as investors increasingly worry about runs on banks, global economic collapse and a deep recession.

It’s requiring the Rudd government to quickly respond to unfolding events, with the rapid-fire announcement of a guarantee on all Australian bank deposits and borrowing followed by a $10.4 billion economic stimulus handout to pensioners, low income earners and first home buyers. Like governments around the world Australia hopes to prevent recession by propping up falling retail spending and home construction, which are the key drivers in most modern economies.

These unprecedented interventions come after an extraordinarily volatile week of record daily and weekly rises and falls for both shares and currencies, as global credit markets remain frozen.

What a week!

The Dow Jones Index has just had its worst week ever – plunging 1,874 points, or 18.2% in just 5 trading days. On Friday 10 October the Dow traded a 1,000 point range – falling 700 points at the open before climbing to be up 300, before falling again to close down 128 points. Yet, in the same week, the index posted its biggest one-day gain in history – up 936 points, or 11.1%!

Fundamentals like price/earnings analysis are apparently being ignored as the market becomes driven by confusion and the fear that the credit-squeeze will spill into the real world and choke economic growth and cost jobs. That’s seeing the share sell-off shift to target retail and discretionary-spending stocks likely to be hurt by falling consumer spending or a recession.

Australian equity markets followed Wall Street’s roller-coaster lead, while the Australian dollar was battered and beaten to post record daily rises and falls of over 5%. Our dollar is under fire as it is closely tied to plummeting commodity prices – it has fallen more than 30% in just 3 months from a high of almost US$0.98 in July to a low of US$0.65 on 10 October.

What needs to happen?

Frozen world credit markets have to be thawed for the worries about global recession to ease.

Banks have been too scared by the risk of a corporate collapse to lend to each other or to big business, and economic growth is likely to be restricted unless they re-open their vaults and lower the costs of borrowing.

In Europe 3-month interest rates on US dollars are nearly 4% higher than the US Federal reserve target rate of 1.5%. Meanwhile, the London Inter-bank Overnight Rate (LIBOR) remains near its highs for the year at 4.82%, while the gap between European and American interest rates (the TED spread) remains stubbornly wide.

Stabilising trust in the global banking system is expected to loosen lending and lower borrowing costs, which is seen as a critical first-step toward removing recession concerns and bringing stability to global equity markets.

What is being done?

For the first time since the sub-prime crisis began global governments and central banks are co-ordinating their efforts to re-inflate the rapidly sagging global economy by:

* Buying toxic debt – The US and European governments have provided trillions of dollars to buy troubled sub-prime debt off banks’ balance sheets to help them be able to lend again;
* Supporting banks – many of the worlds largest banks are receiving government equity, guarantees or bailouts;
* Protecting deposits – Australia followed the lead set by Ireland, Greece and the US to guarantee for three years the safety of all deposits held in Australian banks;
* Cutting interest rates – Coordinated interest rate cuts of 0.5% have been delivered by the central banks of the US; Europe; England; Canada and Switzerland following Australia’s Reserve Bank rate-cut of 1%; and
* Stimulating consumer demand – Australia’s $10.4 billion stimulus package targets pensioners and low income families who are likely to pump the money straight back into the economy in their Christmas spending and increase GDP by 0.5%. European and US governments are also pumping money into their economies.

What’s going to happen next?

No-one knows – that is the problem! There is simply no living memory of markets being like this.

Almost all asset values appear to be falling at the same time with share-market, commodity and house price declines in the US, UK and Europe hitting consumers hip-pocket hard. Like Australia, it is expected that growth in these developed economies will slow and unemployment will rise. Meanwhile the costs of economic support is cutting into government budgets with Australia committing to spend half of this year’s surplus on its stimulatory package. In America, which is believed to already be in recession, the budget deficit has skyrocketed to US$2 trillion – a staggering 12.5% of GDP!

According to the International Monetary Fund (IMF) growth will continue in developing economies, but at lower levels. The IMF predicts that China will grow at 9.3%, India at 6.9% and Russia at 5.5%.

Some are hoping that the record volatility may signal bottom of the bear market, but history is not so clear. Only two of the last five daily rises of more than 10% on the Dow Jones Index have marked the end of bear markets (1987 and 1933) – the other three (1929,1931 and1932) were only temporary pauses before the sell-off started anew.

What is the investor fallout?

Mercer reports that to the end of September none of the 100 Australian share funds it monitors reported a positive return. The median Australian share fund fell 9.9% for the month (the worst was 16.4%), and is down 25.5% for year to September 30 (the worst was 37.1%). That’s the worst performance for equities since 1974, when the first oil-shock plunged the world into recession.

For investors it:

* proves the benefits of diversification across markets and within markets.
A 100% exposure to US or Australian shares would mean a very poor year indeed, while individual companies are hard to ‘stock-pick’ when balance sheets and contingent liabilities may be impossible to determine;
* Prompts a flight to quality assets.
Investors only want A1-prime assets. For deposits that means a government guarantee which now extends to all Australian Deposit Institutions including banks, building societies, credit unions and foreign bank subsidiaries. For equities it means avoiding stocks which are illiquid or highly geared and that’s leading to an increase in indexing in the US to ‘buy the market’ and avoid company-specific risks.
* demonstrates the perils of trying to time markets, as such wild market gyrations defy conventional analysis; and
* highlights the benefits of a disciplined, regular investment strategy with some analysts believing today’s prices will be regarded as bargains five years from now.

What is Vanguard® doing?

We do not know when or where markets will bottom, but we do know from history that:

* a bottom will be reached, and you can’t participate in any bounce if you are not invested in the market; and
* some of the best daily and weekly returns on record are achieved during periods of intense volatility, but again you can’t participate if you are not in the market.

As an index manager it is business-as-usual for Vanguard Investments Australia, as we stay true to our mission and mandate. We don’t change our strategy because of day-to-day market moves, and our returns are the market returns – unlike some active managers who have made bad stock selections and suffered losses far in excess of the wider market falls.

Vanguard
by Staff and Writers
16th October 2008

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