Is a new season of volatility for local equity markets on the horizon?

By Paolo Senatore, Chief Investment Officer Ashburton Investments

The weather patterns of the last few weeks have reflected the mood among Main Street and Wall Street participants – sunny and warm on Tuesday, cloudy on Wednesday, and sand storms sweeping through the country on Thursday. Similarly, financial markets have been subject to an abrupt increase in volatility in recent weeks with risky assets having been sold off sharply as global equities declined by over 6% in the first half of October before bouncing. The FTSE/JSE All Share Index did not escape the volatility as the market declined by 5%, before recovering in the month, and 25 shares reached new 52 week highs at the end of October.

The Volatility Index (VIX) breached levels last seen in mid-2012 before declining by more than 10% per day for three consecutive days. This heightened volatility should probably not come as a great surprise when one considers the reasons equity markets have done so well following the depths reached during the financial crisis of 2008/09. There have been two main drivers behind the recovery since those dark days. Firstly, interest rates have remained low for a considerable amount of time (equity prices are driven up by the lower rate at which future earnings and dividends are discounted back to present value) and secondly earnings and dividend growth have recovered significantly from a low base.

Recent market weakness appears to have been triggered by doubts creeping in on the global economic growth front. The International Monetary Fund (IMF) cut its global economic growth forecast yet again, emphasising the uneven and fragile nature of the recovery seen over the previous 18 months. This stems from a definitive lack of inflation pressure globally and downward trending inflation more recently in Japan, China, and Europe (see graph below). This deflationary impulse typically results from a lack of end demand and hence the creeping doubts about economic growth. Safe-haven global bond markets have benefitted from these recent concerns with the US 10 year bond yield plummeting from 2.6% to 2.2%.

News from Euroland in the last month emphasised the concern that the momentum in recovery in this region is slowing and prolonged sluggish growth is now being priced in. The most recent stimulus efforts of the European Central Bank (ECB) to spur growth are mostly aimed at boosting the rate of bank lending. However, given dire business sentiment and constrained households, further credit growth is unlikely to accelerate meaningfully in the near term.

The ECB's effort to spur inflation has also been held back by weak consumer spending, a high unemployment rate and sluggish income growth. Should economic activity remain as is, the ECB has committed "to do whatever it takes to preserve the Euro". The bank has already announced a mortgage backed securities purchasing program and may also have to consider the much debated sovereign quantitative easing (QE) program as a weapon to stimulate growth and inflation.

Over the past few months, in an attempt to aid the Chinese economy, the People's Bank of China (PBOC) have reportedly injected RMB500bn into the banking system, and cut the repo rate by 20bp. The bank also loosened the national property policy for the first time since 2008, increasing mortgage availability to second-home buyers and non-local residents. It is expected that these measures of policy easing will support the recovery in property home sales and further ensure continued spending in railway, infrastructure and water projects.

The Federal Reserve's third quantitative easing (QE3) campaign ended in the last week of October. Although the market has largely priced in the effect of the QE3 tapering coming to fruition, it has always been expected that some degree of volatility would occur on termination. As one stimulus campaign came to an end, another campaign came back into focus. Eighteen months ago, a Japanese stimulus program was launched with an aim to stimulate growth and increase inflation in that economy. The impact and success of this program so far seems to be faltering as that economy continues to grapple with low inflation and growth. At the end of October, the Bank of Japan unexpectedly boosted its unprecedented monetary easing by announcing a ¥80tn or $726bn (up from ¥60tn to ¥70tn) expansion in the monetary base in a renewed effort to reflate the economy.

On the local front, South Africa continues to face a number of additional challenges. These include a large current account deficit (which serves to keep the rand in a relatively fragile state), constrained fiscal spending, the prospect of higher taxes in 2015 as well as a weak consumer environment. Despite an uptick in export volumes, South Africa's terms of trade continue to be negatively impacted as a result of lower commodity prices. These factors contribute to sub-par economic growth which is likely to persist for some time. On a more positive note any inflation flowing through a relatively weak currency is likely to be offset by a low oil price and reducing consumer demand. Although local interest rates are still anticipated to rise in response to a rising global yield environment, this muted inflation outlook is likely to place less upward pressure on short-term interest rates.

Notwithstanding the obvious concerns mentioned above, there are a number of reasons to still remain relatively positive on global equities. Ongoing robust growth in the world's largest economy together with undemanding valuations will likely prove supportive of global markets. Should the current low oil prices persist, it will have a net positive impact on global growth and potentially have a beneficial impact on corporate profit margins in many industries. Global monetary policy should remain fairly supportive with central banks in Japan, China and Europe likely to provide further support should economic conditions deteriorate. There is little doubt that the road ahead could be bumpy but global equities remain the asset class of choice when seen in the context of poor returns expected from other asset classes.