Perpetual: Putting the market turmoil into perspective

We ask Portfolio Manager of Perpetual's Diversified Funds, Michael Blayney, about the recent market turmoil.

Q. Should investors be concerned about the extreme market volatility amid increased talk of a possible 'double dip' recession in the US, and the seemingly intractable problems of government debt in the Eurozone?

A. It has definitely been an uncomfortable time for investors as markets have swung wildly amid incessant media coverage of what can seem overwhelming problems for the global economy and financial system.

The ongoing problems of uncontrolled government debt in the Eurozone have fuelled talk of a Greece default, sparking Europe's version of the collapse of the US investment bank Lehman Brothers collapse in September 2008.

The situation has not been helped by political brinkmanship over the US government debt limit, or the painfully slow economic recovery in the US raising concerns of a double-dip recession.

In Australia, the instability of a minority government, uncertainty over the potential impact of the proposed carbon tax, and the apparent gloomy outlook for the retail and manufacturing sectors, have all contributed to undermining investor confidence.

At a global level, the stratospheric rise in the price of gold shows just how much fear and uncertainty has been priced into financial markets. As the most ancient, physical store of wealth, that will always exist whatever happens on financial markets, gold has long been a proxy for the level of fear in the financial system.

Q. Is the fear justified?

A. Fear of the unknown is hard to quantify. We prefer to analyse the underlying risks and rewards. To do that, it helps to take a step back and put the present situation into a longer term perspective.

Following many years of strong economic growth and bull markets in the developed world, leading up to the GFC, financial markets had become somewhat oblivious to the underlying risks.

Many of the problems, such as unsustainable debt, were there prior to the GFC. In seeking to steer the developed market economies through the GFC via stimulus and bailouts, the levels of government debt became even worse. Now as the world slowly works its way through the various problems exposed by the GFC, financial markets have a heightened sense of the risks at play. The key difference for investors between now and 2007, is that risk is more appropriately priced – shares are trading on lower valuations, and the required additional yield for credit instruments over an equivalent (high quality) sovereign instrument is much higher. While risk is always present, lower starting prices imply less downside risk.

Q. Certainly, the government debt problems in Europe are real, but what are the risks for Australian investors?

A. Australian companies, including our major financial institutions, are well capitalised and have very little direct exposure to European Government debt. The real risk is contagion, that the linkages between markets and economies globally mean there are significant adverse flow-on effects here. By international standards, our own government debt is very low, particularly when compared to our economic growth prospects. While there will always be economic cycles, the industrialisation of emerging economies, in particular China, has greatly boosted our terms of trade and revenue, with many billions of mining investment planned for the next few years.

Certainly, some sectors of the Australian economy are not doing as well; in particular, retail, tourism and manufacturing. The fact that Australians are saving more is a good thing over the long term because we did have high household debt coming into the GFC and it means as a nation we will be less dependent on foreign capital.

Q. What does all this mean for the major asset classes?

A. Firstly, the general market downturn following the GFC means that the Australian sharemarket is still well below its peak achieved prior to the GFC. Prior to the GFC, based on the metrics we use to value the Australian equities market, it was very expensive. On current valuations the market represents good value in our opinion.

Australian stocks are generally less exposed to the debt problems of Europe, but of course the banks depend on international funding and the mining companies depend on China demand, which to some extent depends on demand for their goods from the developed markets.

Having largely stabilised following the GFC, over the past few months corporate bond 'spreads' over 'risk-free' government bonds have again increased due to the heightened fear generally on fixed interest markets.

The bonds of governments under debt stress have been sold down severely. On the other hand the 'flight to safety' has meant that highly rated government bonds, including both US and German bonds, have been in such demand that their yields have hit historic lows.

Q. Is this a time to be fearful or a time of opportunity?

A. We remain close to our strategic settings for our diversified funds as, with equity and credit reasonably valued based on fundamentals, it is this diversification that provides the best protection during turbulent times, while maintaining the potential for some upside in the event of a recovery.

There are always investment opportunities, and even more during times of heightened fear and volatility. Dollar cost averaging by investing regularly through markets like this can mitigate timing risk but provide exposure to market recovery.

It is impossible to predict how events will play out, but experience has shown financial markets always do absorb shocks and recover over time.While there was clearly a level of irrational exuberance prior to the GFC, it could equally be said that there is possibly an overblown level of fear at the moment.