It seems the question on everyone’s lips over the past week is “Is this the beginning of another global financial meltdown?” Following on from Thursday’s big fall, on Friday the US stock market seesawed with the DJIA trading in a range of 416 points. The market opened with a 140 point rally only to sell off and be down by 240 points by midday and then rallied at the end of the day to close up 60 points. Similarly the S&P traded in a 50 point range and closed virtually unchanged. However on Friday night Standard and Poors downgraded the ratings on US Treasuries to AA+ from AAA.

In response, Asian markets have opened up weaker this morning. The ASX/S&P200 was down 1.5% within the first half hour of trade, while the A$ has held reasonable steady this morning trading at just above US$1.035.  US equity market futures are currently down 2.25% in early Tokyo trade, signalling that overseas markets are poised for further weakness tonight.  The S&P500 is currently down around 11 per cent over the past two weeks, while the Australian market is down by a similar amount since the start of August.

One of the major forces affecting the US market and subsequently the world is the Republican/Democrat political debate on spending which is essentially about welfare spending with the pro-business Republican demanding spending cuts to welfare programs and no new taxes whilst the Democrats are far more prone to supporting broad social programs. The partisan politics around raising the debt ceiling and last minute brinksmanship have led to S&P doing the unthinkable and lowering the US credit rating as they were seeking larger cuts to spending. It wasn’t that long ago when US treasuries and “risk free” meant the same thing.  

However the S&P credit downgrade has significantly dented the reputation of the US government and this has many possible implications for the world and the US. Firstly, US borrowers will undoubtedly have to pay more for their debt as a result of the flow on of the ratings change. Perhaps the biggest irony is that US Treasuries are trading virtually unchanged after this downgrade.  On the plus side this event may serve as a wakeup call to US politicians and highlight the need for better policies and governance and force them to take appropriate action to prevent further erosion of the US as an economic power. As Sir Winston Churchill is reputed to have said” The Americans will always do the right thing ….after they have exhausted all the alternatives.”

The continued poor handling of the European Debt crisis by the European Central Bank is another factor that is contributing to global uncertainty. This morning after an emergency meeting, the G7 nations issued a joint statement stating that they will take every action necessary to stabilize financial markets. Members agreed to inject liquidity and act against disorderly currency moves should such steps become necessary. Policy makers also prepared market interventions in a sign of concern prices are becoming unhooked from fundamentals, with the European Central Bank indicating it will buy Italian and Spanish bonds and Japan is signalling further dollar purchases.

So what does all this mean for Australia and Australian investors?  Australia is probably the one economy that is poised to weather these economic conditions. Our budget deficit is not very big and when compared with most developed nations our level of government debt is very small. Our banks remain well capitalised and did not require any government bailout during the GFC. Finally whilst other economies are hurting from the rising cost of raw materials, Australians and Australia are beneficiaries of the increasing prices for our resources. While other struggle with weak employment, Australia’s unemployment is near record lows.

So despite the temptation to further increase your cash position I firmly believe that now is not the time to do so. This deterioration in prices has led to growth assets in becoming very attractively priced at these levels.  It may take a while for investor confidence to be restored but I encourage you to please read my latest article "Too Much Cash is not Always Good" as I make a point to investors to carefully consider the risk/return equation in light of their investment timeframe when deciding on an appropriate asset allocation and not over allocate resources to cash. Despite the extreme movements of the past few days, there has been no fundamental change in the world economy in the past 72 hours – the S&P ratings downgrade has just been a sober reminder of what everyone already knew; Spending cannot go on forever and action to cut spending need to happen sooner rather than later.

In closing I would like to point you towards an excerpt from Russell Investments’ latest market update issued this morning.

As a backdrop to the current market gyrations, it is worth re-emphasising the following key fundamentals:

1. The recent softer US data is consistent with our long held view that economic data overseas will oscillate between good and bad for a while yet, but that the net effect is the continuation of a grinding recovery over the next year or more. That is, the US is going through a soft patch rather than a return to recession (the non-farm payrolls data on Friday night supports this, though they are still at anaemic absolute levels).
2. Despite Eurozone debt concerns, core countries such as Germany continue to deliver strong growth, and one of the best performing sharemarkets in the world over the past year – despite everything going on with Greece.
3. Equity valuations remain ok (on the cheap side of longer term averages).  US earnings in particular remain robust with 75-80% of reporting companies in the current earnings season beating expectations – 43% of these by more than 5% (though we do expect US earnings growth to slow to a more sustainable pace going forward).
4. US government bond valuations are now considered to be at extremely expensive levels.  The debt ceiling/deficit cutting issues will be worked through and US default is an extremely low probability going forward.  
5. The S&P downgrade of US debt should serve to focus political attention on the need to stop playing politics and start making hard decisions on deficit and debt reduction.
6. The central scenario for Europe is that sovereign debt worries will continue to muddle through for now, but with any agreement on a long term solution still a way off yet.”
7. Emerging economies remain the key drivers of global growth. Central scenario is for a soft rather than hard landing in China (slowing to 8% pa or so – still impressive)

Click here for the full article by Russell Investments.


Michael Lannon
Founder & Executive Director

Click here to read Michael's most Current Commentary