Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist, published on 9 February 2018
In this note, Dr Shane Oliver looks at the ongoing pullback in share markets.
The key points are as follows:
- The current pullback in shares has been triggered by worries around US inflation, the Fed and rising bond yields but made worse by an unwinding of bets that volatility would continue to fall.
- We may have seen the worst, but it’s too early to say for sure. However, our view remains that it’s just another correction.
- Key things for investors to bear in mind are that: corrections in the order of 5-15% are normal; in the absence of recession, a deep bear market is unlikely; selling shares after a fall just locks in a loss; share pullbacks provide opportunities for investors to pick them up more cheaply; while shares may have fallen, dividends haven’t; and finally, to avoid getting thrown of a long-term investment strategy it’s best to turn down the noise during times like the present.
The pullback in shares seen over the last week or two has seen much coverage and generated much concern. This is understandable given the rapid falls in share markets seen on some days. From their highs to their recent lows, US and Japanese shares have fallen 10%, Eurozone shares have fallen 8%, Chinese shares have fallen 9% and Australian shares have lost 6%. This note looks at the issues for investors and puts the falls into context.
Drivers behind the plunge
There are basically three drivers behind the plunge in share prices. First, the trigger worries that US inflation would rise faster than expected resulting in more aggressive rate hikes by the US Federal Reserve and higher bond yields. Flowing from this are worries that the Fed might get it wrong and tighten too much causing an economic downturn and that higher bond yields will reduce the relative attractiveness of shares and investments that have benefitted from the long period of low-interest rates.
Second, after not having had a decent correction since before Donald Trump was elected president and with high and rising levels of investor confidence, the US share market was long overdue a correction, which had left the market vulnerable.
Finally, and related to this, the speed of the pullback is being exaggerated by the unwinding of a large build-up of so-called short volatility bets (ie bets that volatility would continue to fall) via exchange-traded investment products that made such bets possible. The unwinding of such positions after volatility rose further pushed up volatility indexes like the so-called VIX index and that accelerated the fall in US share prices. Quite why some investors thought volatility would continue to fall when it was already at record lows beats me, but this looks to be another case of financial engineering gone wrong!
With shares having had a roughly 5-10% decline (in fact US share futures had had a 12% fall) from their recent highs to their lows and oversold technically and with the VIX volatility index having spiked to levels usually associated with market bottoms, we may have seen the worst but as always with market pullbacks it’s impossible to know for sure particularly with bond yields likely to move still higher over time and if there is further unwinding of short volatility positions to go.