Market review: Should investors be wary of benign market?
It was another good month for sharemarkets, both here and abroad. It has been interesting to see that these returns have been generated with a relatively low level of volatility (risk).
Tuesday, March 1st 2005, 11:06PM
by Anthony Quirk
An indicator of the low risk in share prices at present is the Vix Index, which is at its lowest level since 1996.
This index was introduced in 1990 by the Chicago Board Options Exchange (CBOE) and it has become an accepted indicator of stock market volatility or risk.
Vix measures market expectations of near term volatility conveyed by stock index option prices.
Since volatility often signifies financial turmoil, Vix is often referred to as the "investor fear gauge".
So why are financial markets so benign at present and should they be more nervous than they appear to be?
My short answer is "yes" because of the factors outlined below.
1) Rising inflation pressures (and therefore interest rates) - Inflation pressures do seem to be building both in New Zealand and overseas. Economists are now saying inflation could hit 3% for March '05 year in this country, testing the top of the Reserve Bank of New Zealand (RBNZ) inflation tolerance band.
The next RBNZ meeting on March 10 looks like an even money bet on whether rates will be raised further. The high kiwi dollar and a likely slowdown in the New Zealand economy this year may cause the RBNZ to delay a further rate rise.
However, this resolve would be tested if the kiwi falls from its historically very high levels or the unions' desire for 5% wage rises this year becomes a reality.
Whatever the outcome on March 10, any decrease in rates seems a long way off – now probably a story for 2006 rather than this year.
Likewise in the US core inflation is rising, up from 1.1% in 2003, to 2.2% in 2004 and it could possibly be at 3% by the end of this year.
An example of the increasing cost pressures for companies in the States was the January month increase of 0.8% for the core producer price index (PPI), the largest rise since December 1998.
The PPI measures company input costs rather than consumer prices in the shops and some companies may decide to absorb this rather than pass it on.
However, US companies appear to have more pricing power (a function of a strong economy and a weak US dollar) and so the PPI rise could ultimately feed through into higher prices.
2) Easing corporate earnings growth - he US company quarterly earnings round in January revealed some cautious outlook statements from many blue chip stocks.
It was New Zealand's turn for earnings results in February and it turned out to be a real mixed bag with some stand outs and some results that fell well short of expectations.
Through the reporting period one of New Zealand's leading sharebrokers (First NZ Capital) downgraded more companies earnings forecasts than it upgraded.
The extent of their revisions made it the worst earnings results season in over three years.
Thus, it probably signals the turning point of rising earnings growth expectations has passed and net downgrading could become more prevalent as New Zealand's economic growth eases.
3) Substantial (and rising) global imbalances - Many Western economies are still spending more than they earn with Australia, New Zealand, the UK and the US, the obvious culprits.
This has helped drive these economies in the short-term but it cannot continue on indefinitely. The current account deficits of these countries are rising quickly and some adjustment must occur.
For example, some economists are forecasting New Zealand's current account deficit may reach 8% this year!
This level would really test the resilience of the kiwi dollar as the typical adjustment for such deficit levels would be a weaker currency and/or higher interest rates, which decreases exports and decreases import demand.
Australia faces a similar problem, just yesterday announcing its second largest ever trade deficit.
One other way to cut the deficit is to cut spending and save! This seems a foreign concept at present in this country but recently the Labour Government confirmed it is looking to push savings as a key policy issue for the upcoming election and beyond.
At least in New Zealand our Government is helping by being a net saver, having a sound positive fiscal position. However, the US Government is compounding its current account deficit problem by having a large Federal deficit as well. This cannot continue but unfortunately markets were under whelmed by the latest attempt by the Bush administration to reassure investors that they had the Budget deficit under control.
The above combination of rising interest rates and slowing earnings growth, mixed in with global imbalances would not usually be considered good news for sharemarkets.
However, these are all publicly available pieces of information and should be impounded in prices already.
So the question has to be asked: what will change to make investors price in much greater risk (volatility) into markets?
One factor that is impossible to factor accurately into current share prices is another large scale terrorism act would undoubtedly raise investor risk levels.
More likely is the measured Federal Reserve (the Fed) interest rate rise response may have to be accelerated. This would bring back the spectre of 1994 when, after soothing Fed noises and a relaxed market, the Fed suddenly and significantly hiked interest rates.
The Chairman of the Federal Reserve, Alan Greenspan, has done a wonderful balancing act so far post-9/11. However, it may be expecting too much for the current interest rate cycle adjustment to be completely smooth, particularly given the global imbalances mentioned above.
To finish my piece on a bullish note I saw recently a well reasoned piece on why oil prices should fall significantly over the next year to the mid-US$20s. Now that would be something that would justify the current relaxed, low risk outlook currently held by many investors!
Anthony Quirk is the managing director of Tyndall Investment Management New Zealand Limited (Tyndall).
Anthony Quirk is the managing director of Guardian Trust Funds Management.
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