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What’s behind the current financial market volatility?

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Two themes are seemingly dominating; the decline in Oil prices and the deliberate and well forecast slowing Chinese economy.

Black Gold

OPEC continues to maintain production pumping daily surplus into the market at a time when Global demand has slowed. The supply/demand equation equals a decline in price. It could be argued that OPEC’s motive is to drive down price that in turn puts pressure on higher cost and financially leveraged producers throughout the United States, Russia and Canada. The current trend will likely end up in a case of ‘last man standing’ and some US oil companies may go broke or default on loans. One could surmise that OPEC may then pull back on the throttle, surplus will be consumed and prices inevitably again rise with less competition. One thing is for certain, whilst ever we remain a global community of increasing population and consumption…oil prices will bounce back. Until such time that globally an alternative energy source is widely adopted, we remain dependent upon this resource.

Number Three

China is big but it’s not that big yet. The key challenges that Chinese Policy makers face remain a slowing of their economy, ongoing share market volatility (as leverage is flushed out), currency depreciation and capital outflow. That said it is expected that China will continue to grow somewhere in the order of 6% against a backdrop of stabilisation. Policy easing will likely be in the form of further interest rate cuts, reductions in the Reserve Requirement Ratio allowing banks to lend more, some targeted economic spending and further currency depreciation. The upshot is that China has the powder dry, they now need to execute.

Outlook for Australian Investment

Low single digit levels of economic growth moving forward are likely. If central bankers and politicians reinforce it with sufficient regularity, it becomes the accepted wisdom resulting in the reasons for low growth getting less attention.

In short, real earnings remain attractive and the Australian Share Market should continue to deliver steady and maintainable dividends of least twice the cash and fixed interest rate. I expect extremes of price volatility such that we are experiencing now and extreme price movements on the up and down side will remain throughout 2016. I maintain that investment in low risk, good quality business and assets that maintain a favourable yield to that of cash will continue to reward investors as we move through this cycle of investment.

I quote Martin Conlon of Schroders Australia; “As behaviour continues to wildly overshadow fundamentals, the lure of outsized gains causes investors to forget totally about a margin of safety.  If the share price of BHP Billiton or Rio Tinto continues to decline when the business is not making losses and asset values are already reflecting an exceptionally tough operating environment, the margin of safety is improving.  When share price gains are wildly outpacing the rate of value creation, margin of safety is declining sharply.  These rules are simple, but behaviour is powerful.”

Regards Heath