Market turmoil gives us a warning

Let’s hope this week’s markets turmoil is just a correction. But it’s more likely a warning.

Wall Street traders were caught by another last minute drop. Picture: AP

As Wall Street moved into its final hour buyers became more confident and the market, which has been strong all night, gathered momentum. The Dow index recovery gathered pace and exceeded 500 points. Then the sellers hit and the Dow index lost its momentum, falling sharply in the final 50 minutes. It lost 100 points of the earlier gain to close up around 400 points.

In the first few hours of trading there was significant short covering but as the final hour approached, traders became more confident. Those who earlier in the day were covering their short positions were often moving to long positions, accelerating the recovery. But it was too early to pop the champagne corks and the traders got caught.

Let’s put what is happening in context. The American and Australian sharemarkets have experienced close to a 10 per cent correction which historically signals either the beginning of a new bull phase or the warning of something far more serious.

Wall Street was still up on the night and if that recovery maintains momentum over the next week then the correction was a warning. But if it falters - and the last 50 minutes was a warning - then we are looking at the development of a significant down trend. In Australia today we should have followed Wall Street but our opening was very disappointing and clearly the final 30 minutes of Wall Street trading has spread down under. That indicates that this is more than a correction

But in both America and Australia there are warning signs that we are looking at something more serious. The US market is priced on the basis that nothing will go wrong and that American earnings will continue to surge. This correction was prompted in part because there are cracks appearing in that earnings view.

The so-called “trade war” with China is something far deeper than a simple trade war because it involves stopping the technology transfer to China. Therefore a peace agreement is much harder to settle and that is affecting the earnings of a number of American companies. And Europe is set for a significant slowdown, led by Germany. US interest rates are rising and the Federal Reserve is predicting more rises. US consumers are becoming nervous and that is showing up in housing starts and car sales.

Higher interest rates dramatically change the value equation for shares, because the market had been priced on the basis that interest rate rises would be moderate. The US 10 year bond rate has almost doubled, at a time when the US deficit is boosting government borrowing and the Chinese no longer support the US bond market. President Trump has blasted the Fed’s high rate policy and if it moderated its higher rate stance it would be a big boost to the market.

But to complicate things, shortages of labour are appearing. The growth momentum that was established by the constant increase in the amount of workers employed is slowing simply because suitable people are already employed.

American investment is increasing, but the great hope that Trump’s tax cuts would ignite a new era of prosperity is at least being deferred because companies want to see how the Trump revolution pans. Then of course, there are higher energy prices. All this played out in cracks in the latest profits that many companies announced. Tesla did better than expected and the stock soared. That would not have happened a day earlier.

Here in Australia our circumstances are different. The big falls in BHP and Rio Tinto on Thursday were indications that the market believes that the current stimulation in China will not be sufficient to overcome the effects of the trade war. Both companies joined the recovery but Thursday’s fall was a clear warning that our commodities will come under pressure. That warning may be right or wrong but it is a market fear.

More tangibly, we are watching a severe credit crunch, which is designed to reduce dwelling prices and it is doing just that. But the flower of confidence is being crushed and very soon that will show up in retail sales and other areas of the economy. Our market was not priced for such a decline.

In addition, on the basis of the Wentworth by-election and the opinion polls, an ALP government is odds-on for 2019. That means that franking credits will be damaged and the proposed negative gearing changes will further damage the market, compounding lower consumer confidence.

And then we have the stark realisation that came from the AMP. This great organisation, which in the 1960s was bigger than BHP (albeit a mutual at the time) is now experiencing a dramatic outflow of funds. That outflow of funds will be duplicated to a lesser extent by MLC and Colonial.

The beneficiaries of those outflows, the industry super funds, are less committed to the Australian sharemarket. The full extent of this money transfer not yet known, but it is clearly going to affect the market. Bank shares have understandably been hit in Australia but the same thing is happening in the US.

Let’s hope that both the American and Australian market falls are corrections, but in both areas my fear is that they are a warning of things to come.