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Global Panic: The Impact on Asset Classes

Global markets are in the middle of a painful process of registering lower growth expectations, and not on the brink of destruction.

In less than a week as investors declared "risk off", global markets have declined rapidly. Domestic and international equities markets have fallen and the Australian dollar retraced itself, nearing parity with the $US.  Encouragingly, these circumstances appear markedly different to those of 2008.

Panic gripped the markets in 2008 because the financial system appeared near to collapse. Debt markets froze amid a systemic loss in confidence as financial institutions feared lending to one another. While debt was a common concern to both shocks, the current situation appears less like the earlier period.  Critically, liquidity and a crisis in confidence in the banking system have not been issues thus far, and debt markets look to be operating as usual. Markets have undergone large gyrations, though mostly contained in intraday movements.

The Standard & Poor's downgrade of US debt may have been a catalyst for the decline, but markets have sold off because of lower mid-term growth prospects - not the threat of financial collapse.  As different circumstances have driven returns in 2011, asset classes are not all behaving the way they did in 2008.  

Here's a brief round-up of what's occurring at the moment.  Equities declined across the board in 2008.  Although the Australian economy was relatively strong, economic resilience doesn't necessarily translate into share market success (as emerging markets continually demonstrate), and our market experienced huge losses. Further, because the Australian share market is considered a play on global growth, our risk profile is increasingly similar to that of emerging markets.

Global share markets suffered similarly to Australia, although their greater diversification helps mitigate losses. Emerging markets fell quickly in 2008, and in August 2011. But rosier economic fundamentals, in particular healthy fiscal balance sheets, suggest returns are likely to be more resilient.  Growth expectations remain far stronger for the emerging world relative to mature developed nations. The 'risk off' theme pushed the $A down almost six percent towards parity with the $US in August 2011. The pro-cyclical nature of the $A suggests that when risk on/off trades are being taken off, the $A can free-fall, evident in 2008, and May 2010. For unhedged investors this decline mitigates risk, and provides a buffer from falling foreign asset prices. Therefore, as happened in 2008, the fall in the $A will buffer returns, and dampen volatility. Unhedged investors have benefitted from the declining Australian dollar.

The liquidity crunch and pervasive uncertainty following the collapse of Lehman Brothers played a major role in the significant falls in lower credit quality fixed income securities in 2008. Encouragingly, liquidity is yet to be an issue as debt markets have continued to function normally. One notable difference in the current scenario is that the spotlight has shifted onto the creditworthiness of governments, while many observers consider the balance sheets of the corporate sector generally robust. A broadly-based flight from risk may hit those strategies more exposed to high-yield credit securities, but the same ingredients which fuelled the debt market meltdown in 2008 do not appear to be present.

Volatility is likely to persist, with large and unpredictable movements across asset classes. However, the systemic issues encountered in 2008 have not materialised. The temptation to switch to cash is high, but the investor experience after previous crises suggests that a sensible option in periods of panic is to hold firm. The rapid rise in asset values during 2009 demonstrates why. 

"Habit rules the unreflecting herd."
-- William Wordsworth (English poet, 1770 - 1850)