Shares hit a speed bump – 2004 all over again?

By Shane Oliver, Head of Investment Strategy and Chief Economist for AMP Capital Investors.

Key points

• Shares have fallen over recent weeks on the back of concerns about China's tightening, the regulation of banks in the US and sovereign risk.
• This is consistent with our expectation for rougher and more constrained gains in sharemarkets this year after the strong rebound from March 2009. Notwithstanding increased volatility, rising earnings are likely to underpin a rising trend in shares this year.
• The experience of 2004 is a reasonable guide as to what to expect this year. In 2004, US shares spent nine months stuck in a range and Asian shares (and some commodities) had a decent correction, but this was still within the context of a rising trend in shares.

Market weakness

Concerns that Chinese monetary tightening will trigger a hard landing in China, increasing US bank regulation and continuing financial stress in Greece have contributed to a pull back in sharemarkets and other growth oriented investments over recent weeks. From their highs in early January, major sharemarkets have fallen by more than 7%. Chinese shares have fallen about 10%, although they have been range bound since August. Does this mean the recovery rally in shares and related trades is over?

A correction in a still rising trend

Our assessment is no - it's not. What we are going through is a correction within a still rising trend. This is consistent with our assessment that this year will see a bumpier ride for investors with more constrained, but still positive returns. There are several reasons for this.

1. Reason number one: though further monetary tightening in China is likely, growth should remain strong
   
   While further monetary tightening in China is likely, the hard landing in China now being feared by investment markets is most unlikely. Without the tightening now underway, growth in China this year would probably be heading to 14% or so, creating excessive inflation and other imbalances. By moving preemptively, growth should be capped at a more sustainable pace.
   
   In fact, China is a long way from needing to undertake a draconian tightening designed to crunch growth. China has proved very successful in managing its economy over the last decade and we see no reason why it will be any different this time around. Sure, growth slowed more than desired in 2008, but this was due to a collapse in exports on the back of the global financial crisis (GFC) - and, by its reaction, China showed it will not tolerate a sharp downturn in growth. Recent data is already showing signs of a slowdown in the pace of growth in credit, money supply, fixed asset investment, steel production and industrial production. This suggests the authorities won't have to go too far to prevent the economy from overheating. While inflation is rising, excluding food, it is still just 0.2% year on year.
   
   Overall, we remain of the view that growth in China this year will be 10%, which is still strong by anyone's standards and will provide ongoing support for global growth and commodity prices.
   
2. Reason number two: though governments are likely to play a bigger role in the economy, changes are not likely to be detrimental to the markets
   
   There is no doubt President Obama's more aggressive proposals to regulate banks (limiting their size and barring them from owning hedge or private equity funds and engaging in proprietary trading unrelated to their clients) has created much uncertainty for the sector. Some view it as a hastily conceived move designed to tap popular anti-bank sentiment after the Democrats lost Ted Kennedy's Massachusetts Senate seat. More broadly, it is consistent with a theme of bigger government involvement in the economy post the GFC.
   
   However, the US bank changes will take some time to eventuate and there is a good chance the Republicans will block the restrictions on bank activities. Furthermore, other countries, including Australia and New Zealand, are unlikely to go down this path, but rather focus on strengthening capital adequacy requirements.
   
3. Reason number three: while high public debt levels in some countries are an issue, they are not big enough to derail the economy
   
   While Greece's public finances are a mess and several other countries face similar problems, they are not big enough to derail the global economic recovery overall. For example, Greece is just 2.6% of the Euro area economy. High public debt levels are also a big issue in the US, UK, Europe and Japan more generally, but none of these countries are at risk of default. The more likely scenario of these efforts to wind-back debt will be constraints for growth in these countries, but not a major crisis.
   
4. Reason number four: interest rates will move higher gradually
   
   While interest rates globally are heading higher, the process is likely to be very gradual in key advanced countries with high levels of unemployment and low underlying inflation. In short, we are a very long way from the adoption of aggressive sharemarket threatening interest rate levels in the US, Europe and Japan.
   
5. Reason number five: profits are starting to move higher
   
   While there have been some notable disappointments in the current reporting season in the US, so far nearly 80% of companies to have reported have beaten profi t expectations and around 65% have exceeded revenue expectations. The profi t reporting season in Asia is also proving to be strong. A 20% to 30% gain in profits this year will be the key factor underpinning the continuation of the bull market in shares this year.
   
6. Reason number six: valuations are still reasonable
   
   Finally, we are still in the early stage of a typical bull market cycle, valuations are still reasonable and investors are still relatively underinvested in shares.

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