ASX outstrips expectations, prompts fears of overvaluation

ASX outstrips expectations, prompts fears of overvaluation

At the start of January, we were writing articles questioning whether the most popular ASX index, the S&P/ASX 200, could approach the 7000 point benchmark in 2020. Just two weeks later, such discussions are completely redundant; the index barged through that ceiling on Thursday and has since extended those gains. Investors are riding a giddy high, breaking numerous benchmarks, with January gains as high as 6%. The same is true in international markets, with the Dow closing Friday on its best week since August, and with many new records set.

Strong global outlook

This bullish behaviour by traders has been widely attributed to trade deal secured between the US and China last Wednesday. The deal brings hope of a full stop on the escalating tit-for-tat tariffs the global trade titans have been placing on one another’s imports for the past two years. A renewed sense of hope for the global economic outlook has swept around the world, along with hopes of a swift resolution to the Brexit question with the coming January 31st deadline.

Gains are also being spearheaded by rising commodity prices. Rio Tinto, Fortesque, and BHP are riding high on rising iron-ore and copper prices. There is also the expectation of future growth in the industry following the improvement in China’s economic outlook due to stabilising trade. The turnaround in commodity prices is predicted to bring in a further $6.4 billion to the domestic economy, which will bring some relief to the Treasury’s budget outlook. However, stocks in shakier sectors appear to be riding the tailwinds of the big miners, without any growth in revenue or outlook.

This is because international cooperation and improved growth expectations are not the only forces at play here. Monetary conditions in many of the world’s advanced economies are currently extremely loose. Low interest rates and yields are the scourge of the modern investor, many of whom have been driven away from bonds and other long-term assets into the securities market. The low interest rates have created an environment of cheap credit with which to invest, and the most attractive market in this low-yield environment is for shares.

Possible overenthusiasm on the ASX

Analysts are concerned that the record gains on the ASX could be little more than hot air ignited by low interest rates and misplaced enthusiasm. Price-to-earnings multiples have reached roughly 18x, a rise from about 15x this time last year. The continuing escalation of Australian traded securities seems undaunted by ever diminishing expectations of a domestic growth turnaround.

Many top economists have downgraded growth expectations in wake of the bushfire crisis, which has at present prompted the Federal Government to triple the loan and grant support provided to fire-affected small businesses. ASX heavyweights Nib and Kogan also on 20 January 2020 downgraded profit forecasts, and sluggish consumer sentiment is expected to bring further casualties in this regard.

In a functional economy, the stock market can be expected to act as a reasonable, though volatile, measure of economic confidence. Unfortunately, it seems the inverse pattern could be emerging. The weakening domestic economic outlook has created a broad expectation that the RBA will lower the cash rate again within the next 6 months, with most interest rate futures currently at a 100% expectation of a rate cut by June. This flagging domestic growth is at odds with the optimism within the global economy, which may yet limit the RBA’s desire to loosen monetary conditions further.

If unemployment rises or inflation falls (which is not unlikely given lower job creation expectations for December compared with November) the RBA is likely to cut the official cash rate to give a boost to the local economy. The unintended consequence of this action is that lower interest rates render other financial assets less enticing, funnelling money into the stock exchange.

This divergence we are seeing between securities prices and the rest of the economy may be an early warning sign that all is not well.

What’s wrong with an overvalued stock market?

The huge growth in the ASX these past 12 months has made some people rich, and a lot of people better off. Many traders will be thrilled that the index has hit the all-significant 7000 glass-ceiling. Yet the problem here is not the rising value of the exchange, which can be a good sign of economic health; it is the possibility of overvaluation.

What’s the significance of this distinction? The latter generally leads to a correction course.

It is very difficult to say when a bubble is forming. Value is relative, and the market can sometimes foresee factors that analysts fail to consider. However, speculative valuation in an asset class can lead to a rude awakening, when investors realise the emperor is not wearing clothes after all. This can create a sharp contraction in the market, the kind that has real-world economic impacts: businesses investment falls as equity shrinks, shareholders lose a portion of their wealth, and perhaps most importantly for everyday Australians, superannuation funds are devalued. This is why a stock market collapse can sometimes prompt an economic contraction.

There is another risk within the current financial climate. The historically low rate of interest in Australia means that investors have cheaper access to credit than ever before. This makes the rate of return of loan-backed investments higher and more attractive. In a growing stock market, this doesn’t present a problem; investors borrow money and buy shares, the capital gains of which can pay off the interest and then some, creating the opportunity for much larger profits than an investor’s capital holdings could allow. There will be small scale defaults on unsuccessful investments, but overall the market is going up.

However, if an over-leveraged stock market shifts into a sudden and severe devaluation, investors who sells stocks at a loss become unable to pay back their initial loans. This financial contagion can spread throughout an economic ecosystem, implicating more individuals and institutions in the losses. This is one of the risks the RBA will consider over the next six months as they weigh up the possibility of another rate cut.

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There is no investor left unperturbed with the ongoing trade conflicts between US-China and the devastating bushfire in Australia.

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