On cold winter days there is nothing I like better than a warm hearty soup, and although my liking for soup has no apparent connection to investment markets we can use this analogy to explain the market volatility that we’ve seen in global share markets of late.
Over the last 2 – 3 weeks global share markets have fallen due to the markets anticipation that the US Federal Reserve will pull back its stimulus measures over the coming months.
Why would they do this?
To answer this question let’s return to my liking of soup and assume the US Fed is responsible for keeping us soup-lovers comfortable, satisfied , and warm this winter.
When the soup loving populous are feeling hungry and cold the Fed can provide as much soup as possible to ensure we are all satisfied and warm. However, if you are a soup lover you’ll know that there’s only so much soup you can eat. The liquid quickly fills you up and its warmth quickly heats you up. At some point you have to stop eating!
OK… if we substitute money for soup and the US population for us soup-lovers you can see that the US Fed has been providing as much stimulus (money) as possible to the system so US consumers and businesses can cheaply borrow, spend, and invest this money to create more sales, jobs, and kick-start the US economy.
But just like eating soup, providing stimulus cannot be a perpetual unlimited exercise, as in this case the substitute for a warm, full, soup-filled belly is the fear that too much stimulus could kick-start spending to such a level as to lead to high inflation. And the tool central banks use to reduce inflation is increasing interest rates, which is not the desired action in a weak economic environment.
So the Fed is providing just enough soup to keep us all comfortable, warm, and happy; and at some point, quoting a Seinfeld episode, the Fed must declare ‘No Soup for You!’ The hint (or expectation) of this declaration is prompting profit-takers to sell down their portfolios and take profits off the table.
However, this does not mean that these same profit-takers think that the US economy is in trouble… In fact if the US economy and share markets were not recovering and performing well then there would be no profits to take.
So How Does this Affect the Australian Investor?
The Australian economy is in a different phase to the US in that our economy is weak and structural change is needed to be initiated by the Government and industry to kick-start the non-mining sectors of our economy such as manufacturing.
And the Reserve Bank of Australia (RBA) is also trying (some would say very slowly) to help by reducing interest rates so we can all spend, invest, consume, and to reduce the value of the Australian dollar (AUD) to help our exporters sell their goods more cheaply and competitively overseas.
So if we believe the weakness in the AUS economy will persist (as most commentators are predicting) forcing the RBA to again reduce interest rates, then it follows that the AUD will fall further against the US dollar. Similarly, if we believe the US economy is improving, and the turning-off of stimulus measures by the Fed is further proof of this, then this also supports the idea of a falling AUD against the US dollar.
A falling AUD is not good for holiday-goers travelling to the US (money going abroad) but it is good for investors and exporters investing and selling in the US and accounting in AUD (money coming home); and therefore, a falling AUD will result in better international share returns for us in AUD’s.
So in conclusion, the recent market volatility is not a sign of bad-soup (or bad investment conditions), but a sign of a strengthening US economy due to too much soup (or financial stimulus) by the Fed. And if this stimulus leads to further strengthening of the US economy, in an environment where Australian interest rates are again cut, Australian investors will gain higher returns from their US share holdings due to the fall of the AUD against the USD.
More Soup Anyone?
Value Investment Partners Pty Ltd is a Corporate Authorised Representative (Representative No.: 409849) ABN 72 149 815 707 of Sterling Managed Investments Pty Ltd, Australian Financial Services Licensee (AFSL 340744). This document has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained in this document is General Advice and does not take into account any person’s investment objectives, financial situation and particular needs. Before making any investment decision based on this advice, you should consider, with or without the assistance of a securities adviser, whether it is appropriate to your particular investment needs, objectives and financial circumstances.