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View from the Hill - Making sense of the mayhem

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After 4 years of almost universally good news and outcomes for investors, the events in financial markets over July and early August have changed investor sentiment in the most dramatic of fashions. As with any shock to financial markets, a myriad of views and forecasts are available to investors looking for explanations in the aftermath.

However, following turbulent market events it is particularly important for investors to understand what has changed in a fundamental sense, before any adjustment is made to investment strategies.

It would appear that there are at least 2 fundamental changes that have taken place over the last 6 weeks:

1. Firstly, based on the experience of certain lenders in the US, it became apparent that there has been a serious increase in the rate of delinquencies on certain types of mortgages.

2. Secondly, there was a reasonably significant fall in the level of base metal prices on global commodity markets

The sub-prime meltdown

Mortgages written in the US are generally considered to be “sub-prime” when the borrower doesn’t meet all the lending criteria normally applied by financiers. Often the loans will be written with little documentation and charged at higher interest rates to compensate the lender for the higher default risk. These types of loans became increasingly prevalent in the United States over 2005 and 2006, as interest rates were on the rise.

Often these loans would be packaged up into securities and sold to investment banks and other investors, who then take on the risk of borrower default. In recent weeks, the realisation of the magnitude of default on these loans led to markets significantly dropping the price of the securities in which these loans were held. A very small number of Australian based investment vehicles had exposure to these types of securities. In some cases, the investment vehicles holding these types of securities had also borrowed heavily, significantly magnifying the risk and loss to investors.

However, whilst the incidence of direct exposure to US based sub-prime mortgages in Australia is low, the ramifications do have the potential to be more widespread. The value of credit investment instruments assumes a certain probability of repayment. Forecasting this probability is highly subjective and easily influenced by general market sentiment and events in other related markets.

Up until very recently, sentiment in credit markets was extremely positive, built on the large absence of any widespread loan defaults. Although the flow-on to other credit markets has been relatively contained to date, it remains too early to predict how significant any flow-on to other credit markets will be.

The fall in base metal prices

As has been the case around the globe, Australia’s stock market has been sold down heavily following the emergence of the problems with US sub-prime lending. Sometimes, a sell-off based on fear of the unknown could represent a good opportunity to buy into the market at temporarily cheap prices.

However, the Australian market has also been subjected to another fundamental event over the past 2 months that may take the gloss off any opportunistic buying. Over June and July base metal commodity prices (as measured by the Reserve Bank’s Commodity Price Index) dropped by 12%. This represents the largest fall since 2001, and is the first significant pause in the upward trend that has seen prices increase three-fold since the beginning of 2003.

Rising metal prices have been a key factor underpinning the Australian stock market’s extraordinary run over the past 4 years. Share price valuations are already stretched and factor in an assumption of further earnings growth. Any ongoing weakness in metals prices threatens to erode this assumption and some of the basis for current share prices.

Investment risk considerations

Not only have the past 4 years been kind to investors by providing high returns, the level of volatility (the rate at which prices move in either direction) in financial markets has also been particularly low. One outcome of the 2 events described above is likely to be increased volatility as markets take time to adjust to these and other subsequent events.

Given the lack of volatility in recent times, some investors may have comfortably found their way in to investment vehicles that do not suit their underlying risk profiles in times of normal or above average volatility. It may therefore be an appropriate time for investors to review their portfolios and consider the extent to which they are comfortable with their investment exposures.

As always, volatility can be minimised on a portfolio wide basis by having high levels of diversification. Given the events described above, investors should ensure that they are not over exposed to credit markets or those Australian shares reliant on continued growth in commodity prices.

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