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No need for investor panic over equities

The recent stock market rout has SMSF investors wondering what the turbulence means for them. But investors should not panic – 2018 still has the potential to be a positive year for stocks globally after the dust settles.

It certainly has been a rollercoaster ride for investors in the equity markets. After the longest rally in 30 years, stocks have taken a gut-wrenching tumble.

Amid the turmoil, now is the time to draw a deep breath and assess the outlook from here. The question on most people’s lips is: Is it a short-term correction or the start of a bear market?

The difference is crucial to SMSF investors, who are more likely to be holding stocks for the medium to long term and are less concerned with the day-to-day gyrations of the market.

My view is we’re experiencing a short-term correction, rather than a long-term downtrend that could persist throughout much of the year.

To understand why, we need to look at the factors driving the sell-off.

How did we get here?

A couple of weeks ago, it may have seemed to the casual observer that equity markets were unstoppable. The MSCI World AC Index had been up for 15 straight months, the longest winning streak since its inception in 1988.

However, there were signs the rally couldn’t continue too much longer. Investors were overly bullish on the outlook for earnings and valuations were beginning to look stretched. When everyone is talking about the great year ahead, that’s a good sign a pullback is in the wings.

In late January, Saxo Capital Markets warned the market was ripe for a correction.

The catalyst came in the form of United States non-farm payrolls data for December, which showed the biggest wage gains since 2009, boosting inflation expectations and sending bond yields sharply higher.

To understand why these events have caused a dramatic about-turn in equities, it’s important to remember that for much of the past decade, with central banks driving down interest rates, investors chasing yield have shunned fixed income and turned to stocks.

Now, with expectations rising the US Federal Reserve may need to boost rates faster than thought this year to stem inflation, bond yields have risen to a level where they are starting to look attractive again to yield-hungry investors.

The result is a sudden bout of profit-taking on the equities market in the US that’s flowed on to global markets, including Australia.

So, why should 2018 be a good year for equities?

Fundamentally, not much has changed from where we were recently.

The economic outlook in the US and globally remains strong. The payroll numbers reflect strength in the US economy, which ultimately is good for companies.

The weak US dollar should help to boost earnings in the US where recent tax cuts are also just beginning to take effect. Higher wages will boost consumer spending.

Note also the price behaviour in the run-up to the sell-off didn’t suggest a bubble. There wasn’t the sharp acceleration seen in the lead-up to the Black Monday crash of October 1987 or during the dotcom bubble of the late 1990s/early 2000s.

What’s worth buying?

For long-term investors, a correction is a good time to accumulate and build positions in high-quality stocks that seem oversold, whether through direct investments or exchange-traded funds. Sectors and markets we like include:

Financials: Rising yields are typically positive for insurance companies. Banks also do well in a higher interest rate environment. Recent tax reform in the US should also boost financials there. European financials are likely to benefit from the changing rate outlook with the European Central Bank recently tweaking its wording to flag the end of negative rates and quantitative easing.

Biotech: A surge in mergers and acquisitions is supporting the sector, notably Celgene’s acquisition of experimental cancer drug maker Juno Therapeutics and Danish drug maker Novo Nordisk’s bid for Belgium’s Ablynx.

Electric vehicle metal miners: Miners producing cobalt, lithium and nickel, used in the production of electric vehicles batteries, include Glencore and Chilean-based SQM.

Chinese stocks: Foreign investors are increasing their exposure following China’s moves to open up its capital markets. We prefer segments that are more private, such as consumer technology and consumer discretionary stocks, versus financial or energy stocks, which are more influenced by government.

Biggest risk is the Fed

Ultimately, the correction occurring now will be healthy for the market. Whether a correction brings the market down 10 per cent or 20 per cent from its highs is difficult to predict. However, when we get on the other side of the correction, look for the market to resume an upward trajectory. The market still has the potential to end in positive territory in 2018 because the macro backdrop remains solid.

However, the recent spike in volatility — with the CBOE Volatility Index, better known as the VIX, rising by 84 per cent on Monday, 5 February, its biggest one-day spike of all time — suggests it will be a bumpy ride getting there. The major risk is if the Fed overshoots on rates and the economy takes a turn for the worse, which could raise the prospect of a bear market and a possible recession in 2019. Another catalyst could be if China shows more economic weakness.

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