Surviving the ups and downs

It’s beena tumultuous 18 months — but as in all walks of life, the good times will certainly follow the bad.

The facts:

n The world is now 29 months into the second deepest bear market in the post-war era;

n Global equity prices have fallen around 40 per cent from their peak to date, compared with the 44 per cent decline witnessed in 1973-74;

n While major economies have only flirted with recession, corporate profits in most geographic regions have taken a dive;

n Global markets have experienced high volatility due to an increase in world geo-political risks, such as September 11 and Middle East tensions, and the fallout from accounting ‘irregularities’ — Enron, WorldCom, HIH and OneTel; and

n Recent data suggests that the world economy is starting to improve, albeit at a much slower pace than expected.

Markets and economies have been locked in a ‘vicious’ downward spiral (figure 2). This is the reversal of the ‘virtuous’ cycle of the late 1990s (figure 1) when strong stock markets boosted sentiment and confidence. In turn, boosted investment and consumer spending and the higher economic growth that resulted provided another leg-up for equity markets.

On average, the market has experienced a down year in one in out of every four years, and back-to-back down years, such as the current environment, around once every 20 years. While unavoidable, such market corrections don’t mean the end of the world — up markets have more than compensated for the down years.

Since the bull market came to an end in the late 1990s, the world has experienced some fairly significant events that have destabilised economies and markets, creating the environment of uncertainty. But we can take comfort from historical events.

While past performance cannot guarantee comparable future results, in the weeks and months following some of the biggest historical events of the past 87 years, stock markets have rallied.

The Australian economy continues to be one of the best performing in the world in 2002. Gross domestic product (GDP) growth over the year to the June quarter was a robust 3.8 per cent and consensus forecasts place Australia at the top of the global growth table for 2002. This strong economic performance has been reflected in asset markets, with the Australian equity market outperforming most major global equity markets over the past 12 months.

Australia will not fully escape the vagaries of the global and domestic business cycles, but the economy is fundamentally stronger and more capable of withstanding shocks. Improved macro-economic fundamentals, structural changes in the economy and better economic management have raised growth potential and lowered the volatility in the business cycle.

The sharp rise in household debt is clearly a potential imbalance and will have to be managed carefully by the Reserve Bank and the Government. The full impact of higher interest rates will be felt on the household sector and the appreciating Australian dollar is reducing trade competitiveness.

Conditions in the agricultural sector have deteriorated materially this year. As a result, it is likely economic growth will be somewhat weaker in 2003. However, any slowdown should be consistent with the greatly reduced business cycle volatility that has been a feature of Australia’s growth performance over recent years.

Despite the short-term outlook of continued volatility, there is still good news. With a toughening of accounting practices and improved market sentiment, investors should expect to see an improvement in markets and the global economy.

Now is a perfect opportunity to develop and build long-term investment strategies that will carry investors through the cycle of market emotions. By anticipating and understanding these emotions, investors will be better equipped to tolerate and benefit from market fluctuations.

Damian Kington is with Invesco. The fullversion of this article is available atwww.invesco.com.au