Volatility Continues In World Financial Markets

Last week, volatility returned to world financial markets with a vengeance for the first time since late February. Once again, the US housing market was the catalyst for the widespread declines. The ASX All Ords saw further significant falls on Wednesday of almost 200 points. We will attempt to explain how a rumbling US housing market can reverberate around the world, and why we believe there is no reason for resource sector investors to panic just yet.

"With the big falls in world indices over the past week, resource investors are best advised to sit back, avoid any thoughts of panic and wait for the dust to settle."

The vengeant volatility also spilled over into this week, with the ASX All Ordinaries diving by 198 points on Wednesday.

With the catalyst for the widespread declines being the US housing market, it may seem strange that one country's housing market woes can cause a worldwide stock market sell-off. But as we will emphasise, the linkages in the global economy are now greater than at any time in the past.

However, we believe there is no reason for investors to panic just yet.

We say 'just yet' because in our view, the housing market still has some pain to endure. The impact on consumer spending and therefore on US economic growth could be greater than markets are currently pricing in.

So what are the charts saying about the recent correction? Well, for the past three months a relatively rare pattern known as an expanding top has been forming on the ASX 200. As displayed on the daily chart, this pattern clearly derives its name from diverging lines of resistance and support.

Over the past two weeks, a retreat from the upper edge of this pattern has seen the ASX 200 decline by more than 7%. On Wednesday, the index broke the lower line of support and closed on the low of the day at 5941.2. Although technical indicators are now at deeply oversold levels, the weak stance of the index signals that a move lower remains a distinct possibility in the near term.

Any attempt to rally will encounter noteworthy resistance between 6145 and 6300 in our opinion. Given the current stance of the index, we believe that several months of consolidation will be required before a sustainable rally emerges to challenge the highs.

But before we discuss the potential for further weakness, let's look at the cause of the recent stock market instability.

For some time now, concerns have mounted about the state of the 'sub-prime' mortgage sector in the US. Sub-prime borrowers are those people with weak credit histories.

Without the credit bubble and associated sloppy lending standards, many of these borrowers would not have been able to buy into an inflating property market during 2004 and 2005.

But successful they were, and their loans were packaged and sold off to numerous buyers looking for higher yields. Hedge funds in particular invested heavily in the sector, looking to increase returns by adding leverage (debt) to the mix.

When US house prices topped out during 2006 and low introductory interest rates shot up by several hundred basis points, many borrowers began to default on their loans. In consequence, this placed pressure on the highly-leveraged investors in the loans - mostly hedge funds.

After the collapse of the Bear Stearns (a US investment Bank) hedge funds, countless officials reassured investors that the sub-prime issues were isolated events and therefore nothing to worry about. (Note to Members: take market forecasts from politicians or officials with a very large grain of salt.)

Soon after these calming words were uttered, Countrywide Financial, the largest mortgage lender in the US, warned that earnings would be weaker because a broad range of borrowers were getting behind in their loan repayments, not just sub-prime borrowers! Soon after, investors began to realise that perhaps risk had been priced too low and for too long.

This renewed focus on risk has had a greater impact on stocks than the housing market itself. The increase in risk aversion has had a number of effects. The cost of 'risky' debt (anything other than government debt), has increased substantially over the last week, albeit from low levels.

Borrowing rates for companies and private equity consortiums have therefore increased, which has had a big impact on the potential for debt funded takeovers. This has resulted in a fall in the share price of many perceived takeover targets.

The higher cost of borrowing has another consequence for the market: we believe the stock market is highly geared from an investor's perspective.

Many individual investors, as well as hedge funds, have borrowed heavily to invest in the market. When sentiment turns, as it did last week, these highly-leveraged players exacerbate the volatility by liquidating any asset to pay

Additionally, the increase in risk aversion had significant implications for Japan. The yen carry trade, which involves borrowing yen cheaply (where interest rates are dirt cheap) and investing the proceeds just about anywhere else other than Japan, unwound very quickly.

This is partly the reason behind the steep falls in the A$ over recent days as short-term speculators took to repaying their yen-based loans.

To make matters worse for the Australian market, inflation is now flashing as a warning sign and there is the possibility that the Reserve Bank could raise interest rates in the coming weeks.

All of this has resulted in a big pullback in the Australian share market.

Sparing very few stocks, investors took profits on the fundamentally sound resource sector and sold off banking and financial stocks on concerns that credit growth would begin to slow. Perceived takeover targets were also marked down.

The global outlook will obviously have an impact on the local market in the months ahead, and whilst the outlook in Australia is towards higher interest rates, in the US, official interest rates may go the other way. We anticipate that the US housing market will continue to weaken throughout the year, putting greater pressure on highly-geared home owners and investors in mortgage debt.

Just as consumers increased their spending when house prices were rising, they are also likely to cut back when their primary asset is falling in value. Considering consumer spending accounts for 70% of the US economy, a significant consumption slowdown could tip the US economy into recession.

For guidance on how the US situation should be put into perspective, we believe it is useful to refer to a recent BHP Billiton investor presentation.

BHP noted that China's growth rate during 2006 was 10.7%, the fourth consecutive year that the country's real GDP growth exceeded 10%. BHP was encouraged by the tightening of liquidity and the investment controls implemented by the Chinese Government, which should allow sustainable growth.

Of course, China's growth rate during the June quarter has hit 12%.

Why is all this of significance? Well, it relates to BHP's views on commodities, particularly the relative influence of the US on the world economy.

Please see attached slides below from BHP's briefing to illustrate the point.

Over the past 10 years, China's influence as a proportion of global copper demand has grown from 10% to 22%, whilst the US has fallen from 21% to 13%.

Meanwhile, China is the biggest single consumer of four main commodities - aluminium, copper, steel and oil. Note also that India is a mere speck at present, but it will become a very important player over the next decade, applying significant supply pressure.

What all of this means is that despite the recent rhetoric, the world is not going to end if there is a slowdown or jittesr in the US economy.

China is an increasingly important player in the world economy and is equally as relevant from a global perspective. This is of particular relevance to

Australia, as we believe our direct fortunes these days, particularly as a commodity exporter, are more aligned with China.

Getting back to recent market events, we believe that the sharp falls experienced last week and Wednesday signal the beginning of a consolidation phase. However, we expect the upcoming reporting season will deliver solid earnings across the board, and this good news could lead to a share market rally here in Australia.

We expect the resource sector to perform solidly, with the major producers continuing to deliver strong profit growth, justifying the sharp re-rating the sector has experienced over recent months. The release of Rio Tinto's half-year results tomorrow (Thursday) afternoon will provide an important bellwether for the current resources reporting season.

Corrections such as we are experiencing now serve to remind us that markets can move both up and down. We stress that there is no need for panic in the resources sector any time soon.