Back to earth with a bump

What a difference a week makes. Last week's 5 percent fall in the Australian sharemarket has unsettled investors already concerned about a weakening economy. The extent of the fall, the largest weekly one for years, was surprising given that figures were released during the week showing that higher mineral exports had generated faster than expected gross domestic product growth.

Foreign selling because of rising European bond yields put downwards pressure on the market, especially on bank shares, for some time, but the trigger for last week's correction was the Reserve Bank's decision to retain the official cash rate at 2 percent. Market analysts interpreted this decision as detrimental to the profits of the major banks, because it didn't lower the cost of domestic deposits when overseas bond rates are increasing.

However, a more important determinant of the future funding costs of the major banks is how soon the Federal Reserve acts to increase US interest rates. Given that our official interest rates are likely to remain low for some time and may even fall further, especially if the exchange rate remains stubbornly high, our sharemarket will continue to be underpinned by investors' hunt for yield. Nevertheless, as shown by the savage reduction in the Metcash share price when it announced a halt in dividend payments, the possibility of franked dividend payout reductions is likely to lower individual share prices.

While the major bank dividend payouts don't appear to be of concern, that could change, especially if the Australian Prudential Regulation Authority's pressure to increase capital reserves adds to the burden of higher overseas borrowing costs. With the major banks making up a large percentage of the overall market and the other large mining company component of the index also facing earnings challenges, the hunt for yield is unlikely to generate a quick recovery from the current 5500 ASX 200 index level.

Certainly, expectations earlier in the year that the index would break the 6000 level appear to be too optimistic. The message, as always, for ordinary investors, is to understand that owning equities involves volatility risks. These risks are best dealt with by diversifying portfolios and ensuring that funds needing to be accessed are invested in cash or similar liquid assets.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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