The Australian stock market has regained most of what it lost from October through to the end of last year, meaning that valuations have now returned to what we believe to be relatively full levels, particularly when taking into consideration that earnings growth is forecast to be only 4 per cent.
As a result, tactically over the next few months, we are erring on the side of caution. Global growth indicators have been weak (reflected in falling interest rates), most notably in Europe and China. Market earnings estimates appear to be inexplicably lopsided and usually this has been a reliable indicator that expectations are too high and will likely be revised lower. With May 'confession season' around the corner we think this could also be an early warning signal. We think it is therefore prudent to hold higher levels of cash than normal in this environment.
Global bond yields continue to fall with the Australian 10-year government bonds dropping to their lowest level on record (1.76pc, March 25). It was only a little over six months ago that the market was fretting about rising rates, and today the consensus is increasingly pricing in cuts to policy rates both domestically and abroad.
The lower-for-longer interest rate thematic has come and gone through multiple iterations since the GFC and we think we are entering another period where investors will again seek yield and growth. The earnings yield of the equity market over the bond market has extended further and we think this should continue to favour being invested in the equity market over bonds/fixed income.
Potential changes to franking credit refunds under a federal Labor government is also playing a part in boosting the appeal for equity yield. February reporting season saw a lift in the number of special dividend and buyback announcements as companies look to return surplus franking credits to investors ahead of the proposed changes.
The reduction in government bond yields since the peak in November has helped boost returns on infrastructure stocks not to mention other stocks such as REITs and high growth/PE stocks. It is important to understand though that the reduction in bond rates may not be a free kicker to valuations.
You can think of bond rates as being comprised of inflation expectations and the real interest rate. To be consistent a lower bond rate being used within a valuation needs to be accompanied by lower inflation and/or economic growth expectations.
The infrastructure sector may be considered to be a quasi-inflation hedge, because there is often a direct contractual linkage between revenue growth and CPI. As such, the fall in bond rates may not provide the full free kick for the sector that some expect.
Despite the short-term risks, we see the low interest rate environment supportive for risk assets over the medium term. We think an extended period of elevated valuations will persist until markets once again fret about rising interest rates which at this stage, with inflation subdued, seems a long way off.
- Justin Still, Investment Adviser (Authorised Representative: 000279726) Morgans Financial Limited ABN 49 010 669 726 | AFSL 235410
