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Falling interest rates to push money into equities

Nicki Bourlioufas  |  17 Jun 2016Text size  Decrease  Increase  |  

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Australian 10-year bond yields have fallen to historic low levels as investors seek "safe" assets on concerns that global economic growth will remain lacklustre.

This is expected to push more money into the share market over 2016 as investors seek high-yielding equities, according to David Bassanese, chief economist with BetaShares.

In recent days, the yield on the local, 10-year government bond hit an all-time low of 2.1 per cent. This is pushing down the return on fixed-interest assets such as bonds and term deposits, which are priced off bond yields.

The main driver of falling bond yields has been low inflation, low official cash rates and concerns about global and local economic growth, with Brexit exacerbating market fears.

While sluggish economic activity might put a big question mark over share-market values, and the sustainability of companies' earnings, it is expected to push more money into shares, at least over the short to medium term, says Bassanese.

According to Bloomberg estimates, the market's gross dividend yield as at the end of May was 6.1 per cent, which is significantly above the approximately 2.5 per cent annual rate available on 10-year government bond yields and 1-year bank term deposits.

Bassanese expects the low interest-rate environment will push more of investors' money into high-yielding shares and listed property rather than fixed income.

He anticipates the S&P/ASX 200 could rise to a forward price-earnings (P/E) ratio of 20 times earnings--well above the long-term average P/E of around 14.5 times.

"If interest rates were to hold at current levels, there's even some chance that equity market valuations could be 're-rated'," says Bassanese.

"Let's assume that the sustainable margin between the gross dividend yield and interest rates declines to around 1.5 per cent per annum, then the gross dividend yield could decline to 4 per cent per annum.

"Assuming an 80 per cent payout ratio, that in turn would imply a sustainable price-to-forward earnings ratio of 20 times.

"If we allow for a moderate 1 per cent rise in interest rates (to 3.5 per cent per annum), then keeping all else constant the market's gross dividend yield could still fall to 5 per cent, implying a sustainable price-to-forward earnings ratio of 16x--or not far from current levels."

Bassanese expects bank shares could be a particular beneficiary. Having fallen in price in recent times, the yields on bank shares in mid-June were as high as 7.9 per cent for National Australia Bank (NAB), with Commonwealth Bank of Australia (CBA) at the bottom with a still generous yield of 5.8 per cent.

"Listed property has really done well but shares generally, including bank shares, haven't done as well," he says.

"Unless you think the housing market is going to collapse, then bank shares could benefit from the fund flows into the equity market."

According to Bassanese's analysis, Australian equities gained 3.1 per cent over May, in part boosted by the official rate cut.

Listed property remains the best performing asset class over the past 12 months, followed by Australian bonds--both asset classes which benefit from lower rates.

Bassanese sees even more possible official rate cuts to come.

"Not only did the RBA cut rates [in May], it left the door open for further rate cuts given it has forecast and expressed concern over a possible sustained sub-2 per cent underlying inflation rate over the next year or so."

According to Shane Oliver, head of investment strategy and economics at AMP Capital, the search for yield from equities will be ongoing for some time.

"In times like the present, a focus on the income an investment provides is important," Oliver says.

"First, with interest rates set to remain low or fall further, bank deposit rates--already at their lowest level in Australia since the 1950s--are likely to remain low or go lower … this in turn means there's an ongoing need to understand and consider alternative sources of yield on offer.

"Second, a high and sustainable starting point yield for an investment provides some security during volatile times like the present … since 1900 dividends have provided more than half of the 11.6 per cent total return from Australian shares," he wrote in a recent paper titled "The importance of decent investment yield--especially in volatile times".

But Oliver delivers a warning--investors should focus on companies which are delivering sustainable yields.

"It's critical to focus on opportunities that have a track record of delivering reliable earnings and distribution growth and are not based on significant leverage," he says.

"In other words, make sure the yields are sustainable. On this front it might be reasonable to avoid relying on some Australian resources stocks, where current dividends look unsustainable."

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Nicki Bourlioufas is a journalist and/or Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

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