So far in 2015 we have seen growing evidence and indeed the appearance of growing conviction that interest rates (government bond rates and by default term deposits and high credit quality instruments) are likely to stay lower for longer.
With this as a back drop, lower oil prices and ongoing fiscal and monetary stimulus have acted to buoy asset markets globally.
Global equity markets have rallied, driven in part by the US Federal Reserve moving tantalisingly closer to increasing the Fed Funds rate (seen as confirmation by the Fed that GDP growth is occurring on a sustainable basis) for the first time since 2006. Data for US employment growth, seen as a pre-condition for rates to rise later in the year, rose in the earlier months of 2015.
Further, the European Central Bank announced a one trillion Euro bond buying program in a concerted effort to stimulate growth in the flagging Eurozone.
In Japan, Prime Minister Abe continues with a set of stimulatory reforms which appears to be inching Japan out of its two decade malaise.
In China GDP growth has continued to slow modestly but is still running at a level near 7.0% p.a. The Chinese authorities are seeking to transition the world’s second largest economy from being predominantly export driven to one where domestic consumption plays a meaningful role. This process is creating cultural challenges as state owned enterprises and regional governments are being held accountable for their financial management.
In addition authorities are also addressing endemic corruption to promote transparency and confidence in the administrative system.
China continues its accommodative stance on monetary and fiscal policy and efforts to boost cross border trade flows have assisted the continuation of the Chinese equity market rally which has risen over 17% in 2015 and 78% over the past 12 months after several years of lacklustre performance.
In Australia a similar story for the share market performance unfolded with shares receiving a boost from an RBA rate cut in February. This was a fillip to a market that is receiving longer term support courtesy of its attractive dividend yields as income hungry investors bid up the prices of the higher
yielding key financial and industrial stocks such as the ‘Big Banks’ and Telstra.
The countervailing force to this has resulted from the ongoing decline in global commodity prices, particularly iron ore, which has negatively affected the large resources sector of the Australian market. This was typified by Fortescue’s failed bond raising in March as investors were not enticed by the yield being offered and remained concerned as the iron ore price falls perilously close to Fortescue’s breakeven cost of production. Other junior miners such as Atlas Iron have fared
Investors have become a little more sanguine about the macroeconomic environment and this, coupled with the prospect of an extended period of lower interest rates, has seen equities attract disenfranchised bond holders to share markets in search of yield which is adding further support to prices.
With this scenario being the likely back drop for the coming years, how will it affect portfolio returns?
With interest rates on Australian government bonds remaining low then, all other things being equal, yields on other assets (e.g. property and shares) can be expected to also adjust proportionately. In which case, if corporate earnings are not overly impacted and, in aggregate we do not expect they will be, then for the yield from shares to fall, their prices will need to rise.
This is demonstrated in Chart 1 (previous page) showing Australian share dividend yields (yellow line) being significantly higher than bond yields. As presented the gap between the two has seldom been larger and if normal market conditions prevail and interest rates stay lower then it is likely that equity yields will fall as the result of prices rising.
Recent rallies in US shares have meant that the spread between US bond yields and equity yields has narrowed. The coming earnings reporting season will be of particular interest to see if the higher prices justify the earnings multiples.
Australian shares and property have been strong recently
The Australian share market has been quite strong since its minor correction in October 2014, with gains encapsulating a number of positive factors: the apparent sustainable recovery in the US; a general increase in desire for risk assets as investors become more positive about the global economy; and an upward adjustment in equity prices to reflect the relative attractiveness of their yields relative to lower yielding bonds.
The property market has been similarly affected, particularly Listed Property Trusts (LPT), whose prices have risen to adjust yields downward to re-establish historical yield premia
relationships to bonds.
The Australian residential property market is also caught up in the impact lower rates are having, pushing property prices higher as buyers are able to service larger loans with
Long term expectations for interest rates reduced
After a review of global macroeconomic conditions and forecasts in relation to the level of government bond rates, and by association high quality fixed interest such as term deposits, we have, in line with current market forecasts taken the step to reduce our long term expectations for interest rates. This reduction is now incorporated in our Tipping Point table (previous page).
The obvious effect of reducing our long term term deposit rates forecast is that it increases the levels of the respective valuation bands for growth assets i.e. prices can rise further before they become expensive relative to term deposits. So this recalibration of the inputs to the Tipping Points table has, in effect, given more headroom for markets to rise before they approach ‘fully’ or ‘overvalued’ levels.
From a portfolio positioning perspective we remain overweight to Australian shares relative to global shares. Within global shares we retain an overweight to selected emerging markets, being the most attractively valued, at the expense of the now ‘fully priced’ US market.
In relation to property, the Australian LPTs, in aggregate,have seen a substantial rally in prices. The S&P ASX 200 Property Index has risen approximately 8.5% year to date,and while still showing as ‘fair value’, will soon be flirting with being ‘fully priced’ if the present trend continues. We have a preference for select diversified unlisted property at the moment as the valuations are more attractive, however liquidity can be an issue with these investments.
Conclusion – we remain optimistic about long term returns from most assets
In summary, we are comfortable for portfolios to be fully invested in accordance with recommended portfolio asset allocations. The changes to our long term forecasts for term
deposit rates have provided us more comfort in relation to present valuations in the context of the coming decade.
As we all know, there will be bumps along the way as markets will routinely experience rallies and declines in prices.
However, maintaining a focus on long term value and quality assets provides confidence that the allocations of capital are appropriate.
Because market prices can fall victim to investor sentiment for extended periods of time, it is important to maintain a process of measured adjustment when required. Expensive assets can get more expensive and cheap assets can get cheaper.
Taking a measured approach to portfolio adjustments to smooth the vagaries of the market has proved to be prudent over the longer term.