There is the sound of distant murmuring as concerns rise in the media and amongst economists that inflation is on the rise, raising the prospect that the Reserve Bank will raise rates further. Australia, it seems, is different and that has consequences for investment. It already has comparatively high interest rates compared with most of the developed world. That is, there is a relatively “normal” cost of capital, unlike the rest of the developed world which has a very abnormal cost of capital.
In Europe, America and, as ever, Japan, the cash rate is not far above zero as those governments try to recover from the finance sectors’ attack on the very idea of money.
What does this mean for the stock market? Take a basic measure used to compare shares and bonds. The forward earnings multiple of the All Ordinaries is about 15 times, which translates into an earnings yield of 6.6% (the earnings yield, which is the earnings multiple upside down, can be compared with fixed interest yields). It means that in Australia shares and fixed interest are priced at about the “normal” rate. Shares should attract a premium because they are riskier.
In America, however, there is a big disparity between the [pricing of shares and bonds. The historical earnings multiple of the S&P 500 is about the same as Australia’s: 15 times (equating with an earnings yield of 6.6%). But American interest rates are only 0.25% (the equivalent of an earnings multiple for shares of 400 times!). In the United States share valuations and fixed interest yields have decoupled. Much like America itself, which has decoupled from financial reality for some years now.
Conclusion? Because there is still a functioning cost of capital in Australia, local fund managers have to make conventional decisions about the relative merits of shares and fixed interest securities. Overseas fund managers cannot. They will get little insight from comparing interest rates and share valuations.
That implies that if interest rates continue to rise Australian institutional investors are likely to start moving funds out of the stock market, although perhaps less so with big cap stocks. The broker Southern Cross Equities, which exhibits a passing interest in advising investors to buy, well, equities, notes that the forward earnings multiple on the S&P/ASXtop 100 is 12 times. This equates with an earnings yield of 8.3% – almost 3% above the yield on a 10 year bond, according to an enthusiastic Southern Cross report.
So rush in. Valuations are fine. Although it might be noted that higher interest rates will also tend to push up the $A, discouraging foreign buyers. OK, don’t necessarily rush in. Maybe stock picking, rather than investing in the wider market, has become the strategy de jour.