Equities appear cheap given low interest rates

With the strong rise in the Australian share market over the past month, concern has naturally arisen over whether the market is now overvalued. On some metrics this appears to be the case. But on other measures, the market can either be described as still around fair-value, or decidedly cheap. How so?

Rising dividend payout supports market valuations

As seen in the chart above, at 6.3% p.a. the Australian equity market’s current forward earnings yield (the forward PE ratio inverted) is notably below its longer-run average of 7.5% p.a.. In turn, that reflects the fact the forward PE ratio has lifted to 15.8 p.a., compared with a long-run average of 13.5 p.a.. On this outright basis, the market appears overvalued.

That said, it’s also the case that the market’s current dividend yield remains around 4.2% p.a., which is only a touch lower than the long-run average of 4.3% p.a..  This reflects the fact that the market’s implied payout ratio (ratio of the dividend to forward earnings yield) has lifted to 65%, compared with a long-run average of 57%.  A rising payout ratio may or may not be sustainable, though it clearly seems to reflect the increasing thirst by investors for yield. Based on the dividend yield alone, the market could be described as still fair-value.

Relative to interest rates the market is cheap

So far this analysis has ignored the substantial decline in interest rates over recent years. As seen in the chart below, the real[1] 1-year term bank deposit rate is now only around 1% p.a. – equal to its lows during the global financial crisis, and well below its long-run average of 2.1% p.a..  Relative to interest rates, therefore, the equity market’s current dividend yield appears quite cheap. Indeed, the gap between the dividend yield and this real deposit rate is currently 3.2% p.a., compared to its long-run average of only 2.1% p.a..  With the RBA expected to cut official interest rates to 1.5% p.a. this year, the real term deposit rate is likely to fall further – potentially to as low as 0.5% p.a..

What’s more, the sustainable level of interest rates going forward is likely to be less than that averaged over the past decade or so – as this was a “one-off” period of rising household debt and the greatest mining boom in our history.  If so, such a structural decline in interest rates implies the share market today is even better value.  It would not surprise us therefore if the market’s dividend yield eventually bid down to around 3% p.a. or so, compared to its historic average of just over 4% p.a..

All up, still reasonable equity valuations in the face of low interest rates suggest the “yield chase” by investors is likely to remain an important Australian market driver. In this regard BetaShares has a number of yield-enhanced investment funds that might be of interest:

• The Dividend Harvester Fund (HVST) (managed fund), aims to provide investors with exposure to large capitalisation Australian shares along with regular franked dividend income, paid monthly, that is at least double the annual income yield of the broad Australian sharemarket. In addition, the Fund aims to reduce the volatility of equity investment returns and cushion downside risk.

• The Equity Yield Maximiser Fund (YMAX) (managed fund) aims to provide investors with exposure to a portfolio of 20 blue-chip Australian shares (as represented in the S&P/ASX 20 Index), while providing attractive quarterly income that exceeds the dividend yield of a portfolio of the underlying shares. In addition, the Fund aims to provide lower overall volatility than the underlying share portfolio. As at the 2 January 2015 the ex-date for the most recent distribution, YMAX’s 12mth trailing cash yield was 8.7% p.a., with a 12mth trailing gross yield (inclusive of franking credits) of 10.1% p.a..