Interest rates make yield the big theme

Economies around the globe will have to reboot growth in the next 12 months or face the prospect of the bull market in stocks coming to a halt. Stock prices are fundamentally driven by interest rates and the rate of earnings growth.

With interest rates around the world unable to plumb much lower, the upward march in share prices will require earnings to fire in the medium term to justify an extension of the bull market.

The state of play is most acute in the US where official rates are next to zero but revenue growth by the S&P 500 companies in the first quarter of 2013 was less than 1 per cent.

Investors will be cheering on the Reserve Bank of Australia to cut official interest rates tomorrow.

Lower interest rates have powered the local sharemarket higher since June 2012 and been instrumental in the 135 per cent, four-year rally in the US. Investors around the globe are ravenous for income and if interest rates are on a downward path then dividend- paying stocks become prettier by the day.

It makes sense that if Telstra is paying a 5.6 per cent fully franked yield when term deposits are 4 per cent, then investors will be happy to drive the dividend down to 4.6 per cent if term deposits slip to 3 per cent.

That doesn't sound a lot but it would mean a 16.6 per cent rally from $5.06 to $5.90.

The same rudimentary valuations can be applied to a range of Australian companies including our major banks, gaming, food and retailing companies.

Investors have taken to valuing these equities as if they were lower risk bonds. We should not think we are special in Australia because the same trend is unfolding all over the world, especially in the US, where a 3 per cent yield from a defensive stock is seen as a highly attractive proposition with 10-year bonds yielding just 1.6 per cent and Apple raising debt at around 2 per cent.

In all market periods there is a dominant theme and currently it is yield. Like all other themes it will have its day in the sun and eventually fade, making way for another theme. In the past 15 years we have been mesmerised by the technology theme, the stronger for longer resources theme and now the yield theme.

Strangely all themes last long enough to sucker everyone in and push prices beyond a reasonable level before ending in an unforgiving fashion.

So when does the yield theme come to a close? No one is quite sure and for the moment you are crazy not to play it.

The reality is though, equity valuations can only go so high on compressing stock yields and expanding price-to-earnings multiples.

At some stage there needs to be growth both at the revenue and the net profit lines. It has now been almost five years since the nadir of the global financial crisis at which point the Federal Reserve not only deflated interest rates to zero but also pumped money into the system through quantitative easing.

It would seem this has served to prevent a major financial meltdown and staved off the distinct possibility of a nasty period of deflation. However, it has failed to stimulate growth.

With interest rates so low and the money supply increasing daily, the US economy should be growing at somewhere between 5 and 7 per cent. Instead, the economy is slowing and could sink to below 2 per cent this year.

That is disturbing and if growth does not kick back to above 4 per cent some time in 2014 we are facing the prospect of the US following the Japanese model of deflation and stuck in a perpetual economic funk.

The great hope for the economic bulls in the US has always been the re-emergence of the housing market that was decimated from 2006 to 2010.

The housing recovery is now in full swing with both housing starts and prices gaining momentum. Housing accounts for about 30 per cent of the total US economy. Unfortunately, 18 months into housing recovery US economic growth remains pallid.

The story is worse in Europe and is unlikely to get better in the foreseeable future.

Meanwhile, the other great growth engine of the world, China, has fallen into its own quagmire with all the imbalances created by a dramatic overbuild of capital items starting to bite hard.

To put it simply, growth is proving annoyingly elusive. And the story is starting to unfold the same way in Australia.

The RBA's interest rate cuts since November 2011 have fertilised some green shoots in the domestic economy but this has stalled since February, creating a cacophony of calls to start cutting rates again.

Assuming the RBA does pull the trigger and cuts rates 50 basis points to 2.5 per cent over the next few months, it must start to stimulate growth outside the mining sector, otherwise we face the same predicament as the major economies around the world of next to no growth. In that scenario there would be no benefit in cutting rates any further.

For now sharemarkets, including Australia will happily creep higher in the search for yield. However, this theme has a limited lifespan and we can only hope that growth, a concept that no longer features in investor conversations, will have to reappear. I haven't given up hope but if we are having the same conversation at Christmas time the comparisons with Japan will be hard to ignore.

matthewjkidman@gmail.com