Markets: A cut too far

Another rate cut from the Reserve Bank could trigger a fresh stockmarket rally, but it would be on shaky underpinnings.

Simply put, recent growth in the share market is not sustainable.

Commentary from the RBA about the need for a lower domestic currency has markets once again pondering the possibility of another rate cut.

So far the 90-day Bank Bill Swap Rate (BBSW) isn’t giving too much away, hovering around 2.58 per cent. The BBSW is however close enough to the current cash rate to hint another rate cut in the near term is not off the cards.

For the RBA, the stronger Aussie dollar goes against its quest for a lower exchange rate. But further rate cuts in the immediate future with the sole purpose to quickly reduce the domestic currency could cause greater problems and encourage a catastrophic misallocation of capital. Using some forward thinking, the end result could be considerably more severe than the short-run implications of the domestic currency trading at 94 cents.

Property market investors are enjoying the benefits of lower interest rates. And the share market looks set for a more enthusiastic time in light of historically low interest rates as investors scramble for places to put spare dollars. Apparently cash is no longer king.

The latest rally in the market has largely been driven by two wildly irrational underpinnings. Firstly, investors have proven they are willing to pay more for every dollar of earnings, driven by the fear of missing out on what has become the never-ending rally. The problem with this is, earnings growth hasn’t moved at the same pace as investors have chased each dollar of earnings.

What we have now is the ASX 200 (yellow line) trading well above the forward earnings expectations (white line), which began in June of this year. This hasn’t happened at all in the past three years, suggesting the market could now be overpriced unless earnings get moving and close the gap.

Graph for Markets: A cut too far

Source: Bloomberg

The second irrational underpinning supporting the markets comes from the lack of alternatives that to give you a four or five per cent return, against a cash rate at 2.5 per cent. If ever, now looks the time to be patient with the fundamentals implying the market is looking expensive as it stands today.

Lower interest rates for the purpose of currency manipulation are problematic and would encourage the ASX 200 to move higher as investors are starved for choice when it comes to yield options. For share prices to be justified at higher levels, companies will actually need to deliver improving earnings.

It is risky business to put capital at risk for the sake of yield alone, especially if as an investor you don’t have a long enough time frame to stomach a correction.