Markets: Girt by weak rates and risk

Easy monetary policy has pushed Australia's stock and property markets beyond the general economy's growth curve - and investors into a tight spot.

Think back to early 2011 when you could comfortably get 5 per cent, maybe even 6, on a short-dated term deposit. If you were looking for a steady income minus the excitement of the equity market, you were set.

The landscape is much different now, with interest rates at 2.5 per cent. Lower interest rates are great for those with a mortgage but at the same time essentially penalise those who have kept their funds in cash or linked to the cash rate.

Now with the official cash rate at all-time low, investors are in an interesting position. Do you accept a rate of 3-3.5 per cent in a term deposit or do you chase a better return elsewhere?

If inflation remains within the RBA’s target of 2-3 per cent, there is little real return if you leave your wealth in cash. It pushes investment options like equities and property to the forefront. But that doesn’t necessarily mean they are the right avenues to pursue, with earnings casting a question-mark over equities and a potential house price boom doing the same for property.

Some might go as far as to say that this series of interest rate cuts hasn't generated the desired outcome.

Equity

Theoretically, one of the benefits of central banks cutting interest rates is to encourage investors to move into riskier assets, helping asset prices appreciate. Then everyone feels wealthier and will spend their spare cash more freely helping the economy along.

Since the first rate cut, the ASX 200 index has generated a total return (capital growth and dividends) of just over 30 per cent. This is impressive, but we started from a relatively low point of 4200 points and along the way we have had sharp swings in the market.

The difference between the dividend yield received from equities versus the prevailing cash rate has provided a level of ongoing support for the market over the past two years. With lower rates, this looks set to continue despite weaker economic conditions.

In the US, we have seen the local market, the S&P 500, appreciate 148 per cent from a low reached on March 5, 2009. During this time, interest rates have been kept at 0.25 per cent and the Federal Reserve has pursued a series of aggressive monetary policies to rouse the economy in a bid to continue to drive investors into riskier assets.

In terms of investment, US investors have less desirable options than Australian investors, having had a cash rate near zero for close to five years. The bond market hasn’t even been an option with long-term bond rates hovering around 3-4 per cent. The end result has been money flooding their stock market as investors try and keep their wealth from being eaten away by inflation.

Property

So far the rate cuts have helped property prices along. They are up – earlier this year RBA minutes detailed house prices were up 4.25 per cent since the middle of last year. Fantastic. With fixed term borrowing for three years around 5 per cent it makes debt servicing look a lot more appealing than when rates are 8 or 9 per cent.

Lower interest rates combined with the existing economic conditions we are experiencing can almost fund us with a false sense of wealth. With the majority of Australians' riches associated with property, rising property prices make us feel richer. If the equity market continues on, we count this, too.

The consequence of lower interest rates, I would suggest, is they can encourage speculative investments. When borrowing is cheap and asset price growth is outpacing the growth in the underlying economy, it could be at an unsustainable pace.

Earnings

We are at an interesting point. In simple terms, lower monetary policy is meant to encourage investment but the fundamentals of our share market don’t necessarily support this.

With reporting season upon us, JP Morgan interestingly points out that we have seen consistent earnings downgrades over the past three years. If we continue on this path, we could very well end up in a situation where company earnings don’t reflect their traded market value.

Credit Suisse have a similar view and anticipate earnings forecast for the Australian market could be downgraded by 8 per cent. According to their forecasts, this would put earnings 20 per cent below trend.

Investors generally aren’t rational and, especially, when faced with all-time low interest rates investment fundamentals can get thrown out the window. In favour of the Australian share market, investors tend to have a home country bias so regardless of forecasts and outlooks it could remain their preference, providing continuing support.