Punters dabble in risk as bond yields fall

THE NAB business survey for November shows why the Reserve Bank cut its cash rate by another quarter of a percentage point to 3 per cent last week, but another fixed-interest benchmark helps explain why the Australian sharemarket has rallied by about 5 per cent since mid-November and by about 14 per cent since the middle of the year.

The sharemarket rally was primed by a plunge in 10-year Australian Commonwealth bond yields, from about 5.5 per cent in April last year to a low of 2.8 per cent in early June.

Commonwealth 10-year bonds were yielding about 6.7 per cent in June 2008 as the global crisis was building, and fell below 4 per cent in January 2009 when "end of the world as we know it" theories were circulating. As the crisis eased and apocalyptic talk faded, the yield rose again to trade on either side of 5.5 per cent between June 2009 and the end of March last year. But when the crisis reappeared in the form of Europe's sovereign debt crisis and northern hemisphere rates stayed at or close to zero, it fell again, propelled by investors chasing positive returns and sheltering from the European storm.

The final leg down from about 4.2 per cent in March this year to a low of about 2.8 per cent in early June primed the sharemarket because AAA Commonwealth bonds will always be repaid. They are a risk-free investment, and a key reference point for all other investments.

Bond prices and yields stabilised after June, but the 10-year bond is still offering a yield of only 3.1 per cent. The Reserve Bank, meanwhile, is cutting its cash rate to coax both bank lending and deposit rates lower, house prices are going nowhere and the resources boom is unwinding.

The economy is weak: that points to lower corporate earnings. But the question for investors is: in this low-return environment, does an average earnings yield of 5.65 per cent on the ASX 200 Index actually look that bad?

The economy is struggling, as the NAB survey makes abundantly clear. Business conditions were unchanged and "very weak" in November in the construction, retail, manufacturing and wholesale sectors. Business confidence deteriorated in all the states to be the lowest it has been since April 2009, and fell in all sectors except construction, where it was unchanged, but low.

NAB says it doesn't see a pre-Christmas bounce, and says that its survey points to a slowdown in economic growth, from 3.1 per cent in the year to September, as revealed in the national accounts last week, to something more like 2.25 per cent in the year to the end of December.

It's important to get the the NAB survey and the slide in confidence it detected in context. The survey was conducted after the Reserve surprised by not cutting its cash rate in November, and before its decision last week to cut the cash rate again, by a quarter of percentage point to 3 per cent. At least some of the unhappiness and concern about the future that the survey uncovered in November would have been a backlash against the central bank's decision to do nothing that month.

It is not just perceptions, however. Conditions were also weak, and NAB says there were few signs that businesses had responded to central bank rate cuts that totalled 1.5 percentage points when it conducted the survey and 1.75 percentage points now.

In the sharemarket, though, lower fixed-interest yields have been a factor since the middle of the year when the Commonwealth bond yield bottomed out below 3 per cent. And, as Evans & Partners strategist Michael Hawkins noted last month, the mechanism was mentioned by the central bank itself on November 6, when it announced that it was not lowering the cash rate that month. Interest rates for borrowers had declined to be clearly below their long-term average, the Reserve said, "and savers are facing increased incentives to look for assets with higher returns".

The yield on the earnings of the companies in the S&P/ASX 200 Index has been falling as profits remain under pressure and investors push share prices higher. It was 7.1 per cent in the second quarter of this year, barely above 6 per cent by the end of September quarter, and is now down to about 5.65 per cent. That's still a risk margin of 2.5 percentage points over the risk-free 10-year government bond, however.

The 5.65 per cent earning yield on the ASX 200 points to how much could be distributed as dividends, not how much will be. Mature companies in stable markets distribute more than ones that are preserving cash to fund further growth.

And it is a blended number that hides big variations and potential traps. A company's historical earnings yield may be high, for example, if its shares have fallen on concerns about future earnings and dividends. Historical earnings yields of 26 per cent and 21.6 per cent on media groups APN and Seven West Media and a yield of almost 19 per cent on mining contractor Macmahon Holdings are examples.

However, even after its solid run-up since the middle of the year, the ASX 200 Index still includes 104 companies that are on an historical earnings yield of 5 per cent or more. There are 50 that are on a yield of 8 per cent-plus, and 31 that are yielding 10 per cent or more.

As the economy muddles along and rates stay low or probably go lower, the odds are that some buying support for the local sharemarket will continue. It may, however, become increasingly selective as investors hunt for yields on shares that beat fixed interest by enough to make the risk of owning them acceptable.

mmaiden@fairfaxmedia.com.au