RBA extends the hunt for yield

Markets have had a bit of time to digest the RBA's cut yesterday. It's not that the cut was a surprise, as everyone was looking for them to cut again at some point.

What was surprising though is the fact that the RBA seemed to remove its easing bias – and that's the big debate at the moment. Some think they have finished cutting, others think they haven't.

The market is currently pricing in no change to policy over the next few months, and only a 50 per cent (or just under) probability of a rate cut in the last few months of the year.

That's a pretty decent change from Tuesday morning, when the probability of another cut by the end of the year was just under 90 per cent.

But at this point, I suspect the best bet for investors is to continue to expect further easing.

As I've noted for some time, it will all ultimately depend on the US Federal Reserve.

Why?

Because the RBA is targeting the currency and they made that explicitly clear on Tuesday.

Yet the biggest influence on the Aussie dollar isn't what the RBA does, but what the US dollar does. Indeed the only reason the Aussie dollar is below US90c is because of the 20 per cent spike in the USD over the last year or so. The US dollar is in turn moving on Fed expectations. If the Fed hike in June, then chances are the RBA is done cutting as the Aussie dollar will fall as the Fed hikes.

In contrast, if the Fed continues to delay a hike, and the best evidence we have to date suggests they will, then the US dollar will fall, the Australian dollar will continue to rise, and the RBA will cut again.

Moreover, I think that is the most likely outcome at this point.

So what does the RBA's move mean for the economy?

One of the more unusual features of the RBA's statement is that in trying to justify a cut it was actually upbeat on the economy.

This is unusual for a couple of reasons – firstly they cut. But secondly, because there are rumours circulating in financial circles that the RBA will downgrade growth forecasts later this week.

Yet on the global economy, the RBA notes things are moving at a moderate pace, and likely to get a boost from the commodity price slump.

Then on the domestic economy, and despite expectations that the Bank will downgrade growth forecasts, there is a more critical statement to be aware of. Investors should take note of this line: “In Australia, the available information suggests improved trends in household demand over the past six months and stronger growth in employment.”

This is a material turnaround from what they saw last month. At that time, they didn't even acknowledge the lift in consumer spending and had suggested that the unemployment rate was going higher.

This development is much more important than downgrades to actual growth, if that does happen, because household spending is nearly 60 per cent of the economy. I've noted for some time that economic activity was being underestimated by both the Treasury and the RBA, and the statement yesterday was an acknowledgement – as far as you're going to get one – that things may not be as bad as they thought.

I'm convinced they're not, but that won't stop the RBA targeting the currency in any event. All the same you've got 60 per cent of the economy picking up – and a construction boom. Those two factors matter much more for corporate earnings growth than a decline in mining investment or ‘subdued public spending', even if that does temporarily lead to lower headline GDP numbers.

What does the RBA's stance mean for the market?

In addition to the positive earnings environment, the RBA's ultra-low rate – with the likelihood of more to come – will underpin valuations.

It means that investors will have to continue to augment the price-earnings ratios (PER) for some time. Remember, analysts determine whether a market is expensive or cheap by referring to the deviations in the PER from some sort of average. Yet that's an average that was formed in a much, much higher interest rate environment. It is of little use to us today, other than to note that PERs should be at very high levels, unless you think rates are going back to pre-GFC levels. No one does.

The RBA's cut yesterday and the prospect of more to come also mean that the hunt for yield is alive and well. It will remain a feature of the investment landscape for the foreseeable future and I would dismiss any concerns about the longevity of it. Income is income and people do invest for income as well as growth. Growth isn't necessarily hard to find, but income is, and stable blue-chip income stocks will trade at a premium over time.

The other thing to consider – at the very least it is a real risk to the extent that the RBA has actually dropped its easing bias – is that the Aussie dollar continues to lift. Perhaps markedly. Investors may need to keep stocks which are sensitive to any currency appreciation on their review list.