Why the sharemarket frenzy could fizzle

The Reserve Bank's rate cut has seen domestic investors pour money into high-yielding stocks, but continued economic sluggishness could dent corporate earnings growth.

For once, the local stockmarket is outperforming the rest of the world.

The benchmark S&P/ASX200 index has rallied for 12 days in a row, something it has not done before in its 15-year history. The All Ordinaries hasn’t had a run like this since 1986 (does anyone remember what happened in 1987?).

The Reserve Bank’s shock decision to end a 15-month period of stability with a sudden cut in rates when domestic fundamentals have not changed has had an outsized impact on the equities market.

Domestic investors who were holding onto cash in view of the weak economic outlook have thrown in the towel and tipped money into high-yielding stocks. For self-funded retirees and SMSFs that have been heavily weighted towards cash, term deposit rates after inflation and tax are barely positive.

International investors who stayed away while the Aussie dollar tumbled 20 to 30c are now buying back into blue-chip stocks as our market is looking relatively cheap, particularly for US funds.

While the US market rallied 11 per cent last year, it is slightly negative for 2015; by contrast, our market only rose 1.2 per cent last year but has jumped 6 per cent since the start of the year. According to Bloomberg data, the ASX200 has been the best world performer out of a group of 93 indices since January 20, in local currency terms.

The euphoria has been driven by the Reserve Bank’s sudden change of heart, which it attributed on Friday to a softer growth outlook -- not that the data has actually weakened at all since its last public comments. It softened up markets a few days prior to the cut by giving ‘guidance’ to a journalist.

“Growth overall is now forecast to remain at a below-trend pace somewhat longer than had earlier been expected,” the Reserve Bank said, as consumption growth remains below average and non-mining investment fails to recover before late 2015. Above-trend growth is not expected for at least the rest of 2015.

Spare capacity and high unemployment are forecast to continue, cost pressures will remain subdued and the currency remains “above most estimates of its fundamental value”, providing less help to the economy than it could.

Economists also know that the RBA rarely moves in isolated steps, and most often in the past has followed one easing with a second cut a month or two later. Markets are pricing in another move by May at the latest. So yields on cash will only head south.

The Australian government on Friday sold a 2019 bond at a record low yield (below 2 per cent), as new issuance catches up to already low market rates.

Since the ECB entered the brave new world of quantitative easing, the Swiss National Bank gave up protecting its peg and central banks around the world have been scrambling to devalue their currencies through rate cuts. “The globe has become yield-mad," says IG Markets strategist Evan Lucas. “It has sent bond and equities markets into a bidding frenzy.”

The determination of central banks should not be underestimated. Denmark just cut rates for the fourth time this year, saying it will defend its currency peg indefinitely, and there is no upper limit to the size of its foreign exchange reserves.

This has caused unprecedented confusion for Denmark’s banks and their mortgage lending books. The official deposit rate has been cut to minus 0.75 per cent and government bond yields are negative out to five-year maturities. (One bank, Nordea Kredit, has reportedly taken its mortgage lending rate negative while the other banks are sensibly delaying such a move pending talks with the government.)

Since the rally in the Australian market began on January 21, the benchmark index has gained 513 points, or 9.7 per cent.

The consequence of the RBA’s unexpected easing is clear in leading stocks: three of the big four banks hit record highs this week, with the Commonwealth Bank fast approaching $100. Both CBA and another favourite high-yielder Telstra are on a net yield of around 4.5 per cent, although that will diminish.

“Banks look expensive across every measure, except yield differential,” says Brad Potter, head of Australian equities at Nikko Asset Management.

CBA is now trading at the high end of its valuation range and a lot of industrials are looking expensive, with fund managers saying it is impossible to find earnings growth at a reasonable price. If the economy picks up in the second half of the year, some of the current stock speculation may be warranted.

What happens if the economy does remain sluggish for longer, as the Reserve Bank is arguing? The implications for corporate earnings would not be positive.

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