|Summary: The investor hunt for yield has pushed up some stock prices to levels some consider are too expensive. But with interest rates set to remain low, shares are expected to deliver the best asset returns over the medium term.|
|Key take-out: At current levels Australian stocks are still very cheap relative to bonds. They’re even cheaper on a forward earnings basis, taking a consensus earnings per share growth rate for the market of about 8%.|
|Key beneficiaries: General investors. Category: Shares.|
In 2012 Eureka Report saw the bandwagon coming on the rush for yield in the face of falling cash rates and published a series of articles focussing on how our subscribers could capture higher yields. Now in mid-2014 we are going to examine how the ‘hunt for yield’ has changed and what you need to know. Our yield series will run for the next four weeks.
Adam Carr kicks things off today with a panoramic view of yield settings, while Tony Rumble looks at the menu for locally listed high-yield ETFs. On Wednesday we’ll look at which stocks have been growing dividends, and on Friday Robert Gottliebsen will review the cash and term deposit market. Keep an eye out for the distinctive red 'binoculars' logo which will accompany every item in the series. Managing editor James Kirby
Searching for income was made incredibly difficult in the wake of the global financial crisis.
Central banks around the world slashed rates to effectively zero and the major central banks even started printing money. Naturally enough, with official cash rates at zero, the whole term structure of interest rates fell sharply. The net result – a significant reduction in the number of genuine investment opportunities for retail investors. There was simply no point investing in zero return products such as cash or bonds.
Fast forward to 2014 and many analysts now think the yield bid has been pushed too far. Retail investors are told that high dividend yield paying stocks are expensive and that we should clear out – that stocks in general are rich, here and abroad. Similarly, there is no shortage of pundits telling you that the property boom is over, and that current price growth can’t possibly last.
So has the hunt for yield changed that much?
The fact that central banks are looking to tighten appears notionally to justify some concern. Anxieties have certainly been heightened following the Reserve Bank of New Zealand’s decision to hike and comments from Fed chairman Janet Yellen that implied US rates could rise in early 2015. Already the investment outlook appears to be changing.
Now, if central banks do start a genuine tightening cycle, cash products and even government bonds may start looking more attractive – and certainly they will start tightening at some point. But let’s think about where we sit at this point. I can appreciate that on the global front there is supposedly a lot of uncertainty in regards to the rates outlook. The truth is though, I don’t think things are really that ambiguous. For a start, it’s almost certain that rates won’t rise in 2014 – not in any of the major economies and maybe not in Australia as well (although my personal view is that rates should be higher given our point in the cycle). Moreover, even if the RBA does hike this year as it should, it will do so only very modestly. Why? Because of the central bank’s obsession with the exchange rate and the huge lobbying pressure to ensure it weakens. Either way, cash rates aren’t going to move very far over the next year. At this point then, what more do we need to know? For 2014 at least, the hunt for yield will remain alive and well.
On the issue of relative richness, it may be true that equities are expensive relative to their historical benchmarks. Then again, on decent earnings assumptions stocks aren’t that expensive. Either way though, what are the alternatives? Take a look at chart 1 below. It shows the dividend yield of select major Australian stocks – banks, Telstra and a few others. The red bar is the average of available terms deposit rates that you can earn at the bank. As you can see, and as expensive as some may think they are, our major dividend yielding stocks are are still far superior to simply putting your money in the bank – by a good 2-3% (4-5% grossed up).
Indeed, the situation isn’t much changed when you look at wholesale market rates that you might get from a fund. Chart 2 shows the whole terms structure, from cash to a 10-year bond yield. Cash rates all the way to six months are just over 2.5% – less than what you can get on a term deposit and less than the rate of inflation. Even a 10-year government bond only yields a little more than that at 4%, and that’s only if you hold it to maturity (i.e. the remainder of the bond’s life). Selling out prior to maturity might even yield you a loss. Noting this, 4% is hardly adequate compensation for having your funds tied up for such a long period of time.
High dividend yield paying stocks are still far more attractive than any cash or fixed income product, and that’s not to forget that dividends paid only reflect a proportion of a company’s earnings. As such, they only reflect a partial return. Similarly, high-yield ETFs are attractive too, see Tony Rumble’s article on High-yield products with reduced risks.
Take a look at chart 3. The chart shows the ratio of the Australian government 10-year bond yield to the earnings yield of the All Ordinaries. Traditionally, values less than 1 suggest stocks are cheap. Values over 1 suggest stocks are expensive. In the Australian experience, the usual range for the Bond Equity Earnings Ratio (BEER) is between 0.75 and 1. That’s what you normally see in a cyclical upswing. Note where it is now. At 0.63, the ratio shows that stocks are still very cheap relative to bonds. They’re even cheaper on a forward earnings basis, where, taking a consensus earnings per share growth rate for the market of about 8%, the BEER drops to below 0.6.
The fact is, equities pay a much higher yield in effect – 6.3% to something just over 4%. And the fact is, unless you plan on holding it for 10 years you are just as likely to experience a loss on that bond. People can argue all day long that stocks are expensive relative to their own historical experience. But, comparatively, stocks are still exceptionally cheap relative to bonds and cash alternatives.
I don’t doubt that will change over the coming year or two; equity yields will compress relative to bonds but, as it stands now, there is simply no comparison.
What about property?
It’s a very similar situation for property. There is a push to convince investors that property is expensive – price gains can’t last, we are told. Yet this only compares an asset to its past behaviour or some benchmark which may not reflect our current investing reality. This reality is low cash and bond rates for a very long-time to come. So what’s the alternative?
The above chart is from RP Data Rismark. Looking at things purely from a yield perspective, it shows rental yields still well above wholesale cash rates and just above term deposit rates as well. In fact, they’re above the whole term structure. Bond yields are rising, that is true, and at 4.15% now it wouldn’t take much in the way of a sell-off for bond yields to be attractive compared to property yields. This is misleading though, as the risk profile for bonds is far higher than for property.
Don’t forget that the yield you see on a bond is a yield to maturity; it assumes you hold it for the life of the bond. If you need to sell that bond prior to maturity, there is a very good chance you will lose money because, in a rising interest rate environment, bond prices fall. For property we’ve got the opposite problem. You’ll probably make money – which by the way is why some of those property yields have come down. Total gross returns are much higher – the capital city average was 14% in calendar 2013.
That doesn’t mean the hunt for yield hasn’t changed. It has changed, mainly because some of the risk factors that kept some investors fearful and in cash have eased considerably.
I wrote early this year that we face the most benign economic backdrop in nearly a decade, and that still stands. This suggests, and without any meaningful change in global rates, that the hunt for yield will likely intensify this year.