Interest rate differentials between the US and Australia are set to narrow further, creating Foreign Exchange opportunities for investors
Developed market equities appear expensive compared to average long-term price-to-earnings ratios. However, given relatively subdued earnings growth, many investors argue that they aren’t expensive when compared to current bond yields.
While developed markets equities appear expensive relative to average long-run price-to-earnings ratios and, given relatively subdued earnings growth, many investors argue that they aren’t expensive when compared to current bond yields. Academic theory suggests that risky assets such as equities should return, on average, about five to six percentage points more than “risk free” long term government bonds. This is based on long term studies comparing equity returns with bond returns.
With the 10-year Commonwealth Government bond in Australia yielding 2.66% per annum (at the end of April), theoretically equities should return about 7.5-9.0% per annum, on average, over the next few years. This return doesn’t appear too demanding when looking at current equity valuations. At current prices, the local share market is providing a dividend yield of 4.5% per annum, another 1.5% per annum in franking credits (so a grossed-up yield of 6.0% per annum) and, if we assume that companies can grow earnings per share at about 3% per annum then we can easily get to 8-9% per annum in long run average equity returns, all else being equal.
Of course, if bond yields return to more “normal” levels – typically the rate of GDP growth plus inflation – so about 6% per annum, then equity returns need to rise through higher dividend yields (potentially involving lower share prices) or earnings need to grow more rapidly. For these reasons, asset allocators and investors need to understand the path of interest rate normalisation undertaken by central banks to avoid a situation, such as in 1994, when bond yields rose rapidly causing both bond and equity prices to fall in unison.
Overall, there are no compelling reasons to change our asset allocations this month.
Our asset allocation summary:
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