Watch out for stock valuations when QE ends
Central banks could soon end their bond buying activities, thereby unwinding quantitative easing. Should this occur, real interest rates would again be driven by the normal forces of supply and demand. And this could affect stock valuations.
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Max Zan
:
Excellent article Stuart
Currently the ten year Australian bond rate is sitting at about 2.74% and inflation running at 2% so the real long term rate is about 0.74% – your graph confirms that.
If the real long term rate increases by 1% to 1.74% and inflation remains at 2% then it follows that the nominal long term rate will be 3.74%.
The Reserve Bank has recently stated that they see the cash rate moving to the neutral position of 3.5% going forward – does that mean the cash rate and the long term rate will end up being the same going forward ? How long will it take for both the Cash and Long Term rates to say increase by 1% ? If rates rise it’s an indication that the economy is improving and we may not see valuations hammered as EPS increases will compensate and current stretched valuations may prove to be justified. The risk/danger comes if rates
rise and EPS don’t rise sufficiently to compensate and PE’s contract. It’s very much a stock specific issue and one that affects companies that are carrying Debt, particularly short tern Debt – the more Debt the higher the risk. The trick is to avoid companies with high levels of Debt and poor growth profiles as they are sure to get hammered .
Stuart Jackson
:
The neutral position cash rate is the RBA’s estimate of the rate that would be required to provide no stimulus or brake on the economy. This would reflect a combination of the RBA’s neutral real interest rate plus inflation. The mid cycle or equivalent bond rate would be slightly higher than this reflecting a liquidity and risk premium, so the long bond rate would be expected to be slightly above 3.5%.
andrew ronan
:
Hi Stuart ,as you say they are making noise about reducing asset purchases but they also make noise about standing ready to intervene if things fall apart, so far the markets have called their bluff, and if markets ever get any real say in interest rates things will get very interesting very quickly. Maybe its just more buy the dip from here ,maybe the dips just get bigger. While they do their best to manipulate asset prices lower. But the problem they have is that most investments made by the average joe these days are made on the basis of capital gain due the distruction of yield due to low interest rates, so now that they are going to remove the capital gain from our investment aspirations, so what comes next ? Maybe we all head to the casino now? At least your in with a chance , although I wonder if we are already sitting at the roulette wheel with a belly full of the cheap stuff.
Stuart Jackson
:
Hi Andrew,
I agree that the outlook for capital gains will deteriorate if real interest rates increase, but I wouldn’t recommend a move that far down the risk curve to compensate given that casino games have a negative expected return. At least equities have a positive expected return on a long term basis. While there is heightened risk around the short term return that will comes from equities at present, in the long term I would prefer to bet on investments with a positive outlook.