Low interest rates boosting shares
The US share indices have reached new highs but the Australian market, despite touching a six-year high this week, is still around 20 per cent below its previous highs. Understanding why this is so may provide clues as to the likely future movement in prices and about the risks of a market pull-back.
On a value basis, analysts are finding it difficult to recommend individual shares to investors because price earnings ratios are at unprecedented high levels. Future share price increases will depend on earnings growth and investor willingness to bid prices up to increase their annual income.
By international standards, encouraged by the imputation credit system that refunds company tax payments to resident shareholders to offset their tax liabilities, dividend payout ratios are relatively high. These dividend payouts have underpinned the recovery of the Australian market after the global financial crisis, particularly during the past 18 months of historically low interest rates.
Prices in the US, European and Japanese markets have also increased because of low interest rates in those countries, with one important difference to Australia. Interest rates overseas have been lower for much longer in most cases, providing negative returns after allowing for inflation.
Our 2.5 per cent a year cash interest rate is still slightly positive, even allowing for inflation, resulting in an inflow of overseas fund. While it could happen, it is most unlikely the Reserve Bank will reduce the cash rate further because of its fears of a property price bubble. This means that the Australian dollar is likely to remain relatively strong until overseas countries, particularly the US, start increasing their interest rates.
Treasury economist David Gruen was optimistic this week, saying the Australian dollar will fall to more realistic lower levels when overseas rates start rising. This is on the basis that our terms of trade will continue to fall as they have recently.
Without higher overseas rates, or an event that triggers the loss of our current safe haven status, the strong dollar will inhibit further share price appreciation for two reasons. First, overseas investors who own 30 percent or even more of our largest companies will continue to have a strong incentive to take their profits while the dollar is relatively strong. Second, the high dollar is eating into the profits of our exporters who are receiving lower prices for their commodity and manufactured exports.
While our sharemarket will continue to be underpinned by investors seeking higher yields, it is unlikely to return to previous peak levels until the dollar falls to more realistic levels.