Liquidity still the main game in town
The main lesson we have learned in the 10 years since the GFC is that lower interest rates and easy liquidity conditions are very good for both share and bond prices. During 2018, the US Fed began to withdraw monetary stimulus by raising interest rates and reducing money supply but it appears now they are reversing course and aligning with the ECB, BoJ and our own RBA by potentially easing policy again. While the US economy appears quite healthy, the Fed remains concerned about the adverse economic impact of a drawn out trade war and stands ready to inject stimulus if required. In recent months, the RBA has joined the party by cutting rates twice and signaling there are more to come. It is likely that the local cash rate will fall to 0.5% over the next 6 months which in combination with recently passed tax cuts and improved confidence levels will be a fillip for both the property market and the broader economy. The knock on impact of lower interest rates is that the yield on all financial assets falls as the search for income pushes prices higher. With global inflation still trending down below target levels, easy monetary conditions are likely to continue for some time and will support equity prices even as they approach record highs. It’s worth remembering that when interest rates fall, the earnings yield (E/P) for shares also falls and therefore the inverse of this equation (the P/E) rises as investors are prepared to pay more for any given levels of earnings. While valuation measures such as P/E’s appear stretched compared to history, it must be remembered that bond yields are at all time lows and likely to fall further so it is entirely reasonable for share prices to move higher.
Our medium term strategy assessments have not changed materially over the past month and hence we are holding course on asset allocation strategy. The major threat to the outlook remains the potential for slower global growth due to rolling trade disputes between the US and other regions especially China but also Europe, Japan and India. Even the much heralded revision to the trade treaty between the US, Mexico and Canada has yet to be ratified by the US Congress. While earnings growth will continue to be modest, easy liquidity will support equity markets for the foreseeable future and bond yields are likely to reach new lows. In May, we increased the weighting to Australian shares but for now the prudent course is to maintain current levels of diversification which we believe to be appropriate in the current environment.