Will the ASX follow Wall Street to record highs?

Day-to-day, it’s almost anyone’s guess whether the market will rise, fall, or stay put.

Sure there are factors that influence stocks like overnight global market movements, company announcements and economic developments, but, generally speaking, you can’t predict these things.

If you step back a bit though, you can see some genuine trends emerge.

One obvious trend since the global financial crisis is the gradual reduction in interest rates and the subsequent rise in stocks.

It’s been so pronounced that now Wall Street is again consistently producing new record highs.

So is this likely to continue, and most importantly, is the Australian market heading in the same direction?

Let’s take a look.

Basic theme?

Fortunately, what’s happening on Wall Street right now is super easy to understand.

It comes down to the bang you get for your buck.

Right now US bond yields are close to record lows. The US investment firm, Morgan Stanley, has bond yields at just 1 per cent in the first quarter of 2017.

So the choice for the investor is fairly straight forward: take a measly 1+ per cent on a bond investment, or something close to 5 – 10 per cent on the share market.

Now the conventional wisdom has always been that every investor has a different capacity to cope with risk – a different risk tolerance. That’s why we have different asset classes.

Bonds offer the least risk and the least return, while derivate securities (options, futures, swaps) carry some of the highest risks and naturally offer the greatest returns.

What if, though, you find that you can’t afford the standard of living you’ve become used to by investing in bonds? You guessed it, you’re ‘forced’ into shares.

Right across the globe, right now, millions of people are reluctantly entering both the share market and the property markets because interest rates are so low.

The share market is attractive because it offers returns north of 1 per cent, the property market’s attractive because the scope of loans individuals can now service has skyrocketed.

US interest rates

So a key question then is, where are US interest rates heading?

The market’s currently pricing in slightly below a 50 per cent chance of a rate cut by the end of the year.

Why? Because interest rates are near zero and the economy is showing tentative signs of life: there’s been a pick-up in jobs growth, retail sales, industrial production and housing starts.

It’s hardly a glowing endorsement of tighter monetary policy in the US though.

If there’s any resistance at all to pushing new record highs on the S&P 500, it’ll be because individual company valuations just don’t justify it.

Indeed last week when a few US companies posted lacklustre results, the index pulled back from its highs. Again though it’s individual companies pulling the index back, not the prospect of rising interest rates.

As long as interest rates stay low, and it looks like they will well into next year, investors will have a huge incentive to park their money in the share market.

Australian story

The Australian story has similarities with the US but there are notable differences.

Firstly, Australian interest rates are still providing adequate (and I use that term loosely) returns on term deposits. Many term deposits will net you something close to 2.5 to 3 per cent return (before tax).

Secondly, there are unique forces that are holding the ASX200 back: there’s consensus that commodities prices will fall over the longer term (affecting miners); that banks are potentially over-exposed to the housing market, and face increasing systemic risks (including costs of funding); and the Australian economy is forecast to slow further, putting valuations on stocks like David Jones, Harvey Norman and JB Hi-Fi under pressure.

Other broad, but key, challenges for the ASX

The federal government is managing a budget that’s in structural deficit – that just means it hasn’t got a prayer of moving into surplus anytime soon.

The ratings agency Moody’s got wind of this the other day and gave the Treasurer a slap on the wrist. It said, ‘balance your books, or I’ll give you more than just a slap on your wrist.’

So relying on federal government stimulus or infrastructure projects (in true Keynesian style) to crank up the economic engine (and markets) again is misguided.

Another key policy measure, interest rates, has its limitations too. If the Reserve Bank cuts interest rates too much, it risks taking the property market into extremely dangerous territory.

So while there’s incentive overseas to park your cash in the stock market, it’s not quite so clear cut here.

Where to from here?

Apart from an obvious global financial shock, I suspect the key challenge for industrial stocks will be whether Australia can maintain an unemployment rate south of 6 per cent. It’s a terribly broad measure, but aggregate, or total demand in any economy always suffers when employment growth stalls to nothing.

In very basic terms, you’re less likely to buy that new TV, couch, home appliance, or whatever, if you’re not sure where your next pay check is going to come from.

The economy is humming along right now, but it will need to keep humming along to prevent any major falls on the stock market.

As far as offshore markets are concerned, well it’s a little more straight forward.

The markets are betting that both Japan and the UK will continue to ease policy (cut interest rates). Indeed last week official data showed UK retail sales fell 0.9 per cent in the month of June (biggest drop in 6 months).

Clearly the full impact of Brexit is yet to be felt, and there will be increasing pressure on the Bank of England to further stimulate the economy.

So there will continue to be a whole bunch of money sloshing around the world looking for decent returns in the coming months, and global stock markets should continue to look relatively attractive… obviously absent some sort of shock.

The ultimate market magnet

Extraordinarily low interest rates act like a magnet to the stock market. You either buy stock because the money market doesn’t cut it for you in terms of yield, or you use low interest rates to leverage a greater stock portfolio (margin lending).

Either way, as long as extremely low interest rates are employed around the world, there will an overwhelming temptation to invest in equity securities.

It forces people to take on more risk than they would like, and it creates huge distortions in asset markets. It’s dangerous. So maybe it’s not such a bad thing that Australia’s share market hasn’t been as caught up in this money mania as the rest of the world.

 

David Taylor is a journalist with the ABC. Before taking up a position with the ABC, David was a financial markets analyst and economics commentator. You can follow him on Twitter: @DavidTaylorABC.