Article - Money Matters

Governments throughout the developed world have accumulated masses of debt. One way in which this debt burden can be reduced is by governments keeping their interest rates artificially low. By doing so their debt in real terms starts to fall, if they can reduce their spending.

In the US, the Federal Reserve has set the cash rate at close to zero. This keeps short term interest rates artificially low. To keep longer term rates artificially low the government employs a tool called quantitative easing (QE). This involves the government buying back their own bonds on the open market.

Low real interest rates are crucial in reducing government debt. For example with interest rates at 0.2% p.a. and inflation running at 2% p.a., there is a transfer of wealth from investors to the government of 1.8% p.a.  

The winner from this financial manipulation is clearly the government. The loser is the conservative investor. In this environment, investing in conservative assets leads to negative real returns.

This helps explain why the return on the US share market has been superior to the Australian share market of late. US investors have essentially been forced to buy equities in the hope of achieving positive real returns.

A company that pays a dividend of 3% p.a. looks attractive from a valuation point of view when compared to cash at bank earning zero % p.a. The trouble is this same company continues to look attractive when its share price doubles and pays a dividend of 1.5% p.a.

The financial manipulation employed by the US government should help with its debt burden but it should also help support and inflate stock prices.

We have seen some bizarre reactions where the US market has cheered bad economic news because it likely means further government intervention, most recently in the form of QE3.

We haven’t seen the same phenomenon in Australia. Conservative investors are able to access acceptable returns from term deposits and so haven’t been forced into equity markets.

The end result is a perverse outcome where the US, with all its debt and economic problems has a booming share market and Australia with its relatively strong economy and low debt has a share market which is languishing.
    
A reduction in interest rates in Australia should help our equity market play catch up to the US. If term deposit rates fall further then shares will look more attractive on a relative basis. 
 
Further flows from overseas looking to take advantage of Australia’s higher share yields should also act to buoy our market.

We now live in a strange world where bad news can actually be good and yield has become a very valuable commodity.

The above views are a summary of ideas expressed by investment specialist Tim Farrelly. Tim Farrelly sits on our investment committee.

Please note that the above is general advice only. Please contact us if you would like advice specific to your needs.