Australia | Jul 06 2007
By Chris Shaw
Yes, bond yields have risen in recent weeks and this is creating some nervousness for investors as they factor in the Australian equity market trading at or near record highs, but according to Commonwealth Bank chief economist Michael Blythe the key fundamentals that have driven the market higher over the last five or six years remain in place.
He points out the primary driver of markets this decade has been excess liquidity, created by the gap between savings and investment that opened up late in the 1990s. This money eventually began to find its way into financial investments at the same time as the average investor increased his or her appetite for risk and interest rates were very low, creating a situation where investors had no choice but to put funds into assets paying a decent yield or offering potential for capital gains.
While things are not quite as attractive now in that bond yields and asset prices have subsequently moved higher and there has been some spread compression, the fundamentals remain favourable in Blythe’s view.
He suggests the major risks to the story are an increase in global investment spending, further significant increases in interest rates and a fall in the risk appetite of investors, so it is worth assessing each of these variables.
While there are signs global investment is increasing, this isn’t a surprise given the global economy is into its fifth year of above average growth. Assuming investment returns to more normal levels it is true the loser would be global liquidity, but here he suggests the downside risk has been reduced by the emergence of a new group of savers who are enjoying the windfall of higher oil prices and as a result adding to global liquidity levels.
Interest rates have gone higher, but are still well below long-run averages and the consensus view according to Blythe is they don’t have much further to rise. Indeed, Japan seems the only major economy where there is potential for large increases in rates from current levels, but Blythe suggests this is both not likely to happen and would take a long period of time to implement even if it did.
So assuming interest rates remain lower than long-term averages and inflation remains relatively under control, as is currently the case, and the outlook is for risk appetites to remain higher than average for some time. This likely means any shakeouts are short-lived and the market quickly returns to the prevailing trend.
The latest incarnation of the excess liquidity story is private equity, but here Blythe suggests investors need to keep things in perspective. Yes activity and buyouts are up, but they still only represent about 2.6% of the market’s capitalization and 2% of private non-financial corporate debt.
That being said he sees the trend continuing as it simply reflects a market situation globally where demand for investable assets is growing faster than supply. Australia in particular is a likely beneficiary, as the country has an excess of profitable opportunities compared to what moves can be financed by domestic investors.
Those concerned about the coincident increase in gearing should also relax a little, as Blythe points out the starting point was gearing levels below long-term averages, meaning the recent deals have only brought gearing back into line with historical trend levels.
Turning to the currency, Blythe notes the Aussie dollar has been the beneficiary of our relatively high interest rates, making it an attractive currency for those putting on the carry trade.
This has helped the Aussie dollar post strong gains in recent years but also makes it more susceptible to any change in the market’s perception as to the viability of the carry trade and the returns that can be made.
Like equities the carry trade corrections in recent times have been short and sharp, though they are quickly recovered as the market returns to the investment based on the prevailing fundamentals in place.
Where there could be longer-term changes in Blythe’s view are from central banks, where as a group they are holding foreign reserves far in excess of any operational needs. Moves to diversify these holdings out of what are primarily US dollar denominated investments could again provide a boost to equities, as those in charge of managing the reserves look for ways to generate higher returns.
According to Blythe it could also boost the Australian dollar as it has the potential to make an attractive alternative reserve currency given it is widely used in international transactions, it has a deep and open market for trading and it potentially offers relatively stable purchasing power.
Add in the fact Australia has high interest rates and offers a number of opportunities for private investment and there appears to be a structural change underway towards a higher domestic currency in Blythe’s view. With this money flowing into the dollar having to be invested somewhere, he remains confident the supportive conditions equity markets have enjoyed for several years remain in place.