The start of 2015 has been stronger than many expected for the Australian share market – February saw the market deliver its best monthly gain since October 2011. The gains have allowed the market to rise to a 12 month PE ratio of above 16 times. Historically speaking this is one standard deviation above the long-term average.
S&P/ASX300 12 month price earnings ratio
Source: BT, IRESS, Datastream
In recent weeks global equity markets have been looking to the US Fed for signals as to when it will commence rate hikes. Their reference to a “patient” approach was removed last week – an action expected by many to presage a tightening cycle – however it was replaced with new language that implied further economic growth needs to be seen before rates will be increased. At this point it still seems likely that US rates will be raised in 2015, but not before H2, leaving the market some breathing space.
Meanwhile, other central banks across the globe are cutting rates to combat slowing growth and maintain competitive currencies. The Reserve Bank of Australia followed the rest of the world’s lead by cutting rates to 2.25% in February, with the market pricing in further rate cuts by June.
This is important, as when the Reserve Bank is in loosening mode, it can support and sustain higher P/E ratios, as shown in the chart below.
Interest rates v Price Earnings multiple of ASX200
Source: Citi, IBES, RBA, CIRA
In this environment we are cautious, but not bearish on market valuations.
The PE multiple is reasonably high on a ten year view, which does leave the market more vulnerable to some sort of exogenous shock.
However this must be balanced against interest rates, which are expected to go lower from here and remain low for some time. In effect, policy makers are buying insurance as they see unemployment rising and mining capex continuing to fall. We do not see the Reserve Bank deviating from the current path until they see the rest of the economy start to kick into gear via higher consumer spending and increased investment as a result of a more competitive Australian dollar.
At the same time, we are seeing increased foreign interest in local markets as a result of QE programmes in Japan and Europe and a weaker Australian dollar, providing further support for current valuations.
What we are likely to see – and this was borne out through reporting season – is that certain parts of the market are likely to be winners either through a supportive cycle (eg. those helped by low rates and a lower Australian dollar) or by demonstration of successful ‘self-help’ initiatives. Conversely stocks that have been bid up based on either their solid franchise or high yield characteristics will be harshly dealt with if they don’t meet expectations, given stretched valuations.