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Nov 2016 Market Update

Current Assessment Of Equity Asset Markets

In summary:

While it is by no means certain that bond yields will increase markedly, the election of Trump has focused attention on some of his key policies which include a significant cut in personal and corporate taxes and spending big on infrastructure. The medium term consequences are likely to include bigger Federal deficits over the next four to six years and much more issuance of US long term bonds leading to yields being higher than they would otherwise be.

If the Trump program passes Congress, we are also likely to see faster economic growth and higher inflation, which will also put upward pressure on bond yields in the USA and elsewhere, including Australia. In the view of the PIC bond yields have broken their long-term downward trend and yields are expected to rise further over the coming year.

Caution is needed with property securities or AREITs. While they have come back from c 130% of NTA to 109% of NTA, they are still somewhat overpriced and therefore vulnerable should bond yields rise more. The new normal range for Australian ten-year government bond rates is likely to be in the range 2.75% p.a. to 3.75% p.a. While this is well below the old historical 5 to 6% level, we are now just at the lower edge of the likely new range.

While the recent low level of bond yields has been supportive of equity prices and may continue to be, this effect will weaken if bond yields continue to rise.

It is important to note that a rising bond yield can have a more significant effect on high dividend, low growth stocks such as Real Estate Investment Trusts, infrastructure stocks and utility stocks, as the valuation of the cash flows from their dividends are more sensitive to increases in the discount rate used in valuing the cash flows.

This is usually closely linked to the current ten-year government bond yield. While a 1% p.a. increase in the ten year bond yield will cause around a 7% fall in the price of a ten-year bond, it will often cause a fall of closer to 15% in the price of REITs or infrastructure securities, which have a much longer dated average term of the expected cash flows.

The longer the effective term of an investment’s cash flow, the greater the effect of a shift in the yield used to discount the cash flow to arrive at the value of the security.

This explains the rationale of reducing exposure to property and infrastructure securities in the portfolios.

 

 

 

 

Madison

Planning Perspective Gold Coast Pty Ltd is a Corporate Authorised Representative of Madison Financial Group Pty Ltd | AFSL No. 246679ABN 36 002 459 001 http://www.madisonfg.com.au
This information is of general nature only and neither represents nor is intended to be specific advice on any particular matter. We strongly suggest that you seek professional financial advice before acting.