A Letter to Investors – Part One

“What we know and what we don’t”

How did we get to where we are?

Following the decade of significant monetary and fiscal support that flowed from the GFC (2008/09), the developed world economy expected to move through a period when the “support” would be unwound.

This expectation faded when a “black swan” event occurred as the COVID-19 pandemic hit.

Rather than unwinding quantitative easing (QE), zero interest rates and fiscal deficits, governments and central banks pressed the accelerator of support to avoid a possible depression caused by economic lockdowns.

Today the world has not yet truly passed the COVID crisis, but there is once again a broadly stated intention of central banks (mainly) to recommence the unwind. This intention became “urgent” when inflation began surging and as the Ukraine war dislocated global energy and grain markets.

Central banks have now committed to adjust cash interest rates upwards, cease unlimited funding for banks, and turn QE into QT (quantitative tightening). At this point, they expect to see bond yields rise and equity markets correct as they fight the most severe inflationary outbreak in 40 years.

Although there is no argument with the need to readjust monetary policies, there is little consensus as to how fast this adjustment can or should take place. Recent settings of monetary policy have been so extraordinary that it is hard to predict how the gap between inflation and interest rates can be closed and where interest rates will ultimately settle.


World capital markets – equities and bonds – need to reset

To explore this conundrum, I will start with a comparison of where markets currently sit against recent history, and review inflation, equity market PERs and cash and bond yields.

The first chart below tracks Australian inflation for the last 40 years. The sustained inflation of the 1980s and the spike in inflation to 6% around 2001/02 can be observed. The spike in inflation (2022) is likely to meet that level of early this century.

The next chart shows the recent history of cash rates set by the RBA. For most of the time, the RBA steadfastly held cash rates above inflation, thereby creating a real positive cash rate (compared to inflation). During the GFC “real” cash rates were taken into negative territory. Since 2016 “negative real” cash rates have prevailed for the most sustained period since World War 2.

In 2001, when inflation last averaged 6%, Australian ten year bonds yielded 7%. At that market rate, bond yields appropriately covered the underlying inflation rate. The yield on long dated bonds performed like it had for decades. The so-called “risk free” rate of return gave bond owners a return that protected the purchasing power of their investment. It also created a hurdle for other investment assets to meet.

When risk free yields (bonds) cover inflation, it naturally forces investors in all alternative investments (which have higher risk) to seek better returns. The market pushes prices lower to create a future return.

Therefore, risk free rates influence the market prices for growth assets – e.g. equities and property. However, the short term setting of market prices is always chaotic. Daily market prices are set largely by a confluence of the interplay between long term investors, index funds (asset allocators) and the speculative activity of traders. The other major influence is the actual and forecast cost and supply of credit or debt. Of course, the cost of debt is greatly influenced by central banks.


The Rule of Twenty – a handy guide to value in the equity market

To understand the relationship between inflation, bond yields and equity market Price Earnings Ratios (PERs), we draw upon the observations above and note the chart below which tracks forward PERs for the ASX200 (that is, using forecast company earnings).

One useful analytical tool for investors in assessing market value is the “Rule of Twenty”. This rule has a few different interpretations, but generally it suggests that a ten year bond yield (which is normally a proxy for the outlook for inflation) added to the PER of the equity market (a forward estimate) should equal 20 or less to indicate reasonable value. Thus, if inflation is (say) 5%, then 10 year bonds should be around 6%, and the one year forward PER of the equity market should be 14.

What does this rule suggest about the value on offer of the Australian equity market?

The forward PER of the market (FY23) is currently at about 15 times, and the current bond yield is about 3.5%, and therefore based on the Rule of Twenty the Australian market (15 + 3.5 = 18.5) presents as being in value.

However, this basic analysis draws from inputs that are somewhat speculative.

These inputs include:

  1. Australian equity analysts are projecting corporate profits to grow in FY23.
  2. Reported headline inflation is 5.1% and the RBA is forecasting 6% by September.
  3. Australian 10 year bond yields are 3.5% and do not match inflation.
  4. Cash rates in Australia are just 0.35% (though soon to rise); and
  5. The RBA is suggesting that cash rates may be 2.5% by mid-2023.

It is a unique situation when both the cash rate and the long term bond yield are well below actual and expected inflation. Therefore, with the risk free rate decoupling from the inflation rate, we question whether the bond yield has also decoupled from the equity market PER.

This breakdown in the relationship of bond yields and market PERs has led some to replace the bond yield with the expected inflation rate in the Rule of Twenty. If we make this adjustment, then the Australian equity market presents as fair value.