Understanding interest rates & equity valuations

Hue Frame

Frame Funds Management

Are equities currently expensive and is now a good time to invest?

We have been asked this question often by investors who are searching for a return above cash, especially in this low yielding environment. To shed light on this topic, we focus on interest rates. 

Globally, interest rates are at historical lows. Locally, the Reserve Bank of Australia (RBA) Cash Rate is at 1% (just 2 months ago it was 1.5%). The New Zealand Official Cash Rate (OCR), the Euro Refinancing Rate and the United States Federal Funds Rate are 1.5%, 0.00% and 2.00%- 2.25% respectively. The Bank of Korea also recently cut their base rate from 1.75% to 1.5%. 

Most central banks have restarted accommodative monetary policy in an attempt to stimulate slowing global growth. Some market participants attribute this slowing growth to the global trade war, while others conclude that this is a natural period following a 10-year expansion. With global interest rates at record lows (and expected to go lower), the investment decision of holding cash and term deposits is not as rewarding as it once was. 

Interest rates are used by Central Banks as a key tool to manage monetary policy and assist in stimulating economic growth, however for market analysts, they are a key input into valuation models. Often, when valuing equities, a discounted cash flow methodology is applied. This method forecasts a company's cash flows into the future and discounts them by applying a discount rate, as is required by the time value of money concept. As the discount rate decreases, the value of future cash flows will be higher in today’s terms and all else being equal, companies will have lower PE ratios. Therefore, if interest rates decrease and the price of the equity remains constant, PE ratios should also decrease. This is a simple, yet certainly not the only, explanation for why we see equity prices rise when a central bank implements a more accommodative policy stance. 

How do low interest rates impact investment decisions? 

At some stage, investors capitulate and allocate additional capital to equities or higher yielding assets, even if it does mean tolerating additional risk (risk premium). Rather than investing in 30-year United States (US) treasuries which yield 2.57% (as at 26.07.19), investors may invest in National Australia Bank (NAB.AX) for instance, yielding 6.36%. The difference between the two is the risk premium. In the current low interest rate environment, additional risk taking is necessary to generate higher returns. 

What are current equity valuations?

If we compare the current to historical Price to Earnings (PE) ratios for the Australian S&P/ASX 200 and the US S&P 500, both markets are slightly above their historical averages. 

With the PE ratios of both markets trading above their historical average, does this mean that markets are expensive? 

Not necessarily. The ratio is simply a measure of investor's willingness to pay for earnings. In the current macroeconomic environment, as interest rates fall, equity prices go up to factor in the relatively higher future earnings of companies and the more accommodative funding markets. If it is anticipated that interest rates will fall, equity markets will bid up the price of equities before this happens, raising PE ratios, which should then stabilise when an interest rate cut is realised. 

To summarise 

From the perspective of most listed companies, lower interest rates are a good thing. Debt is easier to come by and the repayment obligations of that debt is less. Spending by companies may increase, which will generally imply higher growth rates, reducing PE ratios. In this stance market analysts will increase growth expectations and generally equity prices will continue to rise. 

As Warren Buffett said in May, ‘I think stocks are ridiculously cheap if you believe…that 3% on the 30-year bonds make sense’. From an investor's perspective, consistently low interest rates does encourage risk taking, up until the point where investors are unwilling to take on risk for additional investment returns. 

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This information is prepared by Frame Funds Management Pty Ltd (ACN 608 862 442) (Frame Funds, we or us) is a Corporate Authorised Representative (CAR No. 123 9068) of Primary Securities Limited (ACN 089 812 812 635) and is intended only for "wholesale clients" within the meaning of sections 761G and 761GA of the Corporations Act 2001 (Cth). This material is not intended to constitute advertising or advice (including legal, tax or investment advice) of any kind. These materials are not to be distributed to any person who does not qualify as a wholesale client and must not be copied, reproduced, published, disclosed or passed to any other person at any time without the prior written consent of Frame Funds. Primary Securities Ltd (ACN 089 812 635 635, AFSL 224 107) is the Trustee of, and issuer of units in, the Frame Futures Fund (Fund). In deciding whether to acquire, or to continue to hold, units in the Fund please read the current Information Memorandum available from Frame Funds. Past performance of the Fund is not a reliable indicator of future performance. The value of an investment in the Fund may rise or fall. Returns are not guaranteed by any person. Total returns are calculated before tax and after ongoing management costs. In preparing this information, we have not considered your investment objectives, financial situation or personal circumstances and therefore the Fund may not be suitable for you. Neither Frame Funds, Primary Securities Ltd, nor any of their respective related parties, directors or employees, make any representation or warranty as to the accuracy, completeness, reasonableness or reliability of the information contained in this publication or accept liability or responsibility for any losses, whether direct, indirect or consequential, relating to, or arising from, the use or reliance on any part of this material. Any rates of return, forecasts or estimates contained in this publication are not guaranteed. The content of this publication is current as at the date of its publication and is subject to change at any time. It does not reflect any events or changes in circumstances occurring after the date of publication.

Hue Frame
Founder & Portfolio Manager
Frame Funds Management

Hue Frame is the founder of Frame Funds Management and Portfolio Manager for the Frame Futures Fund and Co-Portfolio of the Frame Long Short Australian Equity Fund.

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