There’s a new “valuation paradigm” at play on the Australian stock market according to the Australian equity research team from Macquarie Securities.
In a note to clients Macquarie says it’s one where “earnings and return on capital don’t matter so much for PE multiples which keep rising on the back of a falling discount rate.”
Investors best make hay while the sun shines, Macquarie tells clients.
It’s an uncomfortable equilibrium, because we know it cannot continue ad infinitum. However for now, lower rates mean higher multiples and the potential for yield-sensitive sectors to all trade above “fair value” as positioning trumps fundamentals.
This is the drivers of the global equity rally on the back of super low rates and central bank quantitative easing coming to Australia’s shores.
It appears Macquarie is comfortable framing the PE expansion and stock market rally they are forecasting in those terms.
Their research said (our emphasis):
Australia has entered the global deflation flight that it managed to hold off on for longer than most other developed and/or commodity driven economies. Declining inflation expectations have driven our economic team to make significant downgrades to interest rate and inflation forecasts.
We have lowered our cash rate expectation to 1%, our nominal 10-year bond yield forecast to below 2% (shifting the entire term structure lower) as well as pulling back our long-term cash and long bond yield expectations on the back of a more benign inflation trend.
Of particular importance for stock valuations is that 10-year bonds recently hit their all-time low yield which helped propel earnings multiples to their highest level in 15 years at 16.4x forward earnings.
“The lower bond yields go the higher the PE goes – for now,” Macquarie said.
The problem of course is that the expansion in multiples “is difficult to square with weak earnings fundamentals and a declining return on capital” Macquarie says.
No doubt many investors will agree.
That’s particularly the case given Macquarie has downgraded its “year-end target on the ASX200 from 5900 to 5700” on the back of disappointing earnings expectations for 2016 and their view that “017 are optimistic given the extent of domestic demand weakness which is limiting pricing and potentially driving some absorption of margin pressures”.
In the end, Macquarie says “the market is far more sensitive to a change in the PE multiple than earnings which are already at relatively low levels”.