On some metrics the Australian equities market seems expensive.
But on other measures, the market can either be described as still around fair-value or decidedly cheap. How so? Rising dividend payout supports market valuations.
According to Thomson Reuters, the Australian equity market’s current forward earnings yield is at 6.3 per cent per annum, notably below its longer-run average of 7.5 per cent per annum.
In turn, that reflects the fact the forward price/earnings ratio has lifted to 15.8 per annum, compared with a long-run average of 13.5 per annum. On this outright basis, the market appears overvalued.
That said, it’s also the case that the market’s current dividend yield remains around 4.2 per cent per annum, which is only a touch lower than the long-run average of 4.3 per cent per annum.
This reflects the fact that the market’s implied payout ratio (ratio of the dividend to forward earnings yield) has lifted to 65 per cent, compared with a long-run average of 57 per cent.
A rising payout ratio may or may not be sustainable, though it clearly seems to reflect the increasing thirst by investors for yield.
Based on the dividend yield alone, the market could be described as still fair-value.
Relative to interest rates, the market is cheap
So far this analysis has ignored the substantial decline in interest rates over recent years.
But the real (after inflation) one-year term bank deposit rate is now only around 1.0 per cent per annum – equal to its lows during the GFC, and well below its long-run average of 2.1 per cent per annum.
Relative to interest rates, therefore, the equity market’s current dividend yield appears quite cheap.
Indeed, the gap between the dividend yield and this real deposit rate is currently 3.2 per cent per annum, compared to its long-run average of only 2.1 per cent per annum.
With the expectation that the RBA will cut official interest rates to as low as 1.5 per cent per annum this year due to its concerns over domestic economic growth, the real term deposit rate is likely to fall further – potentially to as low as 0.5 per cent per annum.
What’s more, the sustainable level of interest rates going forward is likely to be less than that averaged over the past decade or so, as this was a ‘one-off’ period of rising household debt and the greatest mining boom in our history.
The post-GFC period, in contrast, has been characterised by sluggish recovery in non-mining investment, brought about by structural headwinds including greater consumer caution and an apparent lengthening in the average lifespan of capital equipment.
If such a trend continues, it will likely lead to a longer-term structural decline in interest rates, which in fact implies that the share market today is even better value.
It would therefore not be surprising if the market’s dividend yield eventually bid down to around 3.0 per cent per annum or so, compared to its historic average of just over 4.0 per cent per annum.
All up, still reasonable equity valuations in the face of low interest rates suggest the ‘yield chase’ by investors is likely to remain an important Australian market driver.
David Bassanese is the chief economist of ETF provider BetaShares.
