Monthly Market Wrap

What is the relationship between interest rates and share prices and why is it important?

There are many moving components in markets, two of the most important of these components are interest rates and inflation. In this article, we would like to work through the impacts that interest rates and inflation (more specifically, real interest rates) have on the market index – the ASX 200.

A key metric in determining the value of markets is the equity risk premium. The equity risk premium is a calculation of the return above a risk-free rate – most typically a short-term Treasury Note with no risk – that holdings in equities provide.

In the graph below, we have set out the real interest rate vs the price of the ASX 200 index between 1992 and now. Real interest rates are derived from the RBA cash rate minus inflation.

As you can see above, there appears to be a long-term, negative relationship between real interest rates and share prices. Whilst there are other factors behind this, including the earnings growth of Australian businesses, the relationship is still significant. The reason for this, is the previously mentioned equity risk premium. As interest rates (or the cash rate) determine where the risk-free rate is set, low interest rates have pushed down the risk-free rate. As the equity risk premium is determined by the outperformance of equities over the risk-free rate, the equity risk premium has increased as the risk-free rate has decreased. The premium that we have been able to attain over the risk-free rate has more than compensated us for the risk that we take, over the long-term.

 

April Market Recap

Global markets performed remarkably well in April as investors become more confident in the prospects of a fast recovery in global economies. The quantitative easing (or QE) measures – that have been undertaken by the Reserve Bank of Australia as well as the US Federal Reserve, the Bank of England, and the European Central Bank – have seemingly achieved their purpose of having funds that were previously held in government bonds pushed into other financial assets, including shares.

In Australia, the ASX 200 rose 8.78% in April in what was a strong bounce-back in our domestic markets. The sectors that have been hit the hardest through the Covid-19 crisis rebounded, albeit off a low base in April, with Energy rising 24.80%, Information Technology rising 22.53% and Consumer Discretionary rising 15.95%. The thesis that oil prices have bottomed boosted Origin Energy by 26.94%; JB Hi Fi rose by 25.57% on the back of strong technology sales in response to the volume of those working from home; and Credit Corp rose 20.89% as investors gain more confidence in their ability to collect a significant portion of the subpar debt that they hold. Further, we saw a large number of equity raisings in the Australian market over the past month as companies move to strengthen their balance sheets and ensure their solvency.

The United States continue to suffer significant losses of life as a result of Covid-19, but nevertheless the S&P 500 rose 12.68% in April. Similarly, the Dow Jones rose 11.08%, and the NASDAQ rose 15.19%. Interestingly, the NASDAQ index is up ~1% over the past year. The market continues to respond positively to both the Fiscal efforts of the US government, as well as the monetary policy of the Federal Reserve. There have however been forecasts that unemployment in the US could rise as high as 30%. We believe that this forecast is outlandish, but it shows that we still must be cautious.

In Asia, the Japanese Topix index rose 3.64% and the Shanghai Composite Index rose 3.99% during the month. This seems lacklustre, but each of these indices fell significantly less than other global indices during March. Asia has been proving particularly resilient and the measures taken by governments in Asia appear to be working effectively in their fight against Covid-19. There are geopolitical threats arising as a result of western leaders demanding an enquiry into the source and initial handling of the Covid-19 crisis, but we do not believe the long-term implications will be material.

European markets similarly bounced back in April. The German DAX rose 9.32%, the French CAC 40 rose 4%, and the UK FTSE 100 rose 4.04%. The European Union are facing headwinds in attempting to implement a unified fiscal policy response. The traditionally conservative Northern European’s (Germany, Belgium, the Netherlands) are reluctant to implement sweeping fiscal policy, whereas the Southern Europeans (Spain, Italy, Greece) are pushing for its implementation. This will be a test for ECB chief Christine Lagarde’s proven negotiation ability. 


Stephen Degiovanni, Olivia Maragna and Cameron Harris are authorised representatives of Aspire Retire Pty Ltd ABN 61 104 563 733.
Level 6 345 Ann Street Brisbane QLD 4000. General Advice Warning: This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial advice prior to acting on this information. Investment Performance: Past performance is not a reliable guide to future returns as future returns may differ from and be more or less volatile than past returns.