Despite the fact that interest rate cuts generally signal a negative stance by the Reserve Bank of Australia (‘RBA’) on the outlook for the economy, they can actually have a positive impact on equities. The reasons are:
1. Potentially higher company revenues through an uptick in domestic spending, a lower exchange rate improving competitiveness/translation of profits and lower interest costs for borrowers
2. Higher equity valuations as a result of a lower discount rate incorporated into future cash flow discount models
3. Equities (yields in particular) become relatively more attractive when compared to cash
The Australian equity market has at times enjoyed a rally when monetary policy has been loosened, particularly in periods when interest rate levels are lowered aggressively. We are potentially only midway through the rate reduction cylcle; the futures market is anticipating an official cash rate of 2.50% within the next 9 months.
The chart above illustrates the performance of the Australian equity market after the official cash rate begins to fall (i.e. at month 0). On average, in the last 6 episodes of easing monetary policy the Australian equity market has risen 17% over the 3 years following the initial rate cut. The historical outliers were during the 1990 rate cuts when Australia experienced its last economic recession and 2008 during the depths of the GFC. At present, we do not expect either a recession in the Australian economy or a GFC equivalent event to be repeated. In the current rate reduction cycle - which began in November 2011 - the market has risen approximately 10%.
Indices:
The Australian All Ordinaries Index has moved up increasing +66 points (or +1.5%) since closing last Friday to 02:50 pm today.
The rest of the world as measured by the MSCI index increased +24 points (or +2.7%) in A$ from closing last Friday to end of trade Thursday.
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