Unsurprisingly our Reserve Bank left interest rates on hold last week citing “stabilisation” in both China and Europe and improved sentiment. And that improved sentiment has certainly flowed in to equity markets generally after a solid reporting season in February where companies reaped the benefits of cost cutting programs. As I write this (a week or so into March) our sharemarket is up over 10% so far this year and now trading at just 5.2% below its’ previous high on an accumulation basis.
To continue our theme from last month about what the future holds from the inflexion point we appear to be at today, let’s look in more depth at cash rates. We are potentially getting close to the end of the easing cycle and while the low point may be in the range of 2.5 to 3% with the futures market currently pricing in a low of around 2.5% in the rate cycle by September, there is an obvious question here – we all know that falling interest rates are stimulatory and can be good for the economy at the margin, but what will happen if rates start to rise again? Could rising cash rates stir up the Chicken Littles and derail the current recovery in the sharemarket?
We have done some research on this topic at Perennial. We looked at the last 4 times we were in a rate hike cycle and what happened to the sharemarket while rates were rising. The results are interesting and quite varied. with the last 3 rate hike cycles being positive for our sharemarket.
We then went one step further, seeking to understand whether there was a difference in how the sharemarket went depending on where we were in the tightening cycle. Two phases were identified in the tightening cycle. Phase 1 was where the cash rate rose from its lowest level to the “neutral” rate (the theoretical interest rate that is neither expansionary or contractionary to the natural non-inflationary growth rate of the economy). Phase 2 was where the cash rate went from the neutral level to its high point in the tightening cycle.
What did we find?
The results show that most of the sharemarket gains tends to occur in Phase 1, in fact in ’09 and ’02 approximately 75% of the returns occurred in this Phase 1 period.
This is fairly intuitive, as the economy and earnings should be responding to earlier monetary easing with a lag. The results are varied as you would expect given the nature of the shocks experienced over the last 15 years.
To continue our theme from last month about what the future holds from the inflexion point we appear to be at today, let’s look in more depth at cash rates. We are potentially getting close to the end of the easing cycle and while the low point may be in the range of 2.5 to 3% with the futures market currently pricing in a low of around 2.5% in the rate cycle by September, there is an obvious question here – we all know that falling interest rates are stimulatory and can be good for the economy at the margin, but what will happen if rates start to rise again? Could rising cash rates stir up the Chicken Littles and derail the current recovery in the sharemarket?
We have done some research on this topic at Perennial. We looked at the last 4 times we were in a rate hike cycle and what happened to the sharemarket while rates were rising. The results are interesting and quite varied. with the last 3 rate hike cycles being positive for our sharemarket.
We then went one step further, seeking to understand whether there was a difference in how the sharemarket went depending on where we were in the tightening cycle. Two phases were identified in the tightening cycle. Phase 1 was where the cash rate rose from its lowest level to the “neutral” rate (the theoretical interest rate that is neither expansionary or contractionary to the natural non-inflationary growth rate of the economy). Phase 2 was where the cash rate went from the neutral level to its high point in the tightening cycle.
What did we find?
The results show that most of the sharemarket gains tends to occur in Phase 1, in fact in ’09 and ’02 approximately 75% of the returns occurred in this Phase 1 period.
This is fairly intuitive, as the economy and earnings should be responding to earlier monetary easing with a lag. The results are varied as you would expect given the nature of the shocks experienced over the last 15 years.
Start of rate hikes
|
Phase 1:
Rates rise to neutral^
|
Phase 2:
Rates
rise from neutral high |
Total Return
(Phase 1 and Phase 2) | |||
Months
|
%
Return* |
Months
|
% Return*
|
Months
|
% Return*
| |
30/09/09
|
13
|
+3.9%
|
-
|
-
|
13
|
+3.9%
|
30/04/02
|
48
|
+85.7%
|
22
|
+31.7%
|
70
|
+117.4%
|
31/10/99
|
5
|
+10.2%
|
4
|
+3.1%
|
9
|
+13.9%
|
31/07/94
|
2
|
-1.0%
|
2
|
-5.9%
|
4
|
-6.9%
|
^The neutral interest rate is the rate when monetary policy is neither expansionary or contractionary.
*S&P/ASX 300 Accumulation Index.
The bottom line is that using the above data, the first part of the monetary tightening cycle is unlikely to spell the death-knell for the Australian sharemarket. After a few years where every time the equity market got going and was then derailed by an unforseen event, investors run the risk of looking for reasons for equities to do poorly. On its own, phase 1 of a tightening cycle is not a negative; investing, as always, is about having an informed Perspective.
Indices:
The Australian All Ordinaries Index has moved down decreasing -33 points (or -0.6%) since closing last Friday to 01:45 pm today.
The rest of the world as measured by the MSCI index increased 1 point (or +0.3%) in A$ from closing last Friday to end of trade Thursday.
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