After the shock drop in inflation reported earlier this week, the likelihood of another interest rate cut is building.
As we reported yesterday, annual inflation (the change in prices from one year to the next) currently sits at just 1.3%. That compares to the Reserve Bank of Australia's (RBA) target range of between 2% and 3%.
What low inflation means for stocks
Almost immediately after the inflation data was released, the Australian dollar dropped as investors saw it as a signal that another interest rate cut was on its way. And it does seem likely.
Analysts at Citigroup estimate the chances of an interest rate cut next week (taking the official rate to 1.75%) is as high as 50%.
And if the RBA wanted more reason to cut interest rates to a new record low, the Australian dollar ($A) to US dollar ($) (AUDUSD) remains slightly above its target range. A high dollar makes imports cheaper, but drags on productivity.
Broadly speaking, the share market will likely receive a boost from another interest rate cut. There are many reasons why shares jump when interest rates are low.
Firstly, it puts more money in consumers' wallets. Depending on the savings rate, it can mean more people spending more money on, for example, casual dining or coffee. Retail Food Group Limited (ASX: RFG) is the owner of Donut King, Gloria Jeans, Crust Pizza and much more. Other retailers like Harvey Norman Holdings Limited (ASX: HVN) might also benefit.
Scentre Group Ltd (ASX: SCG), the Australian arm of Westfield shopping centres, is another company likely to see more foot traffic on account of lower interest rates. Moreover, both Retail Food Group and Scentre pay respectable dividends to shareholders.
Dividends are another big reason the share market does well when interest rates fall. The term deposit interest rates on offer from a big bank currently stand at less than 2.4% annually. Meanwhile, the banks' shares pay dividends in excess of 5% and many generate tax-effective franking credits.
Finally, many Australian companies generate cash from overseas operations. Cochlear Limited (ASX: COH) and Macquarie Group Ltd (ASX: MQG) are two Australian heavyweights kicking goals for shareholders overseas. Both companies generate significant amounts of revenue in US dollars and are showing no signs of slowing down. A stronger US dollar has the effect of boosting their local currency profits.
Foolish takeaway
Successful investors play the game three steps ahead of the market. And while no investment should be based solely on a catalyst like interest rates, each company is likely to continue trucking ahead regardless.
