RBA boss Phillip Lowe channeled his inner Julius Caesar this afternoon in revealing that the ‘die is cast’ on a June rate cut from the central bank after stating in a monetary policy speech in Brisbane today that the central bank will ‘consider the case for lower rates” at its next monetary policy meeting on June 4.
The speech was no soliloquy-infused Shakespearean effort though, but one of a governor fed up over the government’s fiscal inertia, while chasing budget surpluses that have not helped the RBA in its quest to dial inflation higher.
Mr Lowe even reminded the government in his speech that fiscal policy via increased investment or spending is “worth thinking about” in a bid to bring unemployment lower and support demand.
After all a surplus (arguably) suggests the government is not spending enough, or taxes are too high, or both.
However, given the governor also conceded a lower cash rate would “support employment and bring forward the inflation target” a cut now seems inked in on June 4.
Why does this mean shares can go higher?
A cut is likely to be a positive for share market investors as cheaper money or more liquidity inevitably finds its way into stock prices, while lower rates mean the returns on offer from other asset classes such as cash, money market instruments, and longer-dated date become less attractive relative to equities on a risk-adjusted basis.
Equity investors generally demand a greater return above risk-free rates to compensate them for the greater risk involved in owning shares.
Therefore if the risk free rate falls then equity valuations can move higher as the rate of return required above the risk free rate moves lower.
Related to this basic point is that lower rates also mean changes to discounted cash flow (DCF) calculations that are the commonest method or input used by powerful professional analysts today to calculate the intrinsic value of equities.
If rates move lower today then the present value of future cash flows from a stock actually moves higher as the cash flows are worth more now compared to risk free rates.
The present value of nearer term cash flows also carry a heavier weighting in calculating a valuation as they’re naturally more certain than long dated estimates, with lower overall discount rates also translating into higher valuations.
The above is a basic explanation of why the world’s most successful investor in Warren Buffett has repeatedly claimed over the last few years that whether share markets are good value today or not largely depends on your outlook for interest rates.
As evidence of this mantra we saw global equity markets plunge over the final quarter of 2019 as the US Fed lifted benchmark lending rates, before paring back on its intention to lift rates in January 2019 to send share markets rocketing higher again.
The Australian stock market also hit new 9-year highs in April on the back of rising expectations a cash rate cut was coming.
What should I buy then?
One trap to avoid in an ultra-low-rate environment is to blindly bid popular dividend shares like Westpac Bank (ASX: WBC) or Telstra Corporation Ltd (ASX: TLS) higher in an attempt to beat the atrocious returns available on cash deposits.
Another mistake to avoid is buying any of the many poor quality companies floating around on the ASX that are on cheap valuations for good reason. Leave that trick to the “professional fund managers”.
Rather, I’d focus on high-quality companies likely to benefit from a lower Australian dollar, many of which are in the healthcare space.
However, my current pick to play this theme remains CSL Limited (ASX: CSL). The stock has run up a little recently, but I’d still rate it a buy below $208 today.
Another business on my radar today is California-based software player Altium Limited (ASX: ALU) as it’s falling in price and also offers heavy exposure to a weaker Australian dollar given it reports in US dollars.
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Tom Richardson owns shares of Altium, Cochlear Ltd., CSL Ltd., and ResMed Inc.
You can find Tom on Twitter @tommyr345
The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Altium, Cochlear Ltd. and CSL Ltd. The Motley Fool Australia owns shares of and has recommended Telstra Limited. The Motley Fool Australia has recommended Cochlear Ltd. and ResMed Inc. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.