Is yield overvalued or the cash cow of the century?

With central banks continuing to drive market liquidity in one direction and Janet Yellen’s statement that the Fed won’t be impatient, is the yield trade a cash cow or overvalued?

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Source: Bloomberg

The state of play:

- On current statements, no central bank in the developed world is going to rise rates before June. In fact, the market believes no central bank will lift rates before September.

- Currently, the market believes four or even five (including the PBoC) banks could lower rates in the next two months, further driving funds into corporate and sovereign yield plays.

- Bond markets in parts of Europe are trading at record all-time highs on the back of the ECB while US bond markets remain well bid despite changing monetary policy.

- Equity yields are offering rates at the same yield rates that ‘risk-free’ money markets were offering 12 months ago.

- The ASX consensus forecasts FY15 EPS growth of 2.5% (at best).

- The ASX consensus forecast for FY15 revenue growth is 2%.

- The consensus estimate for FY15 payout ratios on the ASX has risen to 65% - the historical average is around 45%. This is expanding yields and is driving funds into these assets.
 

The value risks:

- In places like Germany, almost 60% of bunds (mainly frond-end instruments) have negative yields as unconventional monetary policy creates unconventional trading situations.

- A growing number of fund managers now believe there is a fixed income bubble is brewing.

- In a recent survey of 300 global fund managers, four out of five see corporate bonds as overvalued. Here’s a prime example of how well bid corporate bond-land is: Nestle got a 30-year bond away in Europe at 1.4% - that is a phenomenal price. From a local perspective, BHP is on the verge of getting a benchmark bond away at 3.75% - 150 basis points above the cash rate. This will be lower still if the RBA does lower rates as expected.

- There is a rising possibility of a disorderly sell-off in bonds if liquidity in the buy side dries up on the rising valuation risks and the negative yield returns on offer.

- On the corporate front, will profits be able to cover the forecasted yields? If not, will equity markets see disorderly exits on overvalued equity prices that have been backed by expected payout ratios?
 

The yield trades that matter (with yields based on consensus estimates for FY15)

Sovereign ten yield bonds:

- US ten-year: 1.93%

- UK ten-year gilt: 1.52%

- Germany ten-year bund: 0.18%

- Japan ten-year bond: 0.32%

- Australian ten-year bond: 2.38% (remember the cash rate is 2.25% and all front end over the curve bond in Australia is well below the cash rate)


On the equity front, the banks continue to look like a cash cow with yields as they stand:

- CBA net yield: 4.35%; gross yield: 6.22%

- WBC net yield: 4.58%; gross yield: 6.55%

- ANZ net yield: 4.88%; gross yield: 6.94%

- NAB net yield: 5.05%; gross yield: 7.21%

- TLS net yield: 4.6%; gross yield: 6.68%

- WES net yield: 4.8%; gross yield: 6.88%

- WOW net yield: 4.79%; gross yield: 6.84%
 

Conclusion:

Right now, you can’t fight the momentum that is the yield trade – the central banks want money in the equity markets for the wealth effect it creates. Yields will be continuously bid as they continue to pay rates well over the cash rate despite the risk to capital erosion.

All signs for FY15 point to higher equity prices and an ASX above 6000 points. The risk is the disorder that will come if the lofty expectations are not met.
 

Ahead of the Australian open

It’s a quiet week ahead for macro announcements, there will, however, be several Fed members giving speeches and these may create a bit of a stir if they go against what was released on Thursday

Based on the close of the futures market on Saturday, we are calling the market higher by 34 points to 5985 as global funds flow into yield plays across the world.

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