In the twinkling of an eye, volatility has suddenly returned to world stock markets, impacting on Australian shares, with the ASX 200 in danger of slipping back below 6,000.
While you could blame trade wars, elevated valuations and that we are overdue a stock market correction, the real reason markets are falling is because the return on risk-free assets is looking attractive again.
Specifically, I’m talking about the yield on US 10-year bonds. Right now, you can buy US government bonds and earn around 3.2 per cent on you money, virtually risk-free.
That 3.2 per cent return looks attractive when compared to investing in shares, which is the alternative.
Many Australian investors will roll their eyes when reading about US bond yields, given we’re highly unlikely to invest directly in such an asset.
But it does impact Australians in at least 3 ways…
- Rising US bond yields, and the increasing gap between the equivalent Australian bond yield, shows up in a falling Aussie dollar.
- Australian banks are reliant on offshore funding, and rising US bond yields mean the banks are paying more to borrow. This additional cost shows up in higher mortgage rates for Australian home owners despite the RBA cash rate being on hold at 1.5 per cent for 26 months in a row.
- US investors buy bonds, likely selling equities to do so, pushing Wall Street lower. Where the US share market goes, the ASX follows.
Here in Australia, if you shop around, you can grab a term deposit returning around 2.75 per cent for 6 months.
While that yield has nothing on the Commonwealth Bank of Australia (ASX:CBA) fully franked dividend yield of 6.2 per cent (or 8.9 per cent gross), unlike CBA shares, term deposits are risk-free. The CBA share price has fallen 10 per cent over the past 12 months, not something that happens with term deposits.
And you wouldn’t be faring too well in 2018 in many of the popular managed funds and index tracking ETFs either, seeing as the ASX 200 index has returned almost exactly 0 per cent so far this year.
Source: The Capital Club
By comparison to a flat stock market, you’d take a 2.75 per cent yield on a term deposit any day.
Hindsight is a wonderful thing, but you don’t get rich observing backwards looking charts. Nor do you earning 2.75 per cent on your money.
Looking ahead, budget for annualised returns from the blue chip ASX 200 index of around 6 per cent, on average, over the next five to seven years.
This is lower than the historical average of around 10 per cent because inflation is low, economic growth is low, and stock market valuations are relatively high.
The returns from small cap ASX stocks should be better, given their higher growth rates. Many leading small cap funds target annualised returns of around 10 per cent per annum, on average, over the medium to long-term.
Whilst this current bout of stock market volatility may make you nervous, it’s unlikely to be the precursor to a full blown stock market crash.
The reason why US bond yields are higher is because the global economy is growing nicely, not something that usually signals stocks are about to crash.
If you’re in the stock market, stay in, and add more money, slowly, steadily, and methodically.
If you’re out of the stock market, get in, gradually and regularly.
Invest with money you don’t need to touch for the next 3 to 5 years.
The rest, keep in the bank. A term deposit earning 2.75 per cent is not too bad when the RBA cash rate is just 1.5 per cent.