Interest rates and monetary policy can be a controversial topic. The old school thought of lowering interest rates to grow an economy is still practised today. The idea is that, as money becomes cheaper, it creates an incentive to spend.
But for reasons unknown to central bankers, the rule hasn’t worked well so far. Developed economies are in a period of low interest rates. And at the same time, inflation among developed economies remains low.
The Reserve Bank of Australia (RBA) pushed rates to an all-time low in August this year. The decision was encouraged by low inflationary levels and a high Aussie dollar. The cash rate now remains at 1.50%. Now the question on investors’ minds is, will they be pushed down further?
Monkey see, monkey do
Compared to other developed economies, Australia has a relatively high interest rate. The US has rates set below 0.5%. Europe and Japan even have negative interest rates. Compared to these nations, an interest rate of 1.50% is pretty high.
However, if inflation doesn’t pick up, we could see another interest rate cut. But a decision to lower interest rates might do more harm than good. Every time interest rates are lowered, it gives the Australian share market a little kick.
Investors are already worried about the price of equities getting out of hand. Stubborn inflation could prompt the cash rate to fall even lower. If we’re not careful, we could end up in the same situation as Europe or Japan, having to pay to keep money in the bank.
The RBA’s newest governor, Philip Lowe, has tried to reassure investors. Lowe stated that RBA policymakers were not ‘inflation nutters.’
Yet how else can the RBA stimulate the economy if not by monetary policy? It is their main tool, alongside what they tell markets, in affecting asset prices.
The International Monetary Fund recently forecasted Australia’s growth for 2017 at 2.7%. This was below the RBA’s 3% target. Lowe might not believe RBA policymakers are inflationary nutters. But underperforming growth might be the right excuse to lower rates.
Deflation is a much scarier thought than fuelling an asset bubble in central bankers’ minds. One reasons why is because deflation is incredibly hard to shake off.
What happens now?
While talks of an asset bubble rage on, valuations are as you might think. The price-to-earnings (P/E) ratio of the market is hardly at record levels. This ratio can be used as a general rule to see how much investors are paying for earnings.
Therefore, if the ratio is historically high, then investors are paying more for the current earnings of the market. If the ratio is low, historically, then investors are paying less.
As you can see from the graph below, the market’s P/E ratio has increased since March 2016. It’s currently sitting at a value of 17-times earnings. But this isn’t a major cause for concern. When compared to the eve of the Dotcom bubble, the market’s P/E ratio was at an all-time high of 23.29-times.
Source: Market Index
But if this ratio continues to trend up, we could very well be in for a correction. Yet even a market correction shouldn’t worry you too much. Your investment strategy should be tailored so you can profit when the market is either bullish or bearish.
I’m not talking about defensive stocks. Rather, I’m taking about a system that will take your emotion out of investing. One of the main reasons investors lose money in the market is because of emotions.
Their positions take a hit and they panic. Before you know it, they’re out of the market with nothing but losses to show for it.
The solution to this problem isn’t to wait until you make a profit. The solution is to have a plan before you enter the market. Know when you want to get in, and when you want to get out. Set stop-loss orders to help reduce your losses and let your winners ride.
The number one rule is to not lose money in the market. Of course, this is easier said than done. But if you have an attitude of always trying to cut losers then you’ll likely be a happier investor in the long run.
Junior Analyst, Money Morning
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