If a bank offered you 5% on a term deposit, would you take it?
With the average yield on the ASX currently at around 4%, for many, an offer like that would be too good to refuse.
Not only would the income be handy, it would also save a whole lot of worry. You wouldn’t have to sit there and stress about the future direction of the market.
Of course, you can’t get anything near 5% on a term deposit right now. It’s much more likely to be something like 2–2.5%. And you will have to tie your money up for up to a year to get it.
That’s why a swag of money has found its way into the stock market and stayed there. For many, the yields generated from our biggest blue-chip stocks is the only thing that helps them get by from month to month.
Not always the same
When looking at the current state of play, it’s easy to think that this is how it has always been. That is, that share yields should be higher than cash.
However, there have been times when the yield on term deposits not only matched share yields, but beat them by a margin.
You only have to look at the biggest stock on the market, Commonwealth Bank of Australia [ASX:CBA] to get the picture.
When the first tranche of CBA floated in September 1991, the bank forecast (and later paid) a total dividend of 40 cents for the following year. With an IPO price of $5.40, those that took part in the float enjoyed an initial (fully franked) yield of 7.4%.
On the face of it, a pretty handy return.
However, the cash rate at the time of CBA’s float was 9.5%. And that was a full 8% lower than where it had been less than two years prior. At the start of 1990, the cash rate was an eye-watering 17.5%.
Back then, term deposits generated 2–3 times the income compared to CBA’s dividend.
Some thought those that bought into CBA’s float to be bonkers. And it wasn’t only to do with yield. The full effect of the 1992 recession — which saw CBD property values collapse — had not yet found their way into CBA’s accounts.
Of course, those that did buy in to the CBA float have had the last laugh. If you’d invested in cash instead, inflation and dwindling cash rates would have eroded the value of your investment to a fraction of holding CBA shares.
A wall of worry
Yet with markets, there is always something to worry about. While investors are enjoying the current rally, all bull (and bear) markets eventually come to an end.
One big factor is interest rates.
What would happen, for example, if interest rates returned to anywhere near those levels we saw in the 1990s?
Back then, interest rates had a much bigger effect than they do now. Bank deregulation, high inflation and wanton speculation had boosted asset prices to unsustainable levels.
Ratcheting up rates to 17.5% cooled down an overheating economy. However, interest rates are the bluntest tool in the box — a swag of businesses went to the wall. Only when interest rates sharply fell did Australia emerge out of its recession.
Where are we now?
When the RBA raised rates in the 90s, the direct byproduct of businesses collapsing was a jump in unemployment. While inflation erodes the value and efficiency of the economy, high unemployment is what ultimately kills it.
The RBA knows that it couldn’t use such a blunt approach again, should it ever need to. Low wage growth, combined with higher rates and an uptick in unemployment, is what could trip the economy over.
A rise in rates — to even a fraction of where they were in the 90s — would see a sea of money flow out of equities and into cash like bonds. But, in doing so, the RBA knows that it would pull the rug out from under the economy.
That’s why the gap in yields between cash and shares will remain. Even if rates started creeping up — say a year from now — there is only so far the RBA could go before it knows that it could bring the whole lot crashing down.
Editor, Total Income