Why are sharemarkets performing so strongly and will the upward momentum continue? This is the major dilemma facing most investors.

The answer to the first part is simple, investors have become more confident and they are looking to sharemarkets for yield.

The story of the last few years has been fairly consistent. Governments and central banks have been determined to avoid a major economic depression and this objective has been largely achieved, mainly through money printing and low interest rate policies.

Interest rates around the world are at very low levels, particularly official central bank rates.

For example, the official Bank of Japan rate is only 0.1 per cent, 0.25 per cent in the United States, 0.5 per cent in the eurozone and also 0.5 per cent in the United Kingdom.

Australia and New Zealand, with 2.75 per cent and 2.5 per cent respectively, have two of the highest official central bank rates in the Western world.

Official central bank interest rates are the basis for all other rates and, as a consequence, most global interest rates are exceptionally low.

Ten-year Government bond rates, which usually offer the lowest-risk investment, have fallen dramatically over the past 12 months as follows:

• Greece’s 10-year Government bond rates have plunged from 29.1 per cent a year ago to 8.7 per cent this week.

• Portuguese 10-year rates have fallen from 12.4 per cent to 5.2 per cent.

• Spanish rates have declined from 6.2 per cent to 4.2 per cent over the same 12-month period.

• Irish 10-year Government bond rates have eased from 7.5 per cent to 3.5 per cent.

Investors who purchased these securities 12 months ago have been well rewarded.

The decline in European 10-year government bond rates demonstrates that investors are feeling much more relaxed about the European and world economic outlook.

These drops also demonstrate that investors are finding it more and more difficult to obtain reasonable returns from fixed-interest securities and deposits.

This is why sharemarkets have performed so strongly.

When investors feel more comfortable about the economic outlook they are more willing to take risks and look at sharemarkets, particularly when interest rates are low.

This is particularly true in Europe where the Athens stock exchange has surged 102 per cent over the past 12 months, the Madrid stock exchange is up 34 per cent over the same period, Paris by 38 per cent and Dublin by 37 per cent.

These figures demonstrate that the best time to buy shares is often when the economic environment is particularly gloomy.

The NZX has appreciated by 31 per cent since May 2012, the ASX by 33 per cent, Tokyo by 72 per cent, New York’s Dow Jones Industrial Average by 26 per cent and London by 33 per cent. At the other end of the spectrum is the Chinese market, as measured by the Shanghai Stock Exchange Composite Index, which is down 1 per cent over the past 12 months.

Sharemarkets are appealing because most of them are offering attractive dividend yields compared to 10-year government bond rates and bank deposit rates.

Shares are riskier than government bonds and bank deposits but listed companies that have survived the global recession are mostly in a sound financial position.

A high percentage of listed companies have strong operating cash flows and balance sheets and, as a consequence, directors are responding to shareholder demands for higher dividends.

New Zealand and Australia are attractive from a dividend yield point of view. The NZX has an historic dividend yield of 4.6 per cent and the ASX 4.3 per cent.

The NZX’s 4.6 per cent average dividend yield compares with one-year bank term deposit rates of 4.2 per cent for the four major trading banks.

But it is important to note that most of the New Zealand dividends are fully imputed, and non-taxable in the hands of investors, whereas interest on deposits is taxable.

Inflation is one of the most important economic statistics at present because as long as price rises remain subdued then central banks have little incentive to start raising interest rates again.

The recent news in this regard has been positive. For example:

• The inflation rate in New Zealand was only 0.9 per cent for the March 2013 year compared with the Reserve Bank’s target of 1 per cent to 3 per cent. The Treasury is expecting the inflation rate to remain at 2 per cent or below between now and the March 2016 year.

• Australia’s inflation rate is 2.5 per cent.

• Inflation in the United States is just 1.1 per cent.

• European Union inflation is only 1.2 per cent with 23 of the 27 countries recording annual Consumer Price Index (CPI) increases of 2 per cent or less.

Japan is the standout as far as low inflation is concerned as the country’s CPI has been declining for four consecutive calendar years.

There are a number of reasons why there could be a sustained period of low inflation. These include:

• Labour-saving technologies have reduced costs.

• Union militancy has dissipated, particularly as far as wage increases are concerned.

• There has been a massive increase in the production of goods and services and this has led to some oversupply.

• More competitive marketplaces have made it difficult for suppliers to raise prices.

• The mass production of cheap consumer goods in China and other Asian countries has kept a lid on prices.

• Technological advances have seen the price of some products, particularly telecommunications and electronics, drop sharply.

• A significant reduction in import duties and tariffs has created more import competition and put pressure on high-cost domestic producers.

• Strong currencies, particularly the New Zealand and Australian dollars, have also helped put downwards pressure on prices.

• High house prices in New Zealand have meant that a high percentage of income is committed to meeting interest payments instead of being available for consumption.

• Better price discovery, mainly through the internet, has enabled consumers to identify the cheapest products.

• The demand for consumer products declines as society ages.

On the other hand, there is a strong argument that money printing will inevitably lead to higher inflation but there is little sign of this happening in the immediate future.

Ryan Air is a good example where low costs, low inflation and strong share market performances converge.

The budget carrier, which has the lowest European airfares by a wide margin, reported record net earnings of €569 million ($909 million) for the March 2013 year and forecast net earnings of between €570 million and €600 million for the current year.

It also paid dividends of nearly €500 million, or €0.34 a share, during the March 2013 year.

The company’s share price, which has surged 68 per cent over the past 12 months, traded at a record closing high of €6.76 after this week’s result.

Ryan Air has shown that low-cost producers can continue to reduce prices while still producing strong sharemarket returns in an extremely tough economic environment.

It is difficult to predict how sharemarkets will perform over the remainder of the year but the combination of low inflation, low interest rates and strong company balance sheets are encouraging.

However, investors should keep a close eye on the inflation outlook and central bank monetary policy statement because any dramatic change in these variables is likely to have a negative impact on investor sentiment and sharemarket performances.

Brian Gaynor

Portfolio Manager