The Reserve Bank of Australia’s decision to cut the official cash rate last week – together with growing expectations it will cut interest rates further – has thrown the spotlight back onto yield plays in the Australian equity market.  Although financials have faced bearish investor sentiment in recent months, their still attractive yields and relatively cheap valuations suggest they remain an investment worthy of serious consideration.

Interest Rates Head South

After remaining on hold for exactly one year, the RBA surprised many in the market by cutting official interest rates to a historic low of 1.75% p.a. last Tuesday.  The rate cut came despite still positive signs for the local economy and instead reflected the much lower than expected March quarter consumer price index result, which saw annual underlying inflation drop from around 2% p.a. to 1.5% p.a.

The RBA acted because it did not see this inflation result as a “rogue” number, as evident by the fact it then substantially revised down its inflation outlook in its May Statement on Monetary Policy released three days after its policy decision.  The RBA now forecasts underlying inflation will hold at 1.5% p.a. until the end of this year, rising to only 2% p.a. by mid-2017.

These inflation forecasts are so low, markets are now pricing in (correctly in my view) at least one – and possibly two – further rate cuts over the coming year.  This is positive news for the economy: with inflation posing little threat at present, the RBA is following its mandate to use its interest rate weapon to ensure the economy grows at its maximum sustainable rate.

Declining Rates a Positive for Financials

The Australian financials sector (ex A-REITs) dominates the local equity market, currently accounting for around 35% of the market capitalisation of the S&P/ASX 200 Index.  Although a still popular source of dividend income for many investors, the sector has faced a barrage of negative news flow over the past year  – reflecting capital raisings, higher offshore borrowing costs, and rising bad debt provisions.  Indeed, the S&P/ASX 200 Financials Sector has generally underperformed the market since end-March 2015, declining in price terms by 20.6% to end-April 2016, compared with a decline of 10.8% for the S&P/ASX 200 Index.

That said, as seen in the chart below, the under performance of the sector runs counter to the general tendency of financials to outperform in declining interest rates environments. If this relationship holds into the future, it suggests the RBA’s recent rate cut – together with the prospect of more to come – could lead to improved performance by financials relative to the broader market.

The BetaShares Financials Sector ETF (QFN)