In a practical sense, term deposits represent the risk-free rate for investors, and therefore the yardstick against which other investments can be assessed.
From the early 1990s until the Global Financial Crisis (GFC) in 2008, the dividend yield on Australian shares oscillated between 3 per cent and 4 per cent.
During this period, risk-free term deposits paid investors rates ranging from as high as 8 per cent to around the mid 4 per cent range.
Significantly, term deposit rates were almost always above the dividend yield on shares.
This makes sense. After all, the dividend yield on shares makes up only part of their return, whereas the interest rate paid on a term deposit represents the full extent of its generosity.
Then the GFC hit. Share prices fell and, at the same time, interest rates were cut.
Dividend yields spiked but then settled into a fairly steady range of 4 per cent to 5 per cent.
Following the shock of falling prices through 2008, share market investors were demanding a higher return in compensation for additional risk.
Interest rates on term deposits, however, continued to fall.
So we went from a situation where term deposits rates were typically higher than the dividend yield on shares, to a new normal of the exact opposite.
Share market investors demanded an income return of more than 4 per cent, with capital growth thrown in on top, while others begrudgingly accepted ever-decreasing returns on their “safe money” invested in term deposits.
Today, term deposit rates are less than 2 per cent.
If the Australian share market valuation had adjusted in line with this decline to pre-GFC levels, the dividend yield on shares should be about 1 per cent to 1.5 per cent.
However, perhaps the differential between risk-free term deposits and share market dividends was wrong prior to 2008.
Let’s find a sensible middle ground. Rather than term deposits rates being greater than dividend yields, the two being roughly equal would seem to hold some logic.
As shares produce capital growth in addition to dividends, equity investors are getting a greater return than the term-deposit investors, appropriately reflecting the increased risk (volatility) the share investor is taking on.
On this valuation basis, Australian shares should be producing a dividend yield of about 2 per cent.
To achieve this yield – a rate reflective of the global return landscape we are now in – our market certainly has room to go higher.
The investment universe has changed. The world is awash with money. We have too much savings and not enough investments to absorb them.
Low interest rates are making equity assets more valuable and investors have only just started to catch on.
Paul Benson is a financial planner and creator of the podcast Financial Autonomy.