The Fed has pleased Wall St by again saying they are in no great rush to raise US interest rates. US Fed Funds Futures now point to the first US interest rate rise in October, a full six months from today.

Rate outlook

This year, 24 central banks have cut rates and the Fed is pushing out its cash rate raising timeline (again) mainly due to US dollar strength. That means for the next six months, the monetary policy taps are turned on fully globally and the effect on risk asset prices will be material, as I have been writing.

Let’s start by reminding ourselves of current first world cash rates and bond yields.

You can see the effect on risk asset prices of liquidity pumping. The dash from cash is accelerating globally, with anyone who relies on investment income to live basically forced into equities.

There remains absolutely no doubt in my mind that the cash rates and bond yields we see in front of us today will continue to lead to equity dividend yields being bid down, leading, inversely, to further capital gains in the right equities. That is why, twice already this year, I have lifted my ASX200 trading range (currently 5700-6200) on the basis of global and domestic demand for high equity dividend yields.

Not only is demand for equity yield increasing, the corporate world is paying out a greater proportion of earnings as dividends. Payout ratios are rising, which is leading to a double-whammy re-rating of predictable dividend stream equities. I have written it numerous times before, in fact, I was the first to ever write it in relation to Australian banks and Telstra, but I am convinced for the medium-term that any equity with bond like characteristics is going to be priced like a bond: i.e. inverse to its yield.

That strategic thesis is proving right and I am going to stick with it despite all the howls from equity valuation purists. My view is we have never seen cash rates and bond yields this low, so there is no historic playbook to what comes next. Historic valuation and share price target setting approaches are somewhat obsolete, perhaps even dangerous in the short-term, in a world where central banks are so dominant. My job is to predict how investors react to macro settings and how and where capital will flow.

All the major central banks continue to embrace zero interest rates and either existing, or new, QE polices. As a result, in a low interest rate, low return environment, where cash continues to be undermined as an asset class, I expect equities will continue to outperform as an asset class, and yield will command a premium. As a result, I continue to recommend investors buy fully franked dividend yield.

Pullback play

It’s also worth noting that the bottom of my upgraded ASX200 trading range (5700-6200) held during the recent Wall St and ex-dividend pullback. The ASX200 saw a low of 5748 and has bounced 150 points since, led by anything with a reliable dividend yield and despite resource stocks going backwards. In my view, this bounce from 5748, led by yield stocks, confirms that a wall of cash underpins Australian equities and that unsatisfied wall of cash will be put to work in Australian equities with the right income attributes over the months ahead.

Domestic and global rotational money is now targeting Australian sustainable yield equities in a world where fixed income yield above 0% real is almost impossible to find. I remain of the view that we may all be surprised how low equity dividend yields get bid down to in the months and years ahead as the world hunkers down into an extended period of ultra-low cash and bond rates.

The good ideas

My high conviction yield compression ideas remain:

Major banks

• ANZ (ANZ)
• National Australia Bank (NAB)
• Westpac (WBC)

Regional banks

• Bank of Queensland (BOQ)

Non-bank dividend growth

• AMP (AMP)
• Automotive Holdings (AHE)
• APA Group (APA)
• ASX (ASX)
• Auckland Airport (AIA)
• Challenger (CGF)
• Goodman Group (GMG)
• GPT (GPT)
• IAG (IAG)
• IOOF (IFL)
• Medibank Private (MPL)
• Perpetual (PPT)
• Sydney Airport (SYD)
• Transurban (TCL)
• Suncorp (SUN)
• Tabcorp (TAH)
• Telstra (TLS)
• Wesfarmers (WES)
• Spark New Zealand (SPK)

The bank view

Today, I want to revisit the National Australia Bank (NAB) investment thesis as we head towards the 1HFY15 reporting and dividend season for the Australian banks in May.

Let me just start at the top down level regarding Australian banks. I see some of my strategy competitors have moved to “sell” recommendations on Australian banks. Personally, I think that is massively premature.

Australian cash rates are at record lows and heading lower. Back on the 20th of January I UPGRADED the Australian bank sector and reverted to using 5.00% fully franked FY15 yield based share price targets for the majors. AGB 3yr bonds were 2.07% back then and the cash rate 2.50%. The table below was from that Jan 20th note.

Click here to view larger image

Fast forward to today and CBA and Westpac have exceeded those 5.00% fully franked FY15 yield based share price targets and ANZ and NAB remain below them. In fact, CBA’s FY15 yield has been bid down to 4.52%, making 5.00% fully franked targets for ANZ and NAB seem highly achievable in the not-too-distant future.

The self-fulfilling virtuous circle of bank equity demand in an ultra-low interest rate environment™

National Australia Bank

At current prices I think NAB is the best total return buy of the big four Australian banks. It has the greatest scope for P/E re-rating and greatest scope for dividend growth and in turn, dividend yield compression.

Let’s not over-complicate this: NAB’s two decades of “diworsification” is ending. Yes, that’s my term, “diworsification”.

On that basis, I believe NAB’s two decades of share price underperformance vs. its peers will end.

New CEO, Andrew Thorburn, is moving at pace to shed underperforming, low return on equity (ROE) businesses. His is physically taking the noose off NAB’s share price neck.

Since he has taken the helm, it’s pretty clear the UK banks are on the chopping block, Great Western Bank is going, and MLC will be sold. That will return NAB to its rightful place in the cosy Australian major bank oligopoly, where consistent dividend growth is generated.

Interestingly, NAB shares have broken the 10yr downtrend since Thorburn started talking sense (from the first day he took over). However, they remain well below the all-time high of $44.84

Outlook

Let’s now look at what I forecast for NAB for the next two financial years. Multiples are based off last night’s NAB closing price of $38.38.

It’s worth noting my all-important dividend forecasts are ahead of current consensus for both FY15 and FY16. I forecast 210c fully franked for FY15, the market is currently @205c fully franked, while for FY16 I forecast 228c fully franked, and the market is currently @212cff. I am happy to back NAB’s ability to pay above market dividend forecasts as non-core assets are shed at pace.

I believe the market will eventually bid NAB down to a 5.00% fully franked FY16 dividend yield, as the company simplifies and lifts its ROE.

On that basis, and as I believe Australian cash rates will move lower over the next two years, I am setting a 2-year price target on NAB of $45.60 (228c ÷5%).

I believe you can buy and hold NAB for the next two years and collect a total of 438c fully franked in dividends, or 625c grossed up. I also believe there’s the potential for $7.60 of capital gains, taking the prospective pre-tax total return to $13.85, or 36.4% over the next 24 months.

Even if I am wrong and there is no capital gain, the grossed up 2yr yield of 16.4% is massively compensating you for equity risk versus a likely cumulative cash rate over that period of 4.00% and AGB 2yr bond yield of 1.82%.

That yield could also be potentially enhanced by a tactical covered call option writing over ex-dividend periods.

NAB’s “diworsification” cost all shareholders relative and absolute performance: NAB’s “simplification” will drive a recovery of lost share price performance

NAB remains a core high conviction buy with a 2-year price target of $45.60

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.