Quarterly Market Review June 2014

         Indications are that global economic growth will be subdued for some time.

– Global outlook remains respectable, but low growth.

– Inflation to date has been muted, indeed too low. Employment growth is the best indicator of likely interest rate trends.

– Differential interest rate and monetary policy emerging.

– The outlook for the second half of the calendar year looks better. Inflation is expected to trend modestly up, China undertake some stimulus and the US improve on a weak start.

– Australian economic momentum is captive to the housing cycle and better than expected export performance. The breadth of activity however is low.

– The major risk is the degree and nature of leverage in many regions such as Chinese non-bank lending, European financial system, pockets of US consumer debt and locally the persistence of high household debt.

Longer term structural step changes in energy, demographics and data use offer growth opportunity.

          Central banks are key to asset class performance…

– Central bank guidance and expectations of monetary accommodation continue to have the greatest influence on fixed interest and equity assets.

        …currently favouring equities…

– Equity and bond flows are now evenly paced showing low conviction either way.

– Within global equities, the European market remains favoured due to valuation and earnings upside from a low base, while value sectors such as utilities have outperformed against the sell-off in consumer discretionary and small caps.  We recommend building European allocation to global equity benchmark (circa 25%). For risk tolerant investors we recommend incremental addition of emerging market funds due to their attractive relative valuation.

– We are neutral on Australian equities. Modest earnings momentum faces relatively high valuations and we recommend very selective addition with patient expectation of gains.

         …over fixed interest.

– Fixed interest presents unique challenges at this time. With interest rates highly likely to track higher in coming years, albeit in an inconsistent pattern, the risk of capital loss is elevated. Our bias is therefore towards securities with low sensitivity to interest rate moves (short duration and floating rate). However an underweight buffer in investment grade credit is recommended to reduce portfolio volatility.

The A$

         In our view the A$ is overvalued contributing to difficult domestic conditions.

We rarely come across investment professionals who do not instinctively feel that the A$ is overvalued. The cost of many global goods and services, if translated at the current exchange rate, is an indicator. At an economic level, the wage rate in Australia as compared to other developed nations is at the present A$ rate. Within GDP however, the labour share of the economy is not excessively high at about 60%, in line with the UK, US and Canada and below the OECD average.

A number of economists are moving to the view the A$, while still expected to fall, will stabilise at a mid 80c range rather than fall more sharply. The key reasons are interest rate levels and differentials, better current account due to commodity volumes and subdued import prices and demand for safe haven currencies.

We are comfortable with the fundamentals of a higher A$ (compared to its longer term average), but also take the view the A$ does tend to move away from its assessed fair value, as was the case at 50c/US$ and $1.10/US$. It would therefore not surprise us to see the A$ move to 80c/US$ or even lower, especially if China’s growth path is well below par.

Our recommendation

          We recommend predominantly unhedged global equity holdings.

In periods of low equity return, currency movements can be disconcerting in unhedged portfolios. However we continue to believe the predominant weight in global equities should be unhedged given the likely medium term direction of the A$.

On inflation

        Central bank policies yet to influence the CPI…

From the commencement of the first intervention by the US Federal Reserve in the support of financial institutions to the near global phenomena of central banks becoming pivotal in asset markets, there has been a large and well regarded cohort of economists warning on the dangers of such policies.

Initially many believed inflation was inevitable; as time passed, deflation has become the possible problem. Apart from cyclical inflation due to food, energy and such like prices, the absence of higher prices lies with low wages growth. With services a predominant weight in developed country consumption, labour costs are the major input.

The potential for higher inflation should always be tested; as yet there is no evidence a portfolio should take out insurance against excessively high inflation..

On asset prices

        …but has had an influence on financial assets.

The impact of monetary settings on asset prices is more real. Housing, investment assets and infrastructure assets have all been supported by low interest rates. Indeed valuations are generally based off bond market yields.

Central banks have, to a large extent, welcomed higher asset prices as they can firstly, support consumption through the wealth effect and secondly, should attract new investment. However, both have not had the flow through impact central banks would have hoped for. In short, households have welcomed capital growth but remained highly conservative in consumption. Corporations have been undertaking capital management (buybacks and higher dividends), acquisition of other companies, but less inclined to large scale capital expenditure.

The question is whether the removal of support by the US Fed is a meaningful contributor to the weaker trend in investment markets this year.

In our opinion, the impact of the reduction in Fed asset purchases is somewhat overstated. Valuation in investment markets has reached a point where further upside is now much more limited. We are therefore of the view that investors should now be more certain of the specific attributes of any security, than rely on general momentum from flows seeking the next leg up.

Our recommendation

          In our view care should be taken not to rely excessively on low interest rates to support a portfolio.

We are therefore exploring specific situations, such as a longer term growth strategies, emerging free cash flow or asset realisation and encourage greater patience on behalf of investors as these merits take time to emerge.

Within fixed interest assets, we note the potentially secular change in interest rates. We prefer to advocate a portfolio specific consideration of assets in a fixed interest portfolio. This takes into account the income requirements of each investor, the structure of the equity holdings with respect to income generation, the time frame and the sensitivity to negative returns in any year.

On balance we are skewed to liquid, low interest rate sensitive holdings for allocations with high equity weightings, whereas we prefer bond and high grade credit for moderate or lower equity weight.

Our accompanying document, to be released Thursday 3rd July 2014, summarises some of the key principles which underpin asset allocation and influence our approach to recommended asset weights.

In this report we provide the historic and expected risk and return specific to the above asset allocation strategies.

The premise behind our recommendations is to prioritise preparing a portfolio to deliver over time, rather than predicting the near term. This is based on the probability of the conditions that may prevail, while acknowledging the uncertainty.

Investment Options
Our approach is to steer away from some of the typical asset allocation labels ascribed to portfolios, such as ‘conservative, balanced or aggressive growth’, and rather to focus on the intended outcome. A ‘conservative portfolio’ may imply a predetermined income requirement for some investors, whereas for others it may be the volatility, or chance of a negative return. As we note, each portfolio style requires some tradeoff.

Portfolio Styles

From the features above we have constructed a strategic allocation for each:-

Capital Preservation Portfolio

         Reducing the risk of negative returns is the highest priority. Stable income is a secondary aspect and capital growth can be compromised.

Income Portfolio

         Income generation is the highest priority. Prepared to tolerate a relatively high degree of capital volatility.

Capital Growth Portfolio

        Long term capital growth is the key. Prepared to forego income and tolerate higher volatility.

Summary Strategic Asset Allocation

Australian equities
The high weight of financial and resource stocks within the ASX200 concentrates risk and return in relatively narrow segments of the global economy. Further, the correlation between financial stocks and interest rates, where additional exposure is derived in fixed interest, should be considered. In our view the recommended weightings capture the benefits of the Australian equity asset class, without excessively narrowing the portfolio to these specific risks. We emphasise this is a structural feature and not a judgement on the potential of the asset class.

Global equities
Global equity returns, as measured by the MSCI All Country Index, can be heavily influenced by specific regional issues. We believe the industry diversity and thematic exposure for a longer term growth portfolio is best achieved through this asset class. While the correlation within the equity asset class is high (0.8 between Australian equities and hedged global equities), the unhedged global index has a lower correlation of 0.53 and therefore offers portfolio diversification.

Australian Fixed interest
The Australian fixed interest asset class is relatively narrow but has a higher running yield than most global markets.

Global Fixed Interest
Global fixed interest has substantially greater depth and diversity compared to the Australian market. Further, the interest rate environment is slowly becoming specific to the region again and should allow a manager to add value.

Other assets
We include an allocation to ‘other assets’ in recognition of likely investments held outside of those abovementioned. For example, these could include property (where held for investment purposes) and alternative fund managers. The recommended weighting is based on active strategies, however we would encourage investors to consider the implications to the risk/return profile of any other assets in the context of the overall portfolio.

       Historical returns should be viewed in the context of the economic conditions at the time.

Portfolio weights are established by weighing up historic evidence in conjunction with an understanding of what caused the returns in any period. Forecasts are therefore, in part, based on evidence from long term trends, as well as a judgment of the conditions expected to arise in the next 1-5 years.

The chart below encapsulates what we are aiming to achieve; a balance between the certainty of return (cash and fixed interest) versus the opportunity, yet high risk, of equity assets.

Distribution of annual return

Historic portfolio risk and return

The table below shows the annualised return from the major asset classes over the past 5, 10 and 15 years. The Standard Deviation represents the measured degree of volatility in annual returns (subject to one standard deviation).

For ‘other’ we have chosen to use a value which is not related to any particular investment. Managed alternative funds generally give uncorrelated returns averaging 7-8% with a similar volatility. For unlisted or private assets, we believe it is important to consider what the likely returns

We encourage investors to consider more than just the data to understand the circumstances which contributed to the outcome.

Annualised Return from Major Asset Classes Over the Past 5, 10 and 15 Years

Historic evidence of investment returns is fundamental to building an investment case for an asset class. However there are many complications for which we need to account.

       Returns are based on benchmarks and fully invested portfolios.

– As we noted in our allocation principles report (to be realeased wednesday 3rd July), it is important to understand the benchmark on which the performance data is based. The portfolio returns assume one was fully invested and reweighted to stay at the allocation at all times and with all distributions reinvested.

– Indices are the industry standard. However in certain asset classes it is likely few individual investors will have holdings which approximate the index. Fixed Interest is the best example with the Australian Composite Bond Index predominantly compring government/semi government bonds and selected corporate bonds, all fixed rate.

       Time frame and starting base has a significant impact on historic data.

– When taking into account the historic returns, the time frame and starting base can have a major impact on the data presented. For example, as can be seen from the table below, if viewing 10 year annualised returns from the equity markets, an investor would have observed substantially different outcomes for each of the past four decades.

Annualised Return over decades

          Australian equity returns in context.

It is relatively easy to support the performance of any asset class with respect to its relative performance by moving the time frame in which the data is taken. In recent years investors have sometimes questioned allocations to global equities pointing to the significant outperformance of Australian equities since 2000.  However, it is only the last decade Australian equities have meaningfully outperformed global indicies.

         Fixed interest returns from unique period of falling rates.

Similarly, fixed interest returns achieved during periods of substantial falls in interest rates occur periodically, such as from the 1988-1992 and again from 2008-2012. For those presented with evidence the Australian bond index has achieved an annualised 8.5% return from 1970-2013, only marginally below equities, may come to a different view on asset allocation to those who see the figures for the last 10 years of 6.8%.

Estimated returns over coming 3 years

In assessing return potential we recognise the structural aspects of each asset class that can add to investment returns.

Return estimates, annual over rolling 3 year periods

Structural elements include:-

          Asset classes have specific features which influence weighting and return potential.

– For the Australian S&P/ASX200, dividend franking offers a unique return specific to Australian investors.

– The hedged return from global assets is relatively poorly understood, but can add a meaningful proportion. In short it is the differential between domestic and global interest rates captured through the pricing in currency markets which creates the hedging.

– Interest rate indicies are almost entirely fixed rather than floating rate, whereas most investors have a component of floating rate.

– Alpha is the ability of an asset class to achieve returns above the underlying index, essentially the outperformance an investor should look to achieve through active management. In equities the capacity to outperform the index is higher than in fixed interest, in unhedged global equities we have allowed for active currency management for additional returns. While higher alpha is possible in fixed interest, it invariably means taking on more risk than we believe is appropriate to this asset class.

Forecasts; how accurate can they be?
In our view the predictability of investment returns is overstated. Timely to this argument was the 2013 Nobel Economic Prize which was awarded to recipients who have addressed this issue. The Efficient Market Hypothesis of Fama purports that the prices reflect all known information and therefore in the short term excess returns are unpredictable and unattainable. Schiller conversely provided evidence that selected ratios could guide on the likely direction of markets, in particular for equities the CAPE ratio (cyclically adjusted price to earnings), which is now often cited as evidence of a valuation cycle.

We will not labour on these academic debates. However it is important to appreciate that the return profile of assets, and therefore a portfolio, are our best estimates of what we think is likely.

The chart below shows the range of annual returns from the ASX200 since 1990, from -38% in 2008 to 66% in 1993 and with an (above long term) average of 11.6%p.a.

ASX 200 annual return range 1980-2013

The conditions which determined this outcome varied considerably over that period – exchange rates, interest rates, commodity prices. One we will note is inflation, which averaged 4.2%pa. This implies that the real return was in the order of 7.4%.

In providing guidance on investment returns, the key behaviour we make every effort to achieve is to be consistent: our assumptions on the fundamental drivers such as interest rates, economic growth, etc. will apply to each asset class.

Influences on investment market conditions; a quick history
In the decade prior to the late 1980’s, the high inflation, coinciding with the oil crisis, resulted in volatile interest rates and low return investment markets. Indeed after inflation, real returns were negative through the 1970’s.

By 1988 falling interest rates and therefore high bond market returns from capital appreciation, correlated with similarly high returns from equities. The key reason was the inflation mandate of most central banks which allowed interest rates to reduce in line with a much more stable and predictable CPI.

However by the late 1990’s this had run its course and in the following 15 years interest rates once again played the role of dampening or encouraging economic momentum and the correlation of bond and equity markets became notably negative.

Bond-Equity return correlation