In this note we will summarise our investment asset class views for the year. In a separate note we continue with themes we believe are relevant in our considerations for markets in the years ahead. Our first report is available on our website entitled ‘Investment Themes for 2014 dated 24/12/2013’
It is unlikely the strong performance from equities of the past year will repeat into 2014. In 2013 investors were prepared to pay higher equity valuations due to the increasingly difficult environment for interest rate related assets. Further, confidence in economic growth through the year has been rising as the combination of US housing and consumption, European resilience and revival in China took hold. While corporate earnings may have grown at only a modest pace, there have been few problems or major disruptions.
As markets present today there is some downside risk due to the extent of valuation expansion. However, through the year we anticipate a rise in earnings forecasts reflecting leverage to sales (yet to occur), country specific outcomes such as currency benefits in Japan and Australia, improved financial conditions in the UK and Spain, continued new product development (IT and Industrial companies) and restructuring through write-downs, asset sales and demergers. These are expected to be idiosyncratic drivers compensating for valuation.
A selective approach should do better than an index, though we prefer to balance between the two as managers in recent years have had a patchy record of keeping pace with the changing market conditions.
Australian equity markets are similarly in transition, with the major sub-segments at different stages of evolution.
– Resource companies are vulnerable to selloff if and when the iron ore price gives ground as widely forecast. This is partially redeemed by the prospect of free cash flow through the next few years, even in the event of lower commodity prices.
While there are trading opportunities in the mid and small cap resource stocks, we prefer the large caps where the cash flow is most likely to be returned to shareholders.
– Bank stocks are on solid foundations with low bad debts, modest stable credit growth and the opportunity of cost reductions. Yet capital growth is compromised by the new capital regulations, expectations of a modest credit cycle and high dividend payouts.
We are comfortable matching the high proportion of the financial sector of the ASX200 in domestic portfolios due to relatively attractive distribution yields and low current operating risks. A sharper than expected rise in interest rates is the major risk.
– Industrial companies are a mixed bag. In our view the major opportunities lie in a select number of companies (1) where long term options for earnings can be identified (recognising that this invariably has execution risk), (2) companies which will be willing to transform their businesses by shedding assets which are not core and (3) stable income generators.
We recommend overweight allocation to industrial companies with a mix of defensive companies and longer term growth options.
While many global mandates argue to underweight Australia, we believe the dividend and franking benefit for private investors justifies a more passive allocation approach. If sufficient evidence arises that domestic demand is due for recovery, a short to medium term weight towards companies with leverage to this cycle can be considered. In our view the corporate sector is likely to undertake significant structural change through the year, offering some opportunities, but in reality most see much greater growth potential elsewhere, as recently indicated by moves from Brambles, Amcor, Westfield Group and Fox to focus on their global businesses.
The consensus view is that the US market is currently fully valued, especially given the likely progression of interest rates as well as high profit margins. Nonetheless the US should remain the single largest regional allocation given the predominance of growth companies and proactive balance sheet management. Outside the normal risks, it is possible the US feels the impact of a psychological blow if some of the well-known tech companies with limited or no earnings are sold off.
Investment banks and fund managers have recently increased their holdings in Europe, on the basis that 2014 represents a year of recovery from the distressed financial conditions of 2-3 years ago. Valuations and earnings recovery form a relatively appealing background for stock selection across Europe.
Japan is generally favoured, and we have detailed the outlook for this country as part of a discussion on issues we believe will be important in 2014. Emerging markets are seen as lagging, at least in the early part of this year, with weaker growth momentum, difficult financial conditions, high dependence on commodity markets and state intervention in a number of large listed companies.
The risks to equity performance lie clearly with earnings growth but also policy and politics. In Australia, a sharper than expected fall in commodity prices and an unresponsive domestic sector would result in a much weaker outlook. The US has to weather a rise in rates even with a relatively narrow economic recovery. Across Europe, Portugal and Italy have systemic financial risk and the unsettled political landscape cannot be ignored. The challenge to Japan is arguably greater now that it has embarked on an aggressive new path than previously, where reigning conditions could have been expected to persist.
We recommend a moderately overweight allocation to equities. In terms of regional allocation, we recommend slightly underweighting Australian equities relative to global equities, based on each investor’s benchmark. While Australia should form the core holdings for income and commodities, the growth component of the equity portfolio should be focused on the global allocation. A degree of opportunistic realisation of very high valuation holdings and picking up selected stocks which lag, or are sold off due to short term news flow, may suit active accounts.
Cash, Bonds and Credit
The interest rate markets have been primed for a change in direction since the Fed indicated its intentions to reduce its asset buying programme in May 2013. Broadly based fixed interest indexes therefore delivered one of their weakest performances in some years. Low rated and high yield credit has held up well as benign corporate activity, improving fundamentals and a desire for income drew investors into this asset sub-segment. Note that investors in global fixed interest are likely to have received higher returns than the index due to the carry from the currency hedge, thereby picking up the interest rate differential between Australia and elsewhere.
Domestically, the base case is that the official rate will be on hold for some time. Local bond yields are therefore likely to mark time until eventually resuming their upward move, tempered by an already steep yield curve. Semi government bonds are relatively attractive. In domestic credit, the narrowing spread to bonds has largely run its course and most credit managers have moved to 5-7 year maturity bonds to capture income returns.
For the time being we recommend investors stay in short dated instruments even with low return, alongside floating rate securities. The listed bond and hybrid market has many attractive features, though we note that it is critical to discern amongst those on offer, in particular paying attention to features which may result in a significant change in capital value. Short duration (or low interest rate sensitive) managed funds provide a useful portfolio position with a better yield than deposits, as well liquidity.
We anticipate that by mid-year the interest rate market may well offer a more attractive medium term investment proposition. Fixed income allocations remain critical to reduce portfolio volatility and support income, given equity distributions are potentially always at risk.
Global fixed interest was a highly rewarding proposition prior to the Fed’s tapering call. The fall in yields and narrowing spreads in credit, alongside the capacity to pick up the interest rate differential between Australia and global market through the currency hedge, provided highly attractive investment returns for some years. These conditions are no longer available. However, we are of the view global fixed interest can play an important part in portfolios but will require a flexible approach, which can move quickly between the diverse components of the market as well as regional allocations. This is best achieved through a fund manager.
In the event low inflation remains a feature, moderate economic growth unfolds and the corporate sector sustains conservative balance sheets, corporate credit could offer solid returns with low volatility for some time.
As with Australian fixed interest assets, we believe conditions in the second half the year will provide greater stability and for the moment we recommend low allocations to global strategies.
Deposit and cash rates will remain low, in our view and therefore yield low returns. However at times we believe a higher short term cash allocation is appropriate when market valuations appear at risk or if investors have high equity allocations and are willing to temporarily sell down holdings in order to take advantage of any pullback. Cash historically has only outperformed other asset classes in the event of a sharp rise in rates, which we consider highly unlikely at this time.
Other assets classes
In our view investments such as unlisted property, commodity funds, hedge funds and private equity are best dealt with through an individual approach, rather than across a wide range of different investors. We are therefore reluctant to make a recommendation in a broad research note such as this. In the past year hedge funds, in particular, have performed relatively poorly due to strong equity markets as short strategies have generally not worked well. In the event of sideways or low return markets, such funds are more likely to achieve adequate returns.